LLCs have a natural life cycle. They are formed, they organize, they begin conducting their business. And eventually, eventually all LLCs come to an end – sometimes gracefully, sometimes not.
The end stage for an LLC begins with its dissolution, continues with its winding up, and eventually concludes when the business has been closed down, debts and liabilities satisfied, and any remaining assets distributed to the members. This is sometimes a messy process, with unexpected claims, litigation, overlooked assets, disputes between members, tax surprises, missing records, and other examples of Murphy’s law.
A case last month from Kansas is an example of just such a result, where the LLC’s members had a dispute over whether a payment obligation continued post-dissolution. The case also shows how the Kansas LLC Act’s requirement that dissolved LLCs be terminated can lead to unexpected results. Iron Mound, LLC v. Nueterra Healthcare Mgmt., LLC, 313 P.3d 808 (Kan. Dec. 6, 2013).
Iron Mound and Nueterra were the two members of an LLC formed in 1999 to develop and operate ambulatory surgical centers. Shortly after the LLC’s formation, as allowed by the operating agreement, Nueterra entered into a five-year management agreement with the Manhattan Surgical Center (MSC). The LLC’s operating agreement required that Nueterra pay 20% of its MSC revenues to Iron Mound.
Two years later Iron Mound exercised its right under the operating agreement to dissolve the LLC. After some minor winding-up activities, Iron Mound filed the LLC’s certificate of cancellation under Section 17-7675 of the Kansas LLC Act. At that time the LLC’s only significant company asset was the interest in management fees generated from the MSC management agreement. Id. at 810.
Nueterra continued paying Iron Mound 20% of its revenues from MSC until the management agreement expired in February 2006. MSC exercised its right not to renew the management agreement and invited Nueterra to negotiate a new agreement with different terms. Shortly thereafter MSC and Nueterra entered into a renegotiated management agreement.
Nueterra ceased its payments to Iron Mound when the first management agreement expired, and took the position that it was not obligated to pay Iron Mound any portion of its revenues from the new management agreement. Iron Mound disagreed and filed a breach of contract lawsuit against Nueterra for failing to pay 20% of its revenues from the new MSC management agreement.
The trial court ruled in favor of Nueterra on its motion for summary judgment. The Court of Appeals reversed, finding the payment language in the operating agreement to be ambiguous on whether the parties intended the payment obligations to survive the dissolution of the LLC.
The Supreme Court found that the operating agreement showed an unambiguous intent that Iron Mound’s right to 20% of Nueterra’s fees from the MSC management agreement was dependent on its membership in the LLC and on the terms of the operating agreement. Id. at 813-14. The court also found it to be undisputed that the operating agreement had ceased to exist by the time Nueterra entered into the new management agreement with MSC. “[T]hus there was no ‘Company’ to ‘receive’ revenues and no ‘Members’ to whom such revenues would be allocated.” Id. at 814.
The court concluded that Nueterra’s new MSC management agreement could not have been an asset of the LLC because the LLC and its operating agreement had both ceased to exist before Nueterra entered into the new management agreement. Id. The court reversed the Court of Appeals and affirmed the trial court’s grant of summary judgment to Nueterra.
Comment. The Kansas LLC Act requires that a dissolved LLC’s articles of organization be canceled upon the completion of its winding up, by the filing of a certificate of cancellation. Kan. Stat. Ann. § 17-7675. The LLC’s existence as a separate legal entity ceases when the certificate of cancellation is filed, and its winding-up activities may not be carried out thereafter. Kan. Stat. Ann. §§ 17-7673(b), 17-76,118(b). (The court in Iron Mound referred to the filing of the LLC’s certificate of cancellation and recognized that the LLC no longer existed, