Two recent bankruptcy cases illustrate the courts’ inconsistent treatment of member rights in LLC operating agreements. In one case a bankruptcy court enforced a member’s right to receive an assignment of the other member’s equity in an LLC. In the other case the court ignored state LLC law and the debtor’s LLC agreement in order to allow the trustee to assert management rights in the debtor’s LLC.
Case 1: Assignment of Member’s Interest. A provision in an LLC agreement that resulted in a member’s conveyance of its LLC interest was enforced by the Arizona Bankruptcy Court in In re Strata Title, LLC, No. 12-24242, 2013 WL 2456399 (Bankr. D. Ariz. June 6, 2013). The debtor, Strata Title, LLC, was one of two 50% members of Tempe Tower, LLC. The other member was Pure Country Tower, LLC.
Schedule 1 of Tempe Tower’s operating agreement provided that if Pure Country’s $850,000 capital contribution was not returned to it by February 23, 2013, Strata’s member interest in Tempe Tower would be transferred to Pure Country. Pure Country would then be the sole member of the LLC. Id. at *1.
The language in Schedule 1 used an interesting drafting technique: “[I]n the event that [Pure Country] does not receive 100% of its initial Capital Contribution … on or before February 23, 2013 … [the owner of Strata Title] hereby irrevocably assigns his and the entire right, title and interest of Strata Title, LLC in [Tempe Tower] to [Pure Country].” Id. (emphasis added). The phrase “hereby irrevocably assigns” would normally mean that the assignment is effective on the date of the operating agreement, but the agreement is also clear that the assignment doesn’t actually occur unless and until the capital contribution has not been returned to Pure Country by February 23, 2013.
Pure Country looked to the “hereby irrevocably assigns” language and contended that Strata’s member interest in Tempe Tower did not become property of the bankruptcy estate, because the member interest was assigned to Pure Country on the date of the operating agreement, before Strata’s bankruptcy petition was filed. The court rejected that argument, pointing out that the assignment would be of no effect if the $850,000 were paid to Pure Country before the February 23, 2013 deadline. The assignment was therefore not absolute, and Strata’s member interest in Tempe Tower at the date of filing of the bankruptcy petition became part of the bankruptcy estate. Id. at *3.
Pure Country also sought a determination that Pure Country held a perfected security interest in Strata’s member interest in Tempe Tower, and asked for stay relief so it could foreclose on Strata’s member interest. In the alternative it asked for stay relief to compel Strata to transfer the member interest to Pure Country. The court said it would look to state law to determine the parties’ rights under the operating agreement, and to the Bankruptcy Code to determine how those rights should be treated in the bankruptcy.
The court concluded that Pure Country did not have a perfected security interest in Strata’s membership in Tempe Tower. Even if Schedule 1 created a security interest in the member interest, Pure Country had not filed a UCC financing statement to perfect its lien, and the only other grounds for perfection, control of investment property, were not applicable because the LLC interests were not “investment property” as defined in Article 9 of the UCC. Id. at *4.
The last string in Pure Country’s bow was its request that the court give it relief from stay and order Strata to transfer its Tempe Tower member interest to Pure Country in accordance with Schedule 1. The court phrased the issue as: “Does the Debtor still hold a property interest in the membership interests under the terms of the Operating Agreement?” Id.
Section 544 of the Bankruptcy Code gives the debtor the right to avoid unperfected liens, but it does not give the debtor any power to expand the scope of its contractual property rights. The debtor’s membership interests are subject to the constraints of the LLC’s operating agreement and state law. Id.
The court referred to the Arizona LLC Act, which empowers an LLC’s operating agreement to govern the relations between the members and the LLC, and to define the rights, duties and powers of the members. Ariz. Rev. Stat. § 29-682. Schedule 1 of the operating agreement limited Strata’s rights in Tempe Tower:
Under terms of the Operating Agreement, the Debtor’s membership interests in Tempe Tower could only remain property of the Debtor if it paid $850,000 to pure Country by February 23, 2013. Having failed to do so, the Debtor ceased to own any membership interests in Tempe Tower as of February 24, 2013.
