New York Court Orders Dissolution of LLC - Recharacterizes Capital Contributions as Loans to Reach Equitable Result
An involuntary dissolution case was decided by the New York Supreme Court (the trial court) two weeks ago, on a petition for dissolution by one of the two members of a limited liability company. Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012).
Background. Mizrahi and Cohen’s LLC owned a four-story commercial office building, with the ground floor rented by Cohen’s optometry business and the second floor rented by Mizrahi’s dental practice. The LLC consistently operated at a loss from 2006, the first year the building was occupied. The losses were covered by the members’ periodic capital contributions, although the LLC’s operating agreement didn’t require any additional capital contributions after the initial contributions. The two members each had a 50% ownership interest in the LLC, and initially they contributed additional capital in equal amounts. After a few years, however, Cohen’s capital contributions became sporadic and Mizrahi contributed most of the capital necessary to keep the LLC from defaulting on its mortgage. Over a span of several years Mizrahi contributed approximately $900,000 more than Cohen.
Mizrahi sued for dissolution of the LLC and an accounting of the proceeds of the company. The New York LLC Act uses the familiar standard for judicial dissolution: “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” N.Y. Ltd. Liab. Co. Law § 702. (Washington and Delaware, for example, have similar provisions in their LLC statutes. RCW 25.15.275; Del. Code Ann. tit. 6, § 18-802.)
The Appellate Division held in 2010 that Section 702 requires that for dissolution to be ordered, the petitioner must show, “in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.” In re 1545 Ocean Ave., LLC, 72 A.D.3d 121, 131, 893 N.Y.S.2d 590 (N.Y. 2010).
Dissolution. The gist of the court’s analysis was that continuing the LLC was financially unfeasible because of (a) the significant losses incurred over the years, (b) Cohen’s failure to contribute equally in meeting the losses and his undermining the financial integrity of the LLC by unilaterally withdrawing $230,000 of his capital, and (c) the likelihood that it was only a matter of time, should Mizrahi exercise his right to refrain from making further capital contributions, until the LLC would default on its mortgage and the mortgage be foreclosed upon. Mizrahi, 2012 WL 104775, at *8.
The facts of the case and the court’s analysis are ably described in more detail by Peter Mahler in his New York Business Divorce law blog, here.
Accounting and Winding Up. Having determined that the LLC would be dissolved, the court discussed the accounting procedures to be followed and the winding up and distribution requirements of the LLC’s operating agreement. The operating agreement required that after payment to the LLC’s creditors and satisfaction of its liabilities, any remaining assets would be distributed to the members “according to their ownership interests,” i.e., 50% to each. There was no provision for returning a member’s capital, apparently on the assumption that the members would contribute capital in equal amounts, thus maintaining the 50/50 ratio for contributions as well as for their ownership interests.
But as it turned out, Mizrahi had contributed $900,000 more than Cohen. Ignoring that fact in the final 50/50 distribution would be consistent with the operating agreement but manifestly unfair. “[C]rediting the sums advanced by plaintiff to his capital account would work an inequitable result in that the Operating Agreement prevents the return of a Capital Contribution.” Id. at *11.
The court therefore ordered that Mizrahi’s capital contributions in excess of the amount of Cohen’s capital contributions would be treated as a loan to the LLC, to be repaid to Mizrahi as a debt of the LLC prior to the distributions to the members based on their 50/50 percentage of ownership. Id.
The court also ordered that Cohen’s $230,000 withdrawal from the LLC, whether treated as a loan or a capital withdrawal, would be applied to reduce the amount of any distribution to Cohen. Id. at *9.
The court’s resolutions of these two issues are clearly equitable and fair, but it is striking that the court gives no explanation or authority for either, other than its passing reference to avoiding an “inequitable” result. Trial courts have broad equitable powers, but one would have expected at least some citations to authority for the court’s application of those powers.
New York High Court Punts on Fiduciary Duties of LLC Promoters
Last month New York’s highest court, the Court of Appeals, affirmed a 2010 ruling by the Appellate Division that LLC promoters were fiduciaries of the investors they solicited, prior to the LLC’s formation, to become members. Roni LLC v. Arfa, 2011 WL 6338906 (N.Y. Dec. 20, 2011). The top court’s ruling was a surprisingly short memorandum opinion, given the significance of the issue presented.
