New Jersey Amends LLC Charging Order Rules - Foreclosure Is No Longer Available to a Member's Judgment Creditor
New Jersey Governor Chris Christie signed into law in January an amendment to the New Jersey LLC Act that eliminates foreclosure of a member’s LLC interest from the remedies available to a member’s judgment creditor. New Jersey Bill A4023. The Act continues to allow a judgment creditor to obtain a charging order, which is now a creditor’s sole remedy against a member’s LLC interest.
Background. State LLC Acts almost uniformly give an LLC member’s judgment creditor the right to obtain a charging order, which mandates that any distributions by the LLC that would otherwise go to the member be paid instead to the creditor. A charging order standing alone, however, will provide no benefit to a creditor if the LLC makes no distributions to its members.
Some state LLC Acts go further and allow a judgment creditor to foreclose on the member’s LLC interest, at least under some circumstances. E.g., Cal. Corp. Code § 17705.03. Foreclosure allows the creditor to sell the member’s interest outright, and the purchaser of the interest then acquires all of the member’s economic interest.
A creditor’s rights under a charging order are limited to satisfaction of the debt – once the judgment debtor’s obligation is satisfied, the charging order is extinguished. Foreclosure, on the other hand, results in a permanent transfer of the debtor’s economic interest. But even if foreclosure is allowed, the purchaser typically will not receive the member’s non-economic rights, such as management participation and voting, unless the operating agreement or a vote of the other members admits the purchaser as a member.
The New Jersey Statute. Prior to 2012, the New Jersey LLC Act authorized charging orders but excluded foreclosures: “A court order charging the limited liability company interest of a member pursuant to this section shall be the sole remedy of a judgment creditor, who shall have no right … to seek an order of the court requiring a foreclosure sale of the limited liability company interest.” Former N.J. Stat. Ann. § 42:2B-45 (2004). Many other states likewise narrowly limit the charging order remedy. E.g., Del. Code Ann. tit. 6, § 18-703.
In 2012 New Jersey adopted the Revised Uniform Limited Liability Company Act (RULLCA). RULLCA is a uniform law recommended by the National Conference of Commissioners on Uniform State Laws (NCCUSL). Consistent with RULLCA’s more flexible approach, New Jersey’s 2012 Act allowed foreclosure upon a showing that distributions under a charging order would not pay the judgment debt within a reasonable time. Former N.J. Stat. Ann. § 42:2C-43 (2012).
Once a state adopts a comprehensive, uniform statute such as RULLCA, there is usually some resistance to incremental changes. For one thing, such changes undercut the state-to-state uniformity that is a goal of laws recommended by NCCUSL. Nonetheless, in 2013 the New Jersey Business and Industry Association, and lawyers from the Real Property Trust and Estate Law Section of the New Jersey State Bar Association, supported an amendment that removed the foreclosure remedy for judgment creditors of LLC members. New Jersey Bill A4023 (Bill). The Bill restores the pre-2012 language with only minor changes:
A court order charging the transferable interest of a member pursuant to this section shall be the sole remedy of a judgment creditor, who shall have no right under 42:2C-1 et seq. or any other State law to interfere with the management or force dissolution of a limited liability company or to seek an order of the court requiring a foreclosure sale of the transferable interest.
Bill, § 6.
The principal reason the trusts and estates lawyers supported the change was (drum roll please) to restore certain estate and gift tax benefits. New Jersey State Bar Association, Capitol Report (Jan. 13, 2014). As explained by the Capitol Report, the estate and gift tax laws are based on the fair market value of transferred property, and restrictions on transfer reduce the fair market value of a member’s LLC interest and therefore reduce estate and gift taxes. Allowing foreclosure removes a transfer restriction and is therefore a factor tending to increase the interest’s fair market value and the estate and gift taxes. The Capitol Report also alludes to the reduced asset protection of LLCs if creditor foreclosure is allowed.
Comment. The idea that the impact on estate and gift taxes is a reason to eliminate the foreclosure remedy from an LLC charging order statute seems a bit like the idea that the tail should wag the dog. Not that I’m against reducing taxes, but the impacts of this change on creditors and on the asset-protection feature of LLCs are important and deserve more consideration than they apparently received here.
Delaware’s LLC statute authorizes the Court of Chancery to dissolve an LLC on application of a member “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” 6 Del. C. § 18-802. That’s well and good, but what if the LLC agreement says the members have no right to seek a judicial order of dissolution? Is that enforceable?
Last week the Court of Chancery said yes, it is. The court relied on the Delaware Act’s stated policy of maximizing freedom of contract, and ruled that an LLC member had no right to seek a judicial order of dissolution where the LLC agreement waived that right. Huatuco v. Satellite Healthcare, No. 8465-VCG, 2013 WL 6460898 (Del. Ch. Dec. 9, 2013).
Dr. Aibar Huatuco and Satellite Health Care (SHC) formed a Delaware LLC in 2007. Each owned 50% of the LLC, which owned and operated dialysis facilities in California. SHC managed the company and Huatuco was its medical director.
Dissension eventually reared its ugly head. Disputes between Huatuco and SHC arose over several loans to the LLC and loan guarantees by Huatuco, Huatuco’s role as medical director, and the LLC’s replacement of Huatuco as medical director. On April 18, 2013 Huatuco filed a complaint seeking judicial dissolution of the LLC, and SHC later filed a motion to dismiss the complaint for failure to state a claim.
The Statute. The parties agreed that whether Huatuco was entitled to judicial dissolution was governed by the interplay between provisions of the LLC agreement and the Delaware LLC Act’s authorization of judicial dissolution. Id. at *3.Section 18-802 states:
On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
The Agreement. The LLC agreement specified the events upon which the LLC could be dissolved, such as by a super-majority vote of the members. But the agreement did not mention judicial dissolution – it neither expressly provided nor waived a right to judicial dissolution.
The LLC agreement also contained a disclaimer: “Except as otherwise required by applicable law, the Members shall only have the power to exercise any and all rights expressly granted to the Members pursuant to the terms of this Agreement.” Id.