The automatic stay did not prevent this outcome because § 362 does not alter existing rights in a contract. … (“The mere running of time on contractual rights is not an act of a creditor within the meaning of Section 362(a).”)
Strata, 2013 WL 2456399, at *5 (quoting In re Pridham, 31 B.R. 497, 499 (Bankr. E. D. Cal. 1983)). The court recognized Pure Country’s rights to the member interest and lifted the stay to the extent any further acts by Pure Country were necessary to obtain possession and control of Strata’s membership interests.
Case 2: Transfer of Management Rights. Last month the Nevada Bankruptcy Court dismissed as unauthorized a bankruptcy filing that had been filed on an LLC’s behalf by its sole member. The sole member had previously filed her own Chapter 7 bankruptcy, and her bankruptcy trustee claimed that he had succeeded to all her rights in the LLC, including management rights and the right to decide whether the LLC should file for bankruptcy. Her trustee had not authorized the LLC’s bankruptcy filing and successfully requested the court to dismiss it. In re B & M Land & Livestock, LLC, No. BK-N-13-50543-BTB, 2013 WL 5182611 (Bankr. D. Nev. Sept. 10, 2013).
In 2010 Marsha Raj filed a Chapter 7 bankruptcy petition. She was the sole member of B & M Land and Livestock, LLC, and indicated in her filing that the LLC was an asset of her estate. In 2013, Raj filed a Chapter 11 petition on behalf of B & M, without notifying her bankruptcy trustee. When the trustee learned of B & M’s bankruptcy filing, he moved to dismiss it on the grounds that Raj was not authorized to file B & M’s bankruptcy.
The issue in the case was the impact of Nevada’s LLC Act:
Unless otherwise provided in the articles or operating agreement, a transferee of a member’s interest has no right to participate in the management of the business and affairs of the company or to become a member unless a majority in interest of the other members approve the transfer.
Nev. Rev. Stat § 86.351(1). This provision is similar to many other state LLC Acts, and clearly provides that a transferee of an LLC member’s interest will not have any management rights unless the operating agreement or articles of formation allow it, or a majority in interest of the other members consent. It reflects the “pick your partner” principle, which is inherent in LLC statutes as well as partnership law.
Section 541(a)(1) of the Bankruptcy Code provides that the estate of the bankrupt includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” If a debtor is a member of an LLC, this section in effect makes the bankruptcy trustee a transferee of the debtor’s member interest.
The court relied on prior case law and interpreted Section 541 to mean that the trustee acquired not only the member’s economic interest, but also the member’s management rights. “In obtaining the debtor’s rights, the trustee is not a mere assignee, but steps into a debtor’s shoes as to all rights, including the rights to control a single-member LLC.” B & M, 2013 WL 5182611, at *4.
Conflicting state law does not matter, said the court, opining that Section 541 “trumps any conflicting analysis or rules in state law relating to the control of LLCs or partnerships.” Id. at *5. The court granted the trustee’s motion to dismiss the LLC’s bankruptcy on grounds the debtor did not have authority to file the LLC’s bankruptcy. Id.
Comment. These two cases are inconsistent in their approach to state law control of LLC member rights. Strata looked to state law to determine the parties’ rights under the operating agreement; B & M expressly disregarded state law to reach the result that was most convenient for the trustee’s administration of the debtor’s assets. If there is any justification for disregarding state law it is that last point: it’s hard to imagine an effective administration of a Chapter 7 bankruptcy where a significant asset of the debtor is its member interest in a valuable single-member LLC that the trustee cannot control.
Although B & M involved a single-member LLC, the court’s analysis is not limited and would seem to apply to multiple-member LLCs. If that were so, a bankruptcy debtor who owned a majority LLC interest could find the bankruptcy trustee controlling the LLC, against the wishes and to the detriment of the other members. The court did note in passing that its rule might be limited in the case of LLCs providing professional services, which under state law can usually be owned and managed only by professionals licensed in that discipline.