The Appellate Division had applied the corporate rule on pre-formation activities to LLCs. “It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders…. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Roni LLC v. Arfa, 74 A.D.3d 442, 444 (N.Y. App. Div. 2010). I wrote about the Appellate Division’s ruling here, and about last month’s oral argument before the Court of Appeals, here.
The Appellate Division’s ruling had also garnered attention from New York lawyer Peter Mahler, here and here, and from the late Professor Larry Ribstein, who passed away recently, here. Professor Ribstein also filed an amicus brief on the case with the Court of Appeals. The major criticisms of the 2010 ruling have been that the rule of the old corporate cases is no longer necessary because of the disclosure requirements of the federal and state securities laws, and that the corporate rule should not be applied to LLCs because their contractual nature distinguishes them from corporations.
The Court of Appeals put off the question, however, whether mere status as a pre-formation LLC promoter is adequate to create a fiduciary relationship. “Based on the foregoing analysis, we need not decide the question of whether the promoter defendants’ status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship.” Roni LLC v. Arfa, 2011 WL 6338906, at *4 n.2.
The court instead began by citing prior case law to the effect that a fiduciary relationship exists “when confidence is reposed on one side and there is resulting superiority and influence on the other,” id. at *2. The court then reviewed the complaint’s allegations that (1) the promoters planned the business venture, organized the LLC, and controlled the invested funds; (2) the promoters were in the best position to disclose material facts to the investors; (3) the promoters represented to the foreign investors that they had particular experience and expertise in the New York real estate market; and (4) the promoters played upon the cultural identities and friendship of the investors. The court found that the complaint’s allegations showed confidence by the investors and resulting superiority and influence by the promoters, and therefore adequately pled a fiduciary relationship. Id. at *3.
The Court of Appeals ignored the Appellate Division’s holding that the complaint’s allegations are inadequate to establish a fiduciary relationship, which suggests that the Court of Appeals went out of its way to affirm without ruling on the “LLC-promoter-status-equals-a-fiduciary” issue. But if so, it’s slightly puzzling that the court also saw no distinction between LLCs and corporations for the issues in this case:
Certainly there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case: a potential exists regardless of corporate form for “conscienceless promoters [to] accumulate property at a low price under a well-devised scheme to unload it upon others at a high price.
Id. at *4 n.1.
Although the court’s opinion leaves open the “LLC-promoter-status-equals-fiduciary” issue, I suspect that most plaintiff’s attorneys will conclude that the court left them with enough to work with when pleading pre-formation fiduciary duty claims against LLC promoters. For one thing, the first three of the four factual points in Roni referred to by the court and summarized above are likely to apply to most promoter situations.
Fiduciary Duties of LLC Organizers Argued Before New York's Highest Court
Last year the New York Appellate Division ruled that LLC organizers are fiduciaries of the investors they solicit to be members, and that as such they have a duty to disclose their self-dealing. Roni LLC v. Arfa, 903 N.Y.S.2d 352 (App. Div. 2010). I reported on the case, here.
The Roni decision was critiqued by New York lawyer Peter Mahler, who blogs on New York business law, here, and by law professor Larry Ribstein, here. To oversimplify a bit, the gist of the criticism is that the rule of the old corporate cases, on which the Roni court relied, (a) has been made unnecessary by the disclosure rules of federal and state securities laws, and (b) should not apply to LLCs because the contractual nature of the relationship between LLC members allows them to allocate risks and define duties inter se, which is not characteristic of corporations.
Roni has since been appealed to New York’s highest court, the New York Court of Appeals. Oral arguments in the case were heard by the court on November 15, 2011, and yesterday Peter Mahler blogged on the briefing and the oral arguments, here. His article is a fascinating review of the oral arguments before the high court. The judges’ questions apparently ranged widely from “Why should LLCs be treated differently?” to concerns over line-drawing and the reach of the Roni rule articulated by the Appellate Division.
So now we wait for the high court’s decision, which Peter Mahler predicts will likely be in the early months of next year. One can hope, if the Appellate Division ruling is upheld, that the court will provide some guidance on the scope of the Roni duty to disclose.