The Argument. SHC relied on the disclaimer and argued as follows: (a) the parties agreed to forgo any rights not required by law or explicitly granted by the LLC Agreement, (b) judicial dissolution is not a mandatory provision of the LLC Act and the LLC Agreement did not expressly provide a right to seek judicial dissolution, and (c) therefore judicial dissolution was unavailable to Huatuco. Id. at *4. Huatuco riposted that the disclaimer was being taken out of context, because it was embedded in a paragraph dealing with the members’ economic rights and therefore only applied to economic rights.
The court disagreed with Huatuco’s interpretation. The paragraph in question was captioned “Other Member Rights,” implying it was not necessarily limited to economic rights. More importantly, the disclaimer referred to “any and all rights” granted to the members under the Agreement, which would include other rights such as a right to seek judicial dissolution. The court therefore interpreted the disclaimer to mean that the members rejected all default rights under the LLC Act unless explicitly provided for in the LLC agreement. Id.
The court also pointed out that judicial dissolution is not a mandatory provision of Delaware law, citing R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, No. 3803-CC, 2008 WL 3846318 (Del. Ch. 2008) (upholding members’ waiver in LLC agreement of rights to seek judicial dissolution). The court explained that permitting waiver of judicial dissolution in an LLC agreement is consistent with the LLC Act’s broad policy of freedom of contract. “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18-1101(b).
Huatuco argued that as a matter of public policy the court should not deprive him of the right to ask a court for dissolution where no alternative exit options are available. The court dismissed that argument because he had some limited remedies under the agreement and because “[p]ermitting judicial dissolution where the parties have agreed to forgo that remedy in the LLC Agreement would … change in a fundamental way the relationship for which these parties bargained.” Huatuco, 2013 WL 6460898, at *6.
The court concluded that Huatuco had no right to seek a dissolution under Section 18-802, because a right to judicial dissolution is not required by law and was validly excluded by his LLC agreement. His case was dismissed.
Comment. Huatuco is consistent with R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC and is not a groundbreaking case. But these two cases exalt the principle of maximizing freedom of contract to new heights. Both focus on giving the parties the benefit of their bargain, but they ignore the key language in Section 18-802:
On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
6 Del. C. § 18-802 (emphasis added). Judicial dissolution is a remedy that is intended to carry out the purpose of the LLC agreement, not change it.
The need for a non-waivable judicial dissolution remedy has been recognized by the National Conference of Commissioners on Uniform State Laws (NCCUSL), in both the Revised Uniform Limited Liability Company Act (RULLCA) and the Uniform Limited Partnership Act (ULPA). (RULLCA has been adopted in eight states and ULPA has been adopted in 18 states.)
Instead of leaving the issue for later judicial interpretation, RULLCA and ULPA list their provisions that may not be waived by a limited partnership or LLC agreement, and both provide that an LLC agreement may not vary the power of a court to grant dissolution under the conditions specified in the statute. ULPA § 110(b)(9); RULLCA § 110(c)(7).
NCCUSL’s clear rules on non-waivability contrast favorably with the Delaware approach, which results in some uncertainty about the law until the courts resolve which sections in the LLC Act are waivable and which are not.
California’s new LLC Act becomes effective on January 1, 2014. The new act, the Revised Uniform Limited Liability Company Act (RULLCA), will completely replace the current statute, the Beverly-Killea Limited Liability Company Act (Beverly-Killea).
RULLCA was signed into law by Governor Brown in September 2012. The new law is based in large part on NCCUSL’s Revised Uniform Limited Liability Company Act, which has now been adopted in eight states. The passage of RULLCA brings California’s LLC statute more in line with the LLC laws of other states, which should facilitate interstate transactions.
The substance of RULLCA is generally similar to Beverly-Killea, but there are a number of significant changes. I describe some of those below, but my list is not exhaustive.
Operating Agreement. Beverly-Killea defines an operating agreement as any written or oral agreement between an LLC’s members as to the affairs and the conduct of the LLC. Cal. Corp. Code § 17001(ab). RULLCA goes further by allowing an operating agreement to be written, oral, or implied. § 17701.02(s). The significance here is that, subject to the limits of Section 17701.10, an LLC’s operating agreement can override RULLCA’s default provisions.
Manager-managed. In both the old and the new statutes an LLC is member-managed unless the proper steps are taken to establish it as manager-managed, but RULLCA changes the requirements. Under Beverly-Killea an LLC is member-managed unless the articles of organization contain a statement that the LLC is to be managed by one or more managers. §§ 17051(a)(7), 17150. Under RULLCA an LLC is member-managed unless the LLC’s articles of organization and the operating agreement state that it is manager-managed. § 17704.07.
Shelf LLCs. Under Beverly-Killea an LLC exists when its articles of organization are filed, but it is not formed until the members enter into an operating agreement. § 17050. RULLCA, on the other hand, does not require the admission of members in order for an LLC to be formed: “A limited liability company is formed when the Secretary of State has filed the articles of organization.” § 17702.01(d).
Non-economic Member. Beverly-Killea assumes that members have economic rights. For example, its definition of a membership interest includes the member’s economic interest, such as the right to share in profits, losses, and distributions. RULLCA, in contrast, allows an LLC to include members that have no economic interest and make no capital contributions. § 17704.01(d). The NCCUSL comment on this section indicates that the purpose of this provision is to “accommodate business practices and also because a limited liability company need not have a business purpose.” NCCUSL, Revised Uniform Limited Liability Company Act, § 401(e) cmt.
Fiduciary Duties. RULLCA provides a more detailed description of the fiduciary duties of LLC managers and managing members than does Beverly-Killea, and constrains the ability of the operating agreement to eliminate or limit fiduciary duties.
Beverly-Killea incorporates by reference the fiduciary duties of a partner in a partnership: “The fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners of the partnership.” § 17153. The members may modify those duties, but only in a written operating agreement with the informed consent of the members. § 17005(d).
RULLCA instead sets out the fiduciary duties of managers and managing members in some detail, and limits or “cabins in” the fiduciary duties to the duty of care and the duty of loyalty. The limits are evident in the introductory sentence: “The fiduciary duties that a member owes to a member-managed [LLC] and the other members of the [LLC] are the duties of loyalty and care under subdivisions (b) and (c).” § 17704.09(a). The duty of loyalty is limited to enumerated activities, and the duty of care is limited to refraining from grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.