One bankruptcy case involving a debtor’s interest in a single-member LLC reached the same result as B & M, but the court there observed that in a multi-member LLC the result would be different. “Where a single member files bankruptcy while the other members of a multi-member LLC do not, … the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled.” In re Albright, 291 B.R. 538, 540 n.7 (Bankr. D. Colo. 2003).
Bankruptcy Appellate Panel Says Out-Of-State Member's Interest in Nevada LLC Is Located in Nevada for Venue Purposes
It sounds like the beginning of a bad joke. An individual walks into a bar and says “Where’s my LLC?” But that was the question a Bankruptcy Appellate Panel recently had to answer. The court had to determine whether Nevada was the proper venue in an involuntary bankruptcy case. The debtor’s only connection with Nevada was that his principal assets consisted of interests in a Nevada LLC and a Nevada limited partnership. The creditor claimed that venue in Nevada was proper because the LLC and the partnership were formed under Nevada law and therefore the debtor’s interests in the companies were located in Nevada. The debtor contended that his LLC and partnership interests were located where he resided, in Washington.
The case began in 2011 when the Montana Department of Revenue (MDOR) filed an involuntary chapter 7 bankruptcy petition in Nevada against Timothy Blixseth. In re Blixseth, 484 B.R. 360 (B.A.P. 9th Cir. Dec. 17, 2012). The petition asserted that venue was proper in Nevada because Blixseth had assets in Nevada. (Venue for a bankruptcy case may be based on any of four alternatives: the debtor’s (i) domicile, (ii) residence, (iii) principal place of business in the U.S., or (iv) principal assets’ location in the U.S. 28 U.S.C. § 1408(1).)
Shortly after the petition was filed the bankruptcy court on its own initiative entered an order to show cause why venue was proper in Nevada, and expressed a concern about “the paucity of the connection between Blixseth and … the selected venue.” Blixseth, 484 B.R. at 362. MDOR responded that venue was proper in Nevada because Blixseth’s principal assets were his interests in Desert Ranch LLLP, a Nevada limited liability limited partnership, and in Desert Ranch Management LLC, a Nevada limited liability company.
Blixseth took the court’s hint and filed a motion to dismiss. He argued that venue was not proper in Nevada because he had resided in Washington since 2007, he conducted no business in Nevada, he had no place of business in Nevada, and he had no property in Nevada. He did acknowledge that his primary assets were his interests in Desert Ranch LLLP and Desert Ranch Management LLC. The LLLP owned real estate in the U.S. and abroad, and the LLC owned an interest in the LLLP and was its general partner.
The trial court concluded that intangible ownership interests, such as Blixseth’s interests in the LLLP and the LLC, have no physical location and that therefore venue based on the location of Blixseth’s assets was unavailable. The trial court also held, in the alternative, that if Blixseth’s interests in the two companies had a location it was at his residence, which was in Washington. Venue based on the location of Blixseth’s assets was therefore unavailable, and “because it was undisputed that Blixseth did not reside, was not domiciled, and did not have a principal place of business in Nevada, there was no other basis for venue in Nevada.” Id. at 364. The trial court concluded that venue in Nevada was incorrect and dismissed the petition, and MDOR appealed.
Issue on Appeal. The Bankruptcy Appellate Panel phrased the sole issue as “whether, for venue purposes under 28 U.S.C. § 1408(1), Blixseth’s principal assets, consisting of his intangible equity interests in Desert Ranch and Desert Management, were located in Nevada.” Id. at 365.
The court characterized Blixseth’s interests in the LLC and the LLLP as intangible property having no physical location – “the location or situs of intangible property is a ‘legal fiction.’” Id. at 366 (citation omitted). The court noted that the legal location of intangible property is protean: intangible property may be located in multiple places for different purposes. The court looked to the Ninth Circuit’s rule that for venue purposes the court should use a context-specific analysis and employ a “common sense appraisal of the requirements of justice and convenience in particular conditions.” Id. at 366-67 (quoting Office Depot Inc. v. Zuccarini, 596 F.3d 696, 702 (9th Cir. 2010)).
Applying the Ninth Circuit’s “context-specific” analysis, the court focused on the trustee’s duty to administer the bankruptcy estate and realize on the assets for the benefit of Blixseth’s creditors. The trustee will have the same rights as Blixseth’s creditors to realize on his interests in the LLC and the LLLP. 11 U.S.C. § 544(a)(1).
Because the LLC and the LLLP were formed under Nevada law they are governed by Nevada law, including its rules on the rights of creditors. Under Nevada law the only remedy of a judgment creditor of an LLC member or LLLP partner is to apply to a Nevada court for a charging order. Nev. Rev. Stat. § 86.401 (LLCs); Nev. Rev. Stat. § 88.535 (LLLPs).
The court found that “because Blixseth’s interests in the LLC and LLLP were created and exist under, and his creditor’s remedies are limited by, Nevada state law, that is sufficient reason to deem Blixseth’s interests to be located in Nevada.” Blixseth, 484 B.R. at 369. The court found additional support for its conclusion in the Nevada courts’ exclusive jurisdiction over judicial dissolution of the LLC and the LLLP, given that the trustee might seek the dissolution of the companies in order to reach the assets owned by each. Id. at 369-70.
The court also looked to notions of justice and convenience. The court found it disingenuous for Blixseth to argue that Nevada is not a proper venue for his creditors to pursue his interests in the two companies, given his choice to form them under Nevada law. Also, it would be more convenient for a Nevada trustee than for a trustee appointed in Washington (the venue argued for by Blixseth) to apply to the Nevada courts to obtain a charging order or request dissolution of the LLC or the LLLP. Id. at 370-71.
Accordingly, the court held that Blixseth’s interests in Desert Ranch and Desert Management were deemed to be located in Nevada, and that venue in Nevada was proper. Id. at 371.
Comment. Business people and investors who decide to form an LLC must decide which state law to form it under. Nevada is sometimes held out as a haven for the formation of asset-protection LLCs. Corporate service companies or law firms will sometimes encourage even out-of-state business startups to organize as a Nevada LLC.
The Blixseth case shows the potential for unintended consequences when picking Nevada or any other state as an LLC’s state of formation, if the LLC’s principal owner has no other connection to the state chosen. The owner can find itself litigating in the state where the LLC was formed, even though the owner does not live there, has no business activities there, and owns no other assets there. That’s usually less convenient than litigating in one’s home state.
In fact, the differences between Nevada’s LLC statute and the LLC statutes of other states are not huge. All states’ statutes protect an LLC’s members and managers from liability for the LLC’s contracts and actions, and no state’s law will protect a member from legal liability for the harm caused directly by the member. All state LLC acts are written to provide a high degree of flexibility for the members in structuring their LLC.
There are sometimes good reasons to pick a state of formation other than one’s own state, but the factors should be considered carefully, including the potential for litigation far from home.
Kansas recently became the latest state to authorize series limited liability companies. Governor Sam Brownback signed Substitute House Bill 2207 on March 29, 2012, amending the Kansas Limited Liability Company Act to authorize series LLCs. Sub. H.R. 2207. The bill will become law on July 1, 2012, and Kansas will then join the eight other states that have authorized series LLCs.
Series LLCs. A series LLC can partition its assets and members into one or more separate series, each of which can have designated members and managers, and can own its own assets separately from the assets of the LLC or any other series. The liabilities of each series will be enforceable only against the assets of that series, and each series can enter into contracts, sue, and be sued in its own name.
Multiple series within one LLC can be used to avoid some of the inefficiencies and costs involved with using multiple LLCs. For example, separate parcels of real estate could each be owned by a separate series, but all within one LLC. Or, the divisions of a business could be held within one LLC, but with each division in a separate series.