New York Loosens Strict LLC Member Liability for Unpaid Sales Taxes
Many states impose personal liability for unpaid sales taxes and income tax withholdings on LLC managers and employees who are responsible for paying the taxes. For example, in an Oregon Tax Court case I recently blogged about, here, a 10% LLC member and non-manager who occasionally signed checks for the LLC was assessed liability for the LLC’s unpaid income tax withholdings by the Department of Revenue. Because he had authority to sign checks only under the direction of the 90% owner and manager, the Tax Court held that he was not personally liable.
New York has long taken a far different, nay draconian, approach.
Like many other states, New York imposes personal liability for payment of unpaid sales taxes on corporate and LLC employees and managers having a duty to the entity to act for it in complying with the sales tax. N.Y. Tax Law §§ 1133, 1131(1). But the New York statute goes further and imposes personal liability on “any member of a partnership or limited liability company” for the LLC’s sales tax obligations. N.Y. Tax Law § 1131(1). It is irrelevant whether the LLC member is a manager or employee – even passive investors are jointly and severally liable for 100% of the LLC’s New York sales tax obligations. (There is no comparable rule for shareholders of a corporation.)
The rule applies to any LLC that is obligated to collect New York sales taxes – it is not limited to LLCs formed under New York law. For example, the members of a Delaware LLC making retail sales in New York would be subject to personal liability for the LLC’s unpaid sales taxes. The New York Department of Taxation has not hesitated to pursue LLC members for sales taxes under the rule, even passive investors.
The Tax Department’s new policy provides partial relief for minority members, i.e., those whose ownership interest and distributive share of the LLC’s profits and losses are less than 50%. Technical Memorandum TSB-M-11(6)S (Apr. 14, 2011). A minority member will now be liable only for its pro rata share of the taxes, i.e., the product of the LLC’s sales tax liability multiplied by the greater of the member’s percentage of ownership interest or its percentage share of the profits and losses of the LLC.
The policy imposes several conditions before a minority member is eligible for relief. The member must document its ownership interest and percentage share of the LLC’s profits and losses, demonstrate that it was not under a duty to act for the LLC in complying with the LLC’s sales tax obligations, and cooperate with the Tax Department in providing information about other potentially responsible persons and about the structure and ownership of tiered entities, including out-of-state entities.
The new policy provides no relief for LLC members owning 50% or more of the LLC, who will each continue to be personally liable for all LLC sales tax obligations. But by reducing the personal liability of minority members to a pro rata share of the LLC’s tax obligations it can dramatically limit a minority member’s exposure.
More States Are Considering Low-Profit LLCs
At least 10 state legislatures are considering bills to authorize low-profit limited liability companies (L3Cs) – all introduced in the last two and a half months:
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Arizona; Senate Bill No. 1503 |
Arkansas; Senate Bill No. 5 |
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Hawaii; Senate Bill No. 674 |
Indiana; Senate Bill No. 501 |
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Kentucky; House Bill No. 110 |
Maryland; House Bill No. 552 |
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Montana; House Bill No. 415 |
New York; Senate Bill No. 3011 |
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Oregon; House Bill No. 2745 |
Rhode Island; Senate Bill No. 353 |
These have the potential to more than double the number of states that authorize L3Cs. Currently eight states have authorized L3Cs: Illinois, Louisiana, Maine (effective July 1, 2011), Michigan, North Carolina, Utah, Vermont, and Wyoming.
The L3C is a relatively new type of limited liability company, a hybrid which attempts to combine a charitable purpose with a profit-making motive. An L3C is not a nonprofit and is taxed on its profits like any other LLC. I have previously written about L3Cs, here.
Advocates of L3Cs suggest they will encourage investment by private foundations in L3C enterprises. Typical program-related investments (PRIs) made by private foundations in either for-profit or tax-exempt enterprises include equity investments and loans, on terms more favorable to the recipient than a market rate investment. The purpose of the investment must be to support the foundation’s charitable purpose. L3Cs are promoted as facilitating increased investment by private foundations, because the state statutes apply to L3Cs the Internal Revenue Code requirements for the recipient of a PRI made by a private foundation. IRC § 4944(c). The idea is that because L3Cs automatically apply those standards to L3Cs, private foundations will be more willing to invest in L3Cs.
L3Cs have generated a lot of interest in the non-profit and social enterprise community, and a fair amount of commentary is becoming available. The Vermont Law Review sponsored a symposium on L3Cs and other developments in social entrepreneurship in February 2010. (Vermont was the first state to authorize L3Cs.) Articles related to the Symposium were published in a symposium edition of the Vermont Law Review, Symposium, Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship, 35 Vt. L. Rev. 1 (2010).