RULLCA limits the extent to which the members can modify the managers’ or managing members’ fiduciary duties. Any modification of the fiduciary duties can only be done by a written operating agreement. Neither the duty of care, the duty of loyalty, nor the contractual duty of good faith and fair dealing may be eliminated, and the duty of care may not be unreasonably reduced. § 17701.10.
There is one oddity in RULLCA’s fiduciary duty rules. Section 17704.09 comprehensively defines the fiduciary duties of LLC members and managers and appears to exclude any other fiduciary duties. But Section 17701.10(c)(4) says that an operating agreement may not eliminate “the duty of loyalty, the duty of care, or any other fiduciary duty.” (Emphasis added.) A California court may at some point have to resolve this inconsistency, unless it is first clarified by an amendment to the statute.
Effectiveness. RULLCA’s general rule is that it applies to all LLCs after January 1, 2014: “Except as otherwise specified in this title, this title shall apply to all domestic limited liability companies existing on or after January 1, 2014.” § 17713.04(a).
Sub-paragraph (b) provides that RULLCA applies only to acts or transactions by an LLC or its members or managers occurring, or contracts entered into by the LLC or its members, on or after January 1, 2014. § 17713.04(b). Those acts which take place before that date will be governed by Beverly-Killea. This section appears intended to cover issues such as the authority of a manager, breaches of fiduciary duty, and so on, that relate to actions occurring before RULLCA’s effective date.
There is an unfortunate ambiguity in RULLCA’s transition rules, however. As some commentators have pointed out, (1) sub-paragraph (b) states that Beverly-Killea governs all “contracts entered into by the [LLC] or by the members or managers of the [LLC]” prior to January 1, 2014, and (2) an LLC’s operating agreement is a contract between the members. From this they posit that RULLCA was intended to apply only to operating agreements entered into after January 1, 2014.
That would be a surprising result, given that RULLCA consistently uses the defined term “operating agreement” when it refers to the member agreement that governs an LLC. It would also be a poor result from a public policy standpoint, because then all pre-existing LLCs would continue to be governed indefinitely by Beverly-Killea, unless and until they amend or restate their operating agreement or otherwise opt in to the new statute. That is probably not what the drafters of this section and the legislature intended, but predicting how a California court would resolve the issue is a risky business.
Comment. RULLCA makes a variety of other changes to California’s LLC statute. As the end of the year approaches, California’s business lawyers will be reviewing the new law and attending legal education seminars to bring themselves up to speed on the new Act. I expect many will be alerting their clients about the new law and recommending that they review their operating agreements for consistency with RULLCA.
The Florida legislature recently passed unanimously a new limited liability company statute (the New Act), and Governor Scott is expected to sign the bill shortly. The New Act is based substantially on the Revised Uniform Limited Liability Company Act (RULLCA), but with some variations. RULLCA is a uniform law recommended by the National Conference of Commissioners on Uniform State Laws (NCCUSL).
RULLCA was released by NCCUSL in 2006, but until last September only five states had adopted it: Idaho, Iowa, Nebraska, Utah, and Wyoming. In September 2012 New Jersey and California became the first major commercial states to adopt RULLCA. I described the adoptions by California and New Jersey here.
Upon signing by the Governor, Florida’s New Act will be effective January 1, 2014, and will apply to all LLCs formed thereafter. LLCs formed prior to that date are not subject to the New Act until January 1, 2015, unless they elect to be governed by the New Act during the transition period.
The New Act is a major update to Florida’s LLC law, and the changes are numerous. The Bill Summary, prepared by the Senate’s Judiciary Committee, summarizes many of the most significant changes. Florida lawyers Gregory Marks, here, and Charles Rubin, here, have also provided useful summaries of the many changes made by the New Act.
RULLCA has been criticized by commentators and has not been widely adopted. But with Florida’s adoption (even with some significant deviations from RULLCA) and last year’s passage by California and New Jersey, it appears that momentum among the states is increasing.
When LLC members are deadlocked or have claims against each other for breach of fiduciary duty or other wrongdoing, they sometimes seek a court order dissolving the LLC. Once dissolved, the LLC has to be liquidated and wound up. But in New Jersey and some other states a different remedy is available – the LLC or a member can ask the court to dissociate certain members, i.e., to strip them of their membership in the LLC. That happened last month in New Jersey: the Appellate Division of the Superior Court affirmed a trial court’s order dissociating two LLC members. All Saints Univ. of Med. Aruba v. Chilana, No. C-147-08, 2012 WL 6652510 (N. J. Super. Ct. App. Div. Dec. 24, 2012) (per curiam) (unpublished).
Background. ASUMA LLC was formed with four members in 2007, in connection with the operations of a fledgling medical school in Aruba. Financial strains developed, and in 2008 two of the members sued the other two for breach of fiduciary duty and breach of the LLC’s operating agreement. Defendant Gurmit Chilana counterclaimed for fraud, misappropriation, and breach of fiduciary duty.
Several months later Chilana requested the trial court to declare the plaintiffs judicially dissociated from ASUMA. Chilana requested this relief because the medical school required immediate capital to continue operating, and Chilana intended to invest the necessary capital only if the plaintiffs were dissociated. Id. at *8.
Chilana’s request for judicial dissociation was made pursuant to Section 42:2B-24(b)(3) of New Jersey’s Limited Liability Company Act:
A member shall be dissociated from a limited liability company upon the occurrence of any of the following events:
(3) on application by the limited liability company or another member, the member’s expulsion by judicial determination because:
(a) the member engaged in wrongful conduct that adversely and materially affected the limited liability company’s business;
(b) the member willfully or persistently committed a material breach of the operating agreement; or
(c) the member engaged in conduct relating to the limited liability company business which makes it not reasonably practicable to carry on the business with the member as a member of the limited liability company.
Following trial, the trial court’s written decision concluded that the plaintiff’s conduct satisfied the criteria of both subsection (3)(a) (wrongful conduct) and (3)(c) (not reasonably practicable to carry on the business), and decreed the plaintiffs to be dissociated from ASUMA.