Other States. Delaware was the first state to authorize series LLCs, in 1996. Del. Code Ann. tit. 6, § 18-215. Since then Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah have enacted statutes similar to Delaware’s, although there are some differences. I previously wrote about series LLCs when Texas passed its series LLC law in 2009, here, and when the Internal Revenue Service proposed regulations for series LLCs, here.
Kansas Requirements. The Kansas statute is similar in many respects to the Delaware Act. Both authorize an LLC’s operating agreement to establish one or more designated series, and both provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
- the records of the series account for its assets separately from the assets of any other series or the LLC generally,
- the operating agreement states the liability limitations, and
- the certificate of formation, and in the case of a Kansas LLC, the articles of organization, give notice of the limitations on liability.
Series LLCs are relatively new. There are few reported opinions dealing with series LLCs, and the IRS’s proposed regulations have not yet been finalized. There are therefore many unresolved legal questions about series LLC issues such as taxation, bankruptcy, liability limitations, and piercing the veil, particularly when doing business in states outside the state of formation. Caution is advised when implementing a series LLC, given the uncertainty and lack of predictability inherent in their use.
The plaintiff in AA Primo Builders, LLC v. Washington, No. 53983, 2010 Nev. LEXIS 55 (Nev. Dec. 30, 2010), saw its three-year-old lawsuit thrown out because it failed to pay its annual $125 fee to the Nevada Secretary of State. (“For want of a nail ….”) When the case was dismissed the LLC quickly paid the fee and filed the required annual report, but the trial court refused to allow the LLC to reinstate its lawsuit.
Many states require LLCs to file an annual report and pay an annual fee. For example, besides Nevada’s $125 fee, Delaware’s annual LLC fee is $250, and Washington’s is $69. Delaware Limited Liability Company Act (DLLCA) § 18-1107(b); Wash. Admin. Code § 434-130-090.
Failure to pay the fee or file the annual report can result in the LLC no longer being in good standing (Delaware, DLLCA § 18-1107(h)) or being administratively dissolved (Washington, Wash. Rev. Code § 25.15.280). These are enforcement mechanisms – upon later payment of the fees and filing of the required report, the LLC can be reinstated. DLLCA § 18-1107(i); Wash. Rev. Code § 25.15.290.
Nevada’s LLC Act provides that after an LLC has been in default of its filing and annual fee requirement for 12 months, “the charter of the company is revoked and its right to transact business is forfeited.” Nev. Rev. Stat. § 86.274(2). The LLC may then pay all the accrued fees and apply for reinstatement at any time up to five years after the initial default. Nev. Rev. Stat. § 86.276.
The trial court in AA Primo Builders apparently reasoned that if the LLC could not transact business then it could not maintain a lawsuit, and that the LLC’s reinstatement did not cure its default. On appeal, the Nevada Supreme Court overruled the trial court.
The court found three reasons to allow an LLC whose charter is revoked and then reinstated to continue its litigation. AA Primo Builders, 2010 Nev. LEXIS 55, at *13-14. First, an LLC’s right to “transact business” is separate from its capacity to sue and be sued. Id. Second, the LLC’s reinstatement relates back to the date of forfeiture as if the right to transact business had at all times remained in force. Id. at *14. Third, dismissal of the suit because of forfeiture of the LLC’s charter should not be ordered without first staying the case for a brief time to allow the LLC to reinstate its charter. Id.
The court relied in part on Nev. Rev. Stat. § 86-274(5), which says that if an LLC’s charter is revoked, “the same proceedings may be had with respect to its property and assets as apply to the dissolution of a limited-liability company.” A dissolved LLC must be wound up, and the dissolution does not impair any remedy or cause of action by or against the LLC. Nev. Rev. Stat. § 86-505.