Two articles in the symposium edition caught my eye. The first was Program-Related Investments in Practice, 35 Vt. L. Rev. 53 (2010), by Luther M. Ragin, Jr., Chief Investment officer of the F. B. Heron Foundation. Heron has been an active PRI maker since 1997, and at the end of 2009 had $21 million in outstanding PRIs, in 38 separate transactions. Heron’s PRIs were made to a variety of organizations. Most were to non-profits, but 10 were equity or subordinated debt investments in limited partnerships, LLCs, and corporations.
The critical driver for Heron is not the legal form of the organization seeking capital. Heron has found that it can apply the PRI rules and reach positive decisions on PRIs to various types of for-profit entities as well as non-profits, provided the PRI serves a charitable purpose. (The two other PRI tests – no lobbying, and income from the PRI not being a significant purpose of the foundation’s decision to make the investment – must also be satisfied.)
The other article in the Symposium edition that jumped out was The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 275 (2010), by J. William Callison and Allan W. Vestal. The article nicely reviews the law of private foundations and PRIs. It then examines the L3C requirements of the state LLC laws and how they attempt to match the PRI requirements. The article concludes that the statutory form does not match well with the PRI requirements and that private foundations will still need to conduct the same due diligence they would conduct before making a PRI to a non-L3C entity.
The experience of the F. B. Heron Foundation buttresses Callison and Vestal’s analysis. The type of entity, and whether it is a for-profit or a non-profit, play little part in Heron’s decisions about making PRIs.
The article concludes with a discussion of why L3Cs are considered harmful. First, smaller, less well-advised foundations may unduly rely on the L3C status of the recipient when making a PRI rather than on their usual due diligence, resulting in non-compliance with tax requirements and possibly endangering the foundation’s charitable status. Second, in an L3C with profit-seeking participants, where the foundation makes a high-risk, low-return investment vis-à-vis the other investors, there is risk that the foundation may run afoul of the “private benefit” doctrine, which is intended to prevent tax-exempt organizations from conferring private benefit on private participants.
Callison and Vestal’s conclusion is succinct: without changes to federal PRI rules there is little or no value to the L3C structure, the existence of the L3C form is a dangerous trap for the unwary, and the form should be shelved.
The article makes a strong case for the states to stop adopting the L3C form, and for the states that currently authorize the L3C form to revise their LLC laws to delete the L3C authorizations.
Will careful legal analysis and commentary take the wind out of the sails of the L3C movement? It’s hard to say. Popular enthusiasms and fads take on a life of their own. And one of the drivers of the L3C movement is the laudable goal of increasing the flow of private foundation money to ventures with charitable purposes. But that goal appears to be blinding the L3C promoters and some state legislators to the legal realities – L3Cs don’t and won’t accomplish that goal unless and until the federal tax rules are changed, which appears unlikely.
New York Addresses Fiduciary Duties of LLC Organizers
The New York Appellate Division recently applied the fiduciary rules for corporate organizers to the organizers of LLCs, and found the LLC organizers to be fiduciaries of the investors they solicited to become members. Roni LLC v. Arfa, No. 1758, 601224/07, 2010 N.Y. App. Div. LEXIS 4613 (June 3, 2010).
The defendants were the promoters and organizers of several New York LLCs. The organizers entered into real estate purchase agreements, and then assigned the agreements to the LLCs after their formation. The organizers, who were the initial members of the LLCs, solicited outside investors to purchase member interests in the LLCs. The investors’ funds were then used by the LLCs to purchase the real properties.
Subsequently the investors sued the organizers, claiming that the organizers concealed brokerage commissions they received from property sellers and mortgage brokers. The investors alleged that the undisclosed commissions inflated the purchase prices of the real estate by at least $6.5 million.
The investors asserted claims for waste, breach of fiduciary duty, actual fraud, constructive fraud and an accounting. The organizers moved to dismiss for failure to state a cause of action and for failure to plead actual fraud and breach of fiduciary duty with specificity. The trial court denied the motion and upheld all claims, other than the claim for waste. The organizers appealed the dismissal of the motion, contending that the investors had not alleged adequate facts to establish that the organizers were their fiduciaries.