Court’s Analysis. The appellant contended on appeal that judicial dissociation was barred by the LLC agreement, which stated: “Shareholder(s) cannot or shall not at anytime be compelled to give up or sell their shares for any reason. The decision to sell shares must be voluntary. No shareholder(s) can buy out other shareholder(s).” Id. at *12.
The court disposed of that argument by pointing out that under Section 42:2B-24.1 of the New Jersey LLC Act, a dissociated member loses only its management rights, and retains the rights of an assignee of a member’s LLC interest, i.e., the economic rights of the member’s interest. Thus, dissociation does not cause the dissociated member to “give up or sell” its economic interest. According to the court, the dissociated member “may continue to hold his shares, … but as a dissociated member he is enjoined from participating in the management of the LLC.” Id. at *13.
The court then turned to the substance of the trial court’s decision. The trial court had supported its decree of dissociation under both subsection 3(a) and subsection 3(c). Subsection 3(a) requires that the member have “engaged in wrongful conduct that adversely and materially affected the limited liability company’s business,” and 3(c) requires that the member have “engaged in conduct … which makes it not reasonably practicable to carry on the business with the member as a member” of the LLC. The appellate court said that it found it easier to justify dissociation under subsection 3(c) than 3(a). It therefore confined its analysis to the trial court’s determination under subsection 3(c), the “not reasonably practicable to carry on the business” standard. Id. at *14.
After reviewing the record in detail, the court concluded that the trial court had not abused its discretion and had sound reasons when it determined that the plaintiffs had engaged in conduct that made it not reasonably practicable to carry on the business with the other member. Those reasons included: (a) the precarious financial condition of the medical school; (b) the contentious relationship between the members; (c) the plaintiffs’ denial of the school’s financial problems; (d) the plaintiffs’ unwillingness to contribute more capital or loan funds to the school; and (e) Chilana’s understandable unwillingness to invest more capital in the school if the plaintiffs were allowed to continue to manage the company. Id. at *18. The trial court’s order of dissociation was affirmed.
The court cited cases from New Jersey, Indiana, and Delaware to support the importance of the plaintiffs’ unwillingness to contribute capital, but pointed out that that factor alone is not sufficient to conclude that it is “not reasonably practicable” to carry on the business with the non-contributing members. Id. at *16.
Comment. Most state LLC Acts provide for a judicial order of dissolution under certain circumstances, but fewer provide for a judicial order of dissociation of a member. For example, neither the Washington nor the Delaware LLC Act authorizes judicial dissociation of a member for wrongdoing.
New Jersey’s current statutory provision for judicial dissociation is similar in most respects to that in NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA), Section 602. New Jersey recently became one of the eight states that have enacted RULLCA, but the new law will not become effective until March 18, 2013. All Saints, 2012 WL 6652510, at *11 n.9.
New Jersey’s adoption of RULLCA will change New Jersey’s judicial dissociation rules in one key respect. New Jersey’s current statute allows for another member or the LLC to petition for a member’s dissociation, as in All Saints. RULLCA, as promulgated by NCCUSL and as enacted by New Jersey, allows only the LLC to petition for dissociation of a member.
The RULLCA approach to judicial dissociation provides a useful alternative remedy for difficult LLC situations. It is a narrower remedy than the more common remedy of dissolution. Dissolution is a blunt instrument, because it usually brings to an end the members’ ongoing involvement with the LLC’s business. (It is theoretically possible for some of the members to buy the business from the LLC as it winds up, but in many cases that is not a practical alternative.)
Judicial dissociation removes all voting and management powers from the dissociated members, but leaves them with their economic rights. They will continue to receive distributions of cash and allocations of profit and loss in accordance with the LLC agreement. But that points out a potential flaw with judicial dissociation in precisely the All Saints situation, i.e., where the remaining members desire to make future capital contributions without concerns over management involvement by the dissociated members.
Here’s the problem: If the LLC agreement provides for distributions and allocations to be made by percentages or units, and does not have a mechanism to adjust those percentages or units when non-pro-rata capital contributions are made, the dissociated members will benefit unfairly from the remaining members’ future capital contributions. In that scenario the members making the non-pro-rata capital contributions should get their capital contributions back when the LLC is eventually liquidated (assuming it’s a profitable venture), but in the interim the dissociated members will receive larger shares of profits and distributions than most investors would consider fair under those circumstances. This example points out why LLC agreements should always cover the possibility of disparate capital contributions being made. Most do, but that is not always the case.
The governors of California and New Jersey both signed new LLC statutes into law on September 21, 2012, and both states adopted the Revised Uniform Limited Liability Company Act (RULLCA), with some variations. RULLCA is a uniform law recommended by the National Conference of Commissioners on Uniform State Laws (NCCUSL). RULLCA has been slow to catch on, but its passage by California and New Jersey may encourage other states to seriously consider it.
RULLCA was released by NCCUSL in 2006. It was adopted by Idaho and Iowa in 2008, by Nebraska and Wyoming in 2010, and by Utah in 2011. RULLCA has been criticized by the late Professor Larry Ribstein, which I wrote about when Nebraska and Wyoming passed RULLCA, here. But passage by California and New Jersey, the first major commercial states to adopt RULLCA, should increase momentum for its adoption by other states.
California. As originally introduced in the California legislature, the bill for the new statute authorized series LLCs, although that is not a RULLCA provision. (A series LLC can partition its assets and members into multiple series. Each series can own its own assets, enter into contracts in its own name, and incur its own liabilities, separate from the assets and liabilities of the LLC or any other series.) A later amendment deleted that provision from the bill, and the final version made no provision for series LLCs.
New Jersey. The new statute clarifies that a New Jersey LLC “may have any lawful purpose, regardless of whether for profit.” It establishes the default duration of an LLC as perpetual, unless limited by the operating agreement. And although the current LLC Act only allows a written operating agreement to override the various statutory defaults of the LLC Act, the new statute allows the operating agreement to be oral, written, or implied.
