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.