The key to the court’s decision was its extension of the corporate rule to LLCs. The court noted that “[i]t is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.” Id. at **5. From there it was a short jump to LLCs: “By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Id. at **5-6. As fiduciaries, the organizers were obligated to fully disclose the organizers’ interests that might affect the LLC and its members, including the organizers’ profits from organizing the LLC. Id. at **6. The court held that the investors had therefore stated a cause of action by alleging that the defendant organizers had failed to disclose the commissions they received from sellers and mortgage brokers, which inflated the purchase prices of the LLCs’ real estate. Id.
The organizers also defended on grounds that the investors had failed to allege that the undisclosed commissions were material, that the investors justifiably relied on the organizers’ silence, and that the investors were damaged. The court made short work of those defenses. Damages had been alleged, said the court. And because the case was an appeal of the trial court’s denial of the plaintiffs’ motion to dismiss, the issues of materiality and reliance could not be resolved as a matter of law, but would have to be resolved at trial. Id. at **7-8.
The Roni court’s resolution of the fiduciary duties of LLC organizers is an example of legal reasoning by analogy. The court looked at the rule that applied to organizers of corporations, and apparently deciding that LLCs are similar enough to corporations, applied the corporate rule to LLCs.
As the law of LLCs develops, state courts are frequently called upon to decide novel LLC issues. In doing so the courts often look to the law applicable in the analogous corporate context. Examples that I have written on previously include New York (de facto corporations, here), Colorado (creditors’ claims against directors, here), Oregon (requirements for derivative suits, here), and Michigan (officer liability for corporate torts, here).
The Roni court did not explain the principles underlying the corporate rule that it relied upon, but simply applied it “[b]y extension.” Id. at **5-6. The court’s implicit recognition of a close analogy between corporations and LLCs was presumably based on the entity nature of each and the similar roles played by the organizers of each type of entity.
Substance Over Form - LLC "Distributions" Are Recognized as Product Sales
Every so often a case comes along where you read the opinion and say to yourself, “Did they really think this would work?” Meadowsweet Dairy, LLC v. Hooker, Commissioner of Agriculture and Markets, No. 1868, 2010 N.Y. App. Div. LEXIS 1841 (Mar. 11, 2010) is one of those cases.
Steven and Barbara Smith operated a New York dairy and produced and sold unpasteurized milk from 1995 to 2007. During that time they were regulated and inspected by the New York Department of Agriculture and Markets (the Department), and held the permits required by the Department.
In March 2007 the Smiths surrendered their permits and formed Meadowsweet Dairy, LLC. Meadowsweet began operating the dairy and producing unpasteurized milk, cheese and yogurt. But instead of selling milk to the general public, Meadowsweet dealt only with individuals who became members of the LLC. Meadowsweet complied with none of the Department’s permit, inspection and other regulatory requirements.
Meadowsweet’s members were required to make an initial capital contribution of $50, and to make capital contributions at the start of each quarter based on the member’s estimated consumption of milk and dairy products during the quarter. Members were then entitled to receive what were called “dividends,” i.e., distributions from the LLC, in proportion to their capital contributions. The list price of milk received by the member was then credited against the member’s capital account. Milk and other dairy products produced by Meadowsweet were only available to Meadowsweet’s members.
In October 2007 the Department seized 260 pounds of unpasteurized milk from Meadowsweet for noncompliance with its regulations. Meadowsweet then commenced suit, seeking a declaration that the Department lacked jurisdiction.
Meadowsweet’s principal argument was that it was not selling products – that no sale occurred when its members received milk products as distributions. The court, however, looked at Meadowsweet’s system of prepaid capital accounts and offsetting credits equal to the list price of the member’s milk dividend and concluded that “[r]ather than truly constituting dividends in return for their investment in the LLC, this arrangement appears to be a system of prepayment for the sale of dairy products.” Meadowsweet, 2010 N.Y. App. Div. LEXIS 1841, at **10.
The court did not analyze why the arrangement “appears to be a system of prepayment,” but it’s not hard to see what must have been the court’s reasoning. First, the adoption of the new business model (capital contributions and milk distributions that offset against the member’s capital) coincided with surrendering the Department’s permits. But more tellingly, the so-called capital contributions were not used as capital in any normal sense of the word.