In 2010 I opined that RULLCA’s prognosis for becoming widely adopted looked bleak. With California and New Jersey’s adoption, RULLCA’s future now looks brighter.
South Carolina Supreme Court Rules That LLC Does Not Shield Its Member From Liability for His Tortious Conduct
A limited liability company will generally shield its members and managers from the LLC’s debts and obligations, but the shield is not absolute. LLC members or managers who carry out an LLC’s tort can in some cases be personally liable for the injured party’s damages. The South Carolina Supreme Court had to decide such a case earlier this year. 16 Jade St. LLC v. R. Design Constr. Co., LLC, No. 27107, 2012 WL 1111466 (S.C. Apr. 4, 2012).
(A tort is not a breach of contract – it is an actionable, civil wrong. Examples include fraud, breach of a fiduciary duty, and negligently causing an auto accident. A party injured by a tort may be able to recover damages from the wrongdoer if requirements such as causation and proof of damages are satisfied. Tort law has its origins in the English common law and is part of the common law of all U.S. states.)
Background. Carl Aten and his wife were the only members of R. Design Construction Co., LLC, a construction contractor. R. Design contracted with Jade Street for the construction of a four-unit condominium, and Aten served as R. Design’s general manager on the project. Jade Street had numerous complaints of defects in the construction, and ultimately R. Design walked off the job. Jade Street sued R. Design and Aten for negligence, breach of implied warranties, and breach of contract.
The trial court found that R. Design was liable for breach of contract, negligence, and breach of implied warranties. It also found that Aten was personally liable for his negligence. Id. at *2.
The Court’s Analysis. Aten argued on appeal that South Carolina’s Uniform Limited Liability Company Act (ULLCA) shielded him from personal liability for any negligence he committed while working for R. Design. The relevant ULLCA language states:
Except as otherwise provided in subsection (c), the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.
S.C. Code § 33-44-303(a). (Subsection (c) provides for member liability if the LLC’s articles of organization so provide and the member has consented in writing to that provision. It was not applicable to Aten.)
The court saw the question as one of statutory interpretation – did the legislature intend the LLC statute to shield members from personal liability for acts they commit in furtherance of the LLC’s business? 16 Jade St., at *2. The court noted that this was a question of first impression in South Carolina.
Looking first to other states, the court pointed out that a majority of the states that have examined similar statutory language “have concluded that a member is always liable for his own torts and cannot rely on his status as a member of an LLC as a shield.” Id at *3 (citing cases from half a dozen states). The court also cited a number of scholarly articles which opine that LLC statutes do not insulate a member from tort liability “primarily due to the common law concept that one is always liable for his torts.” Id. In the spirit of two-handed lawyers, the court also referred to a few courts that have concluded that their states’ LLC statutes do shield a member from personal liability for at least some types of torts.
Having surveyed the landscape, the court then dissected the language of Section 33-44-303(a). The first sentence says that the liabilities of the LLC, whether arising in contract or in tort, are solely the liabilities of the LLC. Since an LLC is a fictional entity and can act only through an agent such as a member or manager, that sentence seems to say that the member or manager who carries out the LLC’s tort does not thereby incur any personal liability. “[T]his language suggests R. Design alone is responsible for torts committed by Aten in the course of the company’s business.” Id. at *4. The court saw the second sentence as reinforcing the first, by stating that merely being or acting as a member or manager of an LLC will not cause the member or manager to be liable for the LLC’s obligations.
The court recognized, however, that interpreting the statute to shield LLC members or managers who commit torts in furtherance of the LLC’s activities would remove a long-standing common law remedy for injured parties. The court accordingly applied a higher standard of review. “Statutes will not be held in derogation of the common law unless the statute itself shows that such was the object and intention of the lawmaker, and the common law will not be changed by doubtful implication.” Id. at *5 (quoting 82 C.J.S. Statutes § 534 (2009)).
The court then referred to the majority view of the courts of other states, comments from the legislative history of Section 33-44-303, and comments from Section 304 of NCCUSL’s Revised Uniform Limited Liability Company Act (RULLCA). Id. These all follow the principle that shielding LLC members and managers from the LLC’s debts and obligations does not apply to claims seeking to hold members or managers liable for their own tortious conduct. These authorities treat members or managers, even when acting on behalf of the LLC, as also acting on their own behalf when committing a tort.
The court also reviewed the rule for corporations – i.e., that a shareholder is not liable for the debts or obligations of the corporation but is responsible for the consequences of its own conduct – and could find no evidence that the legislature intended to change that rule with respect to LLCs. Id.
Finding no clear legislative intent to restrict the common law, the South Carolina Supreme Court ruled in a three-to-two decision that Section 33-44-303(a) “does not insulate the [member] tortfeasor himself from personal liability for his actions.” The court accordingly affirmed the trial court’s finding that Aten was personally liable for torts he committed in furtherance of R. Design’s business. Id. at *6.
The brief dissenting opinion argued that the statute was clear and unambiguous and not amenable to an interpretation that a member tortfeasor of an LLC is personally liable for torts committed in the furtherance of an LLC’s business. Id. at *7. The dissent did not address the majority’s point that interpreting the statute to shield those who commit torts would derogate from the common law and therefore required a higher standard of review.
Comment. Both the majority and the dissenting opinions ignored the inherent ambiguities in Section 33-44-303(a). For one, the first sentence cannot mean what it seems to say. Ignoring the reference to subsection (c), it says: “the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company.” No exceptions are noted. Read literally, it precludes joint liability of an LLC. Consider the following hypothetical. An LLC borrows money from a bank, and the LLC’s sole member guarantees the LLC’s payment obligation to the bank. A literal reading of the first sentence would mean that only the LLC is liable to repay its debt and the member is shielded from the guarantee obligation it willingly agreed to.
For another, consider that even reading the first two sentences together would not change the result, if the member was acting as a member. The statute does not explicitly require that the member act on behalf of the LLC, only that the member be “acting as a member.” What does that mean? Members in a manager-managed LLC have the status of members and the right to vote for managers, but they don’t act on behalf of the LLC.