The syllogism runs as follows. Major premise: a dissolved LLC can sue and be sued. Minor premise: an LLC whose charter has been revoked for nonpayment of fees is treated like a dissolved LLC. Conclusion: An LLC whose charter has been revoked can sue and be sued. The Nevada Supreme Court accordingly reversed the trial court and remanded to allow the LLC’s lawsuit to proceed.
It happens fairly frequently that LLCs fail to file their annual report and pay their annual fees. Usually the LLC will eventually learn of the problem and reinstate itself. If a lawsuit is underway, courts in most states will generally allow the LLC to continue with its suit if it is reinstated. Nevada’s statute was not clear on the point because its terminology – revoking the LLC’s charter and forfeiting the LLC’s right to transact business – connotes permanence and a lack of power to operate.
As a policy matter, AA Primo Builders came out the right way. The fact pattern involved an LLC that was properly formed but later failed to pay a modest annual fee and make a routine, administrative annual report. The consequence, revocation its charter, is an enforcement mechanism, a spur to cause the LLC to come into compliance with its reporting and payment obligations.
To take away an LLC’s ability to sue in court because it overlooked paying a smallish annual fee, even though the LLC then pays its annual fees up to date and fills out its forms, would be more than is necessary for the state’s enforcement mechanism. It would be akin to killing the dog to eliminate its fleas.
Texas has joined the seven other states that have authorized series LLCs. The Texas bill authorizing series LLCs was signed by Governor Perry in May and will become effective on September 1, 2009. S.B. 1442. The states that currently authorize series LLCs are Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee and Utah.
Most state LLC acts allow an LLC to provide for classes of members with different member rights per class. But a series LLC can go further by establishing multiple series of assets, members and managers. The debts and obligations of a series will be enforceable only against the series’ assets, and will not be enforceable against the other series in the LLC or against the LLC generally, and vice versa. The members associated with a series can be given separate rights and duties with regard to the assets of the series.
The separation of assets and partitioning of liabilities between series, all within one LLC, can avoid many of the inefficiencies and costs associated with multiple related entities. For example, a series LLC could be used to hold multiple parcels of real estate, each in a separate series and all within the one LLC. Or, separate divisions of a business could be held by one LLC, but with each division in a separate series.
The Texas statute is similar in many respects to the Delaware act. Both authorize an LLC’s operating agreement to establish one or more designated series. Both acts provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
(a) the records of the series account for its assets separately from the assets of any other series or the LLC generally,
(b) the operating agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Series LLCs can be useful, but there are legal uncertainties involved in their use. Series LLCs are relatively new – Delaware was the first state to authorize series LLCs, in 1996, and there is almost no case law on them. Major areas of uncertainty involve taxation, bankruptcy, and doing business in multiple states.
There are many open tax questions with regard to series LLCs. Although the Internal Revenue Service issued a Private Letter Ruling in 2008 and clarified that each series’ federal tax characterization is determined independently, other state and federal tax questions remain.
It is unclear whether an LLC series will be treated as a debtor in federal bankruptcy court, or whether the bankruptcy court will ignore the series and only consider the entire LLC. The result may depend on whether the relevant state law will treat the series as a separate entity with its own liability shield.
Including Texas there are now eight states whose LLC acts authorize series LLC, but that leaves 42 other states with no series provisions in their acts. It is not at all clear what the courts of a non-series state would do when faced with a claim by a local creditor against an out-of-state series LLC formed under the laws of, say, Delaware. Will the non-series state honor the series structure and respect the internal liability shield? Would a non-series state even allow a series of an LLC formed under the laws of another state to register to transact business in the non-series state?
The law of series LLCs is an infant, still a little unsteady on its feet. But at one time LLCs were new and LLC law was the infant. There were many articles back then pointing out the uncertainties and risks of using LLCs when they were first adopted by Wyoming in 1977 and later by other states. Many conservative lawyers recommended against using LLCs in the early years of their authorization by the various states, but eventually all the states authorized LLCs. Today LLC law is more mature and LLCs are the most popular entity form for new businesses. History predicts that the question for series LLCs is not whether they will become routinely used, but when.