The “capital” of a business usually means its assets, such as cash, goods, and machinery, that are used to generate income. Capital is usually held for the long term. An LLC’s operating agreement can specify how distributions are made, see New York Limited Liability Company Law Section 504, and LLCs almost always severely limit the extent to which distributions can be made to members. In contrast, Meadowsweet’s members could unilaterally decide how much milk to consume and thereby control their receipt of “dividends.” Each member’s capital fluctuated during the quarter based on its milk consumption.
The court did not recognize any business purpose for Meadowsweet’s structure other than avoiding regulation, and found that Meadowsweet was in effect selling milk to its members. Meadowsweet labeled its members’ payments as capital and labeled the milk delivered to its members as dividends, but the court ignored the terminology and looked to the substance rather than the form of the transaction. Presumably the court was also influenced by the public health character of the Department’s regulations.
The court also found other reasons why Meadowsweet was subject to the jurisdiction of the Department. The regulations required that producers of milk products such as the cheese and yogurt produced by Meadowsweet must obtain a milk plant permit. The court also held that even if the milk was not sold, a permit is nonetheless required for unpasteurized milk given or otherwise made available to consumers.
In considering the results of this unsuccessful attempt to avoid the Department’s regulations, one wonders whether legal counsel were involved and what role they played. Did a lawyer for the Smiths originate the idea of using an LLC and recharacterizing milk sales as capital contributions and dividends? Or did the Smiths originate the idea and use a lawyer to form Meadowsweet and document the arrangements with milk consumers? Or was the entire plan carried out without the benefit of legal advice? If lawyers were involved they appear to have taken what a more conservative lawyer would call an overly aggressive approach, to put it charitably. Sometimes the best advice a lawyer can give is to say “Let’s stop and think this one over,” and that surely would have been good advice here.
An LLC's Property Is Not the Members' Property
A recent New York case dealt with one of the most fundamental characteristic of LLCs – the LLC as a legal entity. Sealy v. Clifton, LLC, 890 N.Y.S.2d 598, 2009 N.Y.App. Div. LEXIS 9020 (N.Y.App.Div. 2009). One of two LLC members, each owning a 50% interest, asked the trial court to partition the LLC’s real estate. In a partition action, real estate held by joint tenants or tenants in common is divided into portions so that each co-owner is awarded full, individual ownership of a portion of the real estate. The trial court refused to dismiss the partition action, but the Appellate Division reversed and required dismissal by the trial court.
Under state LLC laws, an LLC is a legal entity, in effect a legal person. An LLC can sue and be sued, own property, enter into contracts, and do many of the things that an individual human being can do. E.g. N.Y. Ltd. Liab. Co. Law §§ 203(d), 202.
Since an LLC is a legal person, the property it owns is the property of the LLC, not of the members. The New York LLC Act is clear: “A membership interest in the limited liability company is personal property. A member has no interest in specific property of the limited liability company.” N.Y. Ltd. Liab. Co. Law § 601. Other state LLC laws have similar provisions.
Relying on Section 601, the Sealy court held that the LLC, not its members, owned the real estate. Because the members were not co-owners of the real estate, the partition action had to be dismissed. Sealy, 2009 N.Y.App. Div. LEXIS 9020, at *1. Prior New York law allowed partition actions to be brought only by co-owners.
Perhaps the reasoning of the Sealy plaintiff was: “I am a part owner of the LLC; the LLC owns the real estate, therefore I am a part owner of the real estate.” In other words, something like “I own the box, ergo I own what’s inside the box.” The analogy is not apt, but perhaps it convinced the trial judge, since he refused to throw out the partition request.
That theory breaks down because an LLC is a legal entity, a legal person. The real estate in Sealy was owned by the LLC, not by the members. The only way a member could reach the real estate would be to cause the dissolution and winding up of the LLC. In that process either the real estate would be liquidated and its proceeds distributed to the members, or the real estate could be divided by the LLC and the individual parcels of the real estate distributed in kind to the members. But the member apparently had not pursued dissolution.
The legal personhood of LLCs, like that of corporations, partnerships and other entities, is a legal doctrine thoroughly woven into our legal, business, financial and political systems. It allows the law to treat LLCs as persons for many purposes – but not all. For example, LLCs cannot marry, adopt children, hold public office, or vote in public elections.