The majority opinion acknowledged that removing the LLC’s liability shield for members who commit torts on behalf of the LLC “appears to strip away one of the main reasons why a person chooses to form an LLC,” and the court expressed particular concern about single-member LLCs. Jade St., 2012 WL 1111466,at *5. But to have held the other way would have been to open the floodgates – wouldn’t we all want our own single-member LLC to shield us from what would otherwise be liability for our own torts?
South Carolina’s statute allows an LLC to be organized for any lawful purpose. S.C. Code § 33-44-112(a). You could form an LLC for the purpose of owning and driving your personal vehicle. Under the dissent’s view of Section 33-44-303(a), you would presumably be “acting as a member” and therefore would not be liable for any injuries caused by your negligent driving.
This is a far-fetched example, of course, but it shows the lack of clarity in the statute. Given that ambiguity, the majority opinion arrived at what appears to be the correct result, particularly in light of its agreement with the majority of other courts and commentators that have considered this issue for comparable statutes, and with the comments to NCCUSL’s RULLCA.
A low-profit limited liability company, or L3C, is an LLC whose primary purpose is not to earn a profit but instead to significantly further the accomplishment of one or more charitable or educational purposes. It may still make a profit, though, and is not a non-profit as that term is used in corporate non-profit statutes or in federal income tax regulations.
L3Cs are well-intentioned as a way to increase the flow of capital to socially beneficial enterprises, but they don’t provide the principal benefits their promoters tout and can easily mislead investors and foundations. Nonetheless, nine states so far have passed legislation authorizing L3Cs, although the momentum for state passage seems to be weakening. No states have passed L3C legislation this year, and only one in 2011 (Rhode Island), one in 2010 (Louisiana), and two in 2009 (Maine and Illinois).
I wrote last September about some of the problems with L3Cs, when Rhode Island passed its L3C statute, here. In that post I discussed an article by Bill Callison, a partner at Faegre and Benson, and Allan Vestal, Dean and Professor of Law at Drake University: J. William Callison & Allan Vestal, The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 273 (2010). I also discussed an article by Daniel Kleinberger, Professor of Law at William Mitchell College of Law, that analyzes a number of L3C issues: Daniel S. Kleinberger, A Myth Deconstructed: The “Emperor’s New Clothes” on the Low-Profit Limited Liability Company, 35 Del. J. Corp. L. 879 (2010). These articles pointed out some of the significant problems with L3Cs.
In my last L3C post I lamented the communication gap between (a) the lawyers and law professors who analyze and criticize the L3C form, and (b) the state legislators who hear only the alleged benefits from L3C promoters. I suggested then that one of the national bodies with expertise and a broad constituency, such as the National Conference of Commissioners on Uniform State Laws, the American Law Institute, or the Business Law Section or Tax Law Section of the American Bar Association, should play a more active role in making recommendations to the states.
Lo and behold, the Business Law Section of the American Bar Association, on behalf of its committees on LLCs and nonprofit organizations, has taken action to oppose L3Cs. The Section submitted a letter dated April 19, 2012, including a detailed, 17-page Appendix, to Steve Simon, the Assistant Minority Leader of the Minnesota House of Representatives. The letter detailed the problems with the proposed L3C structure and urged Representative Simon to oppose a bill before the Minnesota legislature, House File No. 2702, which was intended to authorize L3Cs. And although I don’t know how the politics played out, after its introduction and first reading, House File No. 2702 received no hearings or other action during the legislative session that ended in May.
The major points of the letter are that L3Cs will not stimulate private foundation investment in socially beneficial enterprises, and that the type of tranched L3C investment by private foundations, as urged by L3C advocates, is highly risky for private foundations and will not be accepted by them. Other criticisms are that (1) L3C promoters erroneously imply that state law can streamline and simplify federal tax law compliance; (2) the model form of L3C statute proposed by advocates has a serious technical flaw; and (3) most state LLC statutes already permit the type of ventures contemplated by the L3C legislation. The letter and its appendix are a thorough and well-written communication.
This action by the ABA’s Business Law Section is a big and positive step in the right direction, and I commend the Section. Although the letter makes clear that it is not the official position of the entire ABA, it does represent the views of the ABA’s Business Law Section, which has about 54,000 members. Furthermore, it represents the considered opinions of both the Committee on Limited Liability Companies, Partnerships and Unincorporated Entities and the Committee on Nonprofit Organizations. The lawyers and academics who sit on these committees represent the perspectives of both the business lawyers who help clients form, operate, and invest in LLCs and other business entities and the lawyers who represent a variety of non-profit organizations, both public charities and private foundations.
The ABA’s Revised Prototype Limited Liability Company Act has been published in the November 2011 Business Lawyer, copies of which were received at my firm last week. The Revised Prototype incorporates a number of welcome changes, and will likely become an even more widely used resource by states considering amendments to their LLC Acts.
Many state LLC Acts were first adopted in the early 1990s. In adopting and amending their LLC Acts, state legislatures have been able to look for guidance to several sources:
- The Uniform Limited Liability Company Act (“ULLCA”) promulgated by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) in 1994;
- The Prototype Limited Liability Company Act (the “Prototype”) published in 1992 by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities; and
Both the ULLCA and the Prototype were influential as the states drafted their LLC Acts, but neither fully occupied the field. As a result there is a lot of variation in LLC laws from state to state. According to NCCUSL, the revised ULLCA has been adopted by only the District of Columbia, Idaho, Iowa, Nebraska, Utah, and Wyoming. The Prototype also was used as the basis for several states’ LLC Acts, and has been used as a reference by other states in amending their Acts.
The Revised Prototype is a major revision and modernization of the Prototype. Changes include terminology, organization, and major points of law. The following is a partial list of the major changes.
Terminology. The name of the formation document has been changed from “articles of organization” to “certificate of formation,” and the principal contract that defines an LLC’s structure and the members’ rights has been renamed from “operating agreement” to “limited liability company agreement.” The latter change reflects the more common terminology, although it is cumbersome. E.g., Washington (RCW § 25.15.005), Delaware (DLLCA § 18-101).
Nonwaivable Provisions. Most state LLC statutes provide numerous default provisions that may be modified by an LLC agreement. Often each default rule will be preceded by language such as “except as otherwise provided in a limited liability company agreement.” Usually, however, some provisions of the statute will be nonmodifiable or nonwaivable by an LLC agreement, in which case the “except as otherwise provided …” language is not used to limit the statutory rule. This was the approach used in the 1992 Prototype.
The Revised Prototype instead simply states that the LLC agreement governs the LLC and its members, and that when the LLC agreement is silent the Act will govern, except that certain statutory provisions listed in Section 110 may not be modified by the LLC agreement. This approach eliminates the need to repeat variants of “except as otherwise provided [in an LLC agreement]” throughout the statute, as all of the default rules in the statute are subject to modification in an LLC agreement unless modification is barred by Section 110.
Manager-Managed vs. Member-Managed; Authority. Many state LLC Acts assume that management of the LLC will be vested either in the members or in one or more managers. Typically the statute will also describe the actual and apparent authority of the members or managers. Oregon and Washington both follow this approach, as did the Prototype.
The Revised Prototype instead takes a more flexible approach by eliminating the need to pigeon-hole the LLC as member-managed or manager-managed. The default rule is that the activities of the LLC are under the direction and oversight of its members. Revised Prototype, § 406. That can be changed by the LLC agreement, which may establish managers, officers, or other decision-makers and define their authority.
The Revised Prototype does not define any actual or apparent authority for members or managers. Instead, the actual and apparent authority of the members or of any officers, managers, or other agents, will be established by the LLC agreement, the decisions of the members, any filed statement of authority, or the common law of agency. Revised Prototype, Article 3.
Power. Most if not all state LLC Acts explicitly state that an LLC formed under the Act has adequate power. The statutes typically refer to LLCs having the powers that are “necessary or convenient” for their activities, or to comparable language. E.g. Delaware (DLLCA § 18-106(b), Washington (RCW § 25.15.030(2)), Oregon (ORS 63.077). Entity power is a fundamental attribute. For example, if an entity lacks power to form a contract and purports to do so, the contract will not be enforceable.
The importance of this issue is shown by legal opinion-letter practice. Lawyers for parties in major transactions are often required as a condition of the transaction to provide a legal opinion to the other party covering, among other things, the power of the lawyer’s client to enter into and carry out the transaction. The TriBar Opinion Committee’s 2006 Report on LLC closing opinions states that a lawyer’s opinion that an LLC has the power to enter into and perform its obligations under an agreement means that the LLC “has that power under … the statute under which it was formed.” TriBar Opinion Committee, Third-Party Closing Opinions: Limited Liability Companies, 61 Bus. Law. 679, 687 (2006) (emphasis added).
The Prototype intentionally did not include any language dealing with the LLC’s power to carry out its activities, apparently relying on the contractual aspect of LLCs. See Prototype, § 106, Commentary. The Revised Prototype, however, has included a statement that an LLC will have the powers “necessary or convenient to the conduct, promotion, or attainment of the business, purposes, or activities” of the LLC. Revised Prototype, § 105(b).
The Revised Prototype explicitly recognizes the entity nature of LLCs, defining an LLC as “an entity formed or existing under this Act.” Revised Prototype, § 102(13) (emphasis added). The Prototype, in contrast, defines an LLC as “an organization formed under this Act.” Prototype, § 102(F) (emphasis added).
It seems odd that the summary of major changes in the introduction to the Revised Prototype makes no mention of the addition of a powers clause, which I think most practicing lawyers would consider major, and the comment to Section 105 of the Revised Prototype makes no mention of the change.
Fiduciary Duties. The Revised Prototype does not provide for fiduciary duties and allows broad latitude to the LLC agreement to expand, restrict, or eliminate fiduciary duties. The implied contractual covenant of good faith and fair dealing may not be eliminated. Revised Prototype, § 110. Note that the absence of a default specification of fiduciary duties does not mean that the applicable state’s common law would necessarily hold that managers of LLCs have no fiduciary obligations. See Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012), which I wrote about, here.
Charging Orders. The Prototype provided that a court may issue a charging order, which gives an LLC member’s judgment creditor the right to receive any distributions the member would otherwise receive. The Prototype left unclear whether a charging order was a judgment creditor’s exclusive remedy. I wrote about the exclusivity of charging orders last year, here.
The Revised Prototype makes clear that a judgment creditor’s charging order is its exclusive remedy against an LLC member’s interest in the LLC. This change brings desirable clarity, but many would argue that there is a policy issue left unaddressed by the Revised Prototype, i.e. whether the charging order should be exclusive even in the case of a single-member LLC.
The new provision provides additional detail about the exercise of the charging order, and also makes clear that a charging order may be obtained against an assignee’s LLC interest.
Derivative Suits. The Prototype did not provide a default rule for derivative suits, although nothing in the Prototype prevented an LLC agreement from authorizing derivative suits. The Revised Prototype authorizes derivative suits for members as a default rule, although not for assignees (unlike Delaware, which allows members and assignees to bring a derivative suit, DLLCA § 18-1001).
Series LLCs. Series LLC provisions were added to the Revised Prototype. A series LLC is an LLC that is split into separate series, each having its own members and managers, owning its own assets separate from the assets of the LLC or any other series, and incurring obligations enforceable only against its own assets. At least eight states have authorized series LLCs (see my blog post, here).
Evergreen. The Revised Prototype has been published by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities. The Committee deserves praise for this comprehensive revision and the thoughtful comments.
The Committee stated in the overview to the Revised Prototype that it will be revised on an ongoing basis, to anticipate and respond to legal and business changes affecting LLCs. This will be especially useful if the Committee can make such revisions publicly available on the Internet (once released), with clear delineation of the changes from one version to another and with adequate comments explaining the changes.
Comments. The Committee has encouraged interested parties to submit suggestions and comments on the Revised Prototype. The Committee can be reached through the ABA’s website, here.
Rhode Island passed legislation in June to authorize low-profit limited liability companies (L3Cs). The bill was signed by the Governor on June 20, 2011, and will take effect on July 1, 2012. With the passage of this legislation, Rhode Island becomes the ninth state to authorize L3Cs, joining Illinois, Louisiana, Maine, Michigan, North Carolina, Utah, Vermont, and Wyoming.