Some constitutional rights apply to legal entities. For example, the U.S. Supreme Court last month invalidated a federal ban on corporate expenditures for public communications intended to affect federal elections. The Court held that the First Amendment’s mandate that “Congress shall make no law … abridging the freedom of speech” applies to corporations. Citizens United v. Fed. Election Comm’n, 175 L. Ed. 2d 753 (2010). The Court’s opinion saw corporations as entitled to be heard in the political arena, like individuals. This was a controversial five-to-four decision that overruled prior Supreme Court precedent.
The boundaries of the legal doctrine that treats corporations and LLCs as persons will continue to be mapped and delineated. And as in Citizens United, the boundary may shift from time to time.
A First -- New York Applies De Facto Corporation Doctrine to LLCs
New York’s highest court, the Court of Appeals, held last month that the doctrine of de facto corporations applies to LLCs. In re Hausman, No. 08854, 2009 NY LEXIS 4145 (Dec. 1, 2009). “De facto corporations” is an equitable doctrine that can be applicable when founders have attempted to form a corporation but failed to fully comply with the statutory requirements. The New York court is apparently the first appellate court in the nation to resolve this issue (other than the Fifth Circuit in Western Sec. Corp., 303 F. App'x 173 (5th Cir. 2008), an opinion that the Fifth Circuit has determined should not be published and which for most purposes is not precedent.)
It sometimes happens that founders of a corporation or LLC to enter into contracts, incur debts or take other actions on behalf of the entity before its formation. But if an agent enters into a contract on behalf of a non-existent entity, under agency law the other party to the contract will usually be able to hold the agent personally liable. The de facto corporation doctrine can permit judicial recognition of the entity’s existence, thereby avoiding personal liability of the agent.
In most states, including New York, an LLC begins to exist when its articles of organization or certificate of formation are filed with the appropriate state agency. E.g., N.Y. Ltd. Liab. Co. Law § 203. But occasionally founders jump the gun and act on behalf of the LLC before the filing is made, sometimes by mistake and sometimes knowing that the articles were not yet filed.
When creditors later claim that the founders are personally liable for contracts entered into before the LLC existed, the founders may defend on the grounds that a de facto corporation existed. There are also other situations, such as in Hausman, where the effectiveness of a conveyance or some other action will depend on whether the LLC existed at the time of the action, and the de facto corporation doctrine may then come into play.
Hausman was a probate proceeding. Lena Hausman’s will left real estate to her son and daughter and to the children of two predeceased sons. Before her death, the son and daughter executed articles of organization and prepared an operating agreement for a New York LLC. Lena Hausman then deeded the real estate to the son and daughter’s LLC, but the articles of organization for the new LLC were not filed with the New York Department of State until 14 days later.
Lena Hausman died seven months later and her will was admitted to probate. In the probate proceedings, the children of the predeceased sons claimed that the real estate should pass by will because Lena’s deed did not convey the real estate to a valid LLC. They pointed out that the LLC did not exist at the time of the deed. The probate court concluded that the deed to the LLC was valid because the LLC was a de facto corporation when the deed was executed.
The Court of Appeals held that the de facto corporation doctrine is applicable to LLCs. “The statutory schemes of the Business Corporation Law and the Limited Liability Company Law are very similar, and we see no principled reason why the de facto corporation doctrine should not apply to both corporations and limited liability companies.” Hausman at *3. The court cited to no other authority, but implicitly recognized that the equitable considerations which support the doctrine for corporations apply to LLCs as well.
The Court of Appeals pointed out that the de facto corporation doctrine requires (1) a law under which the entity might be formed, (2) an attempt to form the entity, and (3) an exercise of the entity’s powers thereafter. Under the facts in Hausman, the court concluded that the second prong was not satisfied¾even though the doctrine was applicable, no de facto LLC existed because there had been no attempt to file the articles of organization until weeks after the deed conveying the real estate was executed.
It is worth noting that many other states have abolished the doctrine of de facto corporations. See, e.g., Equipto Div. Aurora Equip. Co. v. Yarmouth, 134 Wn.2d 356, 367, 950 P.2d 451 (1998). Many of those states have adopted variations of the Model Business Corporation Act, which is intended to abolish the de facto corporation doctrine. See Model Bus. Corp. Act §§ 2.03, 2.04 (2008). Presumably the states that have abolished the de facto corporation doctrine would not apply it to LLCs.
New York Court Holds Distribution Was Not a Misappropriation
Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.
Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.
According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.
Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.
Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.
Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.
The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.
The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.
Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.
The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.