An L3C is a specific type of limited liability company, one whose primary purpose is not to earn a profit but rather to “significantly further the accomplishment of one or more charitable or educational purposes.” 2011 R.I. Pub. Laws ch. 79 (H. B. 5279A). I have previously written about L3Cs, here and here.
The promoters and advocates of L3Cs say that private foundations, as well as commercial investors, will be encouraged to invest in L3C enterprises. The state legislatures seem to be jumping on the bandwagon: L3C bills were introduced in at least nine states this year in addition to Rhode Island, which I wrote about in March, here.
These L3C bills are being pushed because the non-profit community is strongly interested in collaboration between the not-for-profit world and the for-profit-world, and wants to leverage the financial strength of the for-profit, investment-oriented community into charitable and educational activities. Arthur Wood, Transcript: New Legal Structure to Address the Social Capital Famine, 35 Vt. L. Rev. 45 (2010).
The fly in the ointment is that commentators – business lawyers and professors – have written at length about perceived defects in the L3C structure. For example, Bill Callison, a partner at Faegre and Benson, and Allan Vestal, Dean and Professor of Law at Drake University, have written about what they call the L3C illusion. J. William Callison & Allan Vestal, The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 273 (2010).
Another: Daniel Kleinberger, Professor of Law at William Mitchell College of Law, published an article last year that analyzes a number of L3C issues. Daniel S. Kleinberger, A Myth Deconstructed: The “Emperor’s New Clothes” on the Low-Profit Limited Liability Company, 35 Del. J. Corp. L. 879 (2010). If the title of his piece doesn’t give you its thesis, let me list the titles of the sections covered in Part Vof his article, The L3C Concept Debunked: (A) The L3C is Unnecessary, (B) The L3C “Brand” is Unwise, (C) The L3C Construct is Inherently Misleading, and (D) Current L3C Legislation is Nonsensical and Useless. I refer you to his article for Professor Kleinberger’s lengthy and detailed analysis.
With serious questions being raised by academics and business lawyers, one has to wonder why the states are rushing to adopt L3C legislation.
To quote Paul Newman in Cool Hand Luke: “What we’ve got here is a failure to communicate.” The business lawyers and professors are analyzing and criticizing the L3C structure, the non-profit community and other promoters are pushing the L3C law hard at a local level, and state legislatures are passing the laws. But the issues raised by the commentators are apparently being ignored. This is not a good way to make public policy.
What should happen here? There are clearly substantial problems and issues with the current form of L3C law that the states are adopting. The existing L3C laws should either be taken off the books or changed to address the problems, and new laws in the current L3C form should not be passed. Conceivably a form of L3C that addresses the problematic issues could be promulgated for consideration by the states.
I think one of the national bodies with expertise and a broad constituency, such as the National Conference of Commissioners on Uniform State Laws, the American Law Institute, or the Business Law Section or Tax Law Section of the American Bar Association, should take this issue in hand, study it, and make recommendations after thoroughly analyzing the issue and considering input from the various groups and experts. Such a process would result in recommendations and possibly a model statute that would be persuasive to state legislatures.
If you are an NCCUSL commissioner, an ALI member, or a member of the ABA’s Business Law Section or Tax Law Section, think about getting your organization involved in taking a hard look at L3Cs.
The National Conference of Commissioners on Uniform State Laws (NCCUSL) was formed in 1892 to promote uniformity in state laws by providing states with proposed legislation. NCCUSL’s record has been mixed, but it has had notable successes in the area of commercial and business law. Examples include the Uniform Commercial Code (in cooperation with the American Law Institute), the Uniform Partnership Act, and the Uniform Trade Secrets Act.
LLC law has not been one of NCCUSL’s shining successes. NCCUSL released its first Uniform LLC Act (ULLCA) in 1995, after almost all the states had already adopted LLC statutes. ULLCA has since been adopted by only eight states.
In 2006 NCCUSL released a revised version, the Revised Uniform Limited Liability Company Act (RULLCA). In 2008 RULLCA was enacted by Idaho and Iowa.
Earlier this year Nebraska and Wyoming enacted RULLCA, doubling the number of RULLCA states from two to four. Nebraska’s new law was signed by the governor on April 1, 2010. It becomes effective January 1, 2011 and has a two-year transition period. The new Wyoming Act was signed by the governor on March 8, 2010 and became effective July 1, 2010, with a four-year transition period.
There is significant variation among the current state LLC laws, other than those of the eight states that enacted ULLCA, and the four states that have now adopted RULLCA. Many were originally modified versions of the states’ limited partnership laws, while some were copied in part from other states’ laws, from ULLCA, and from the ABA’s 1992 Prototype Limited Liability Company Act.
RULLCA has been criticized. Larry E. Ribstein, An Analysis of the Revised Uniform Limited Liability Company Act, 3 Va. L. & Bus. Rev. 35 (2008). Professor Ribstein has referred to it as “the incredibly misguided Revised Uniform Limited Liability Company Act,” here. His view is that RULLCA “threaten[s] to impose substantial risks and costs on limited liability companies … that there is little reason for states to adopt the Act, and that practitioners should be wary about advising clients to form under it.” Id.
The major criticisms of RULLCA include the following issues. Ribstein, supra, at 78-79.
- Unworkable provisions on shelf registration, i.e., creating an LLC with no initial members
- No provisions for series LLCs
- An overly broad definition of the elements of the operating agreement
- Unclear rules on the agency power of members and managers
- Broader fiduciary duties than the traditional duties of loyalty and care, with uncertain boundaries, and intricate restrictions on operating agreement waivers of fiduciary duties
RULLCA is a valuable resource for states looking to review and revise their LLC statutes, but its prognosis for becoming widely adopted looks bleak.
Given the relatively recent appearance of LLCs on the legal stage, a variety of state approaches may not be such a bad thing. Over time, case law will play out against the statutory backdrops, LLC statutes will be revised based on business needs and the results of litigation, and lawyers and business people can in effect vote with their feet by forming LLCs using whatever states’ laws best fit their needs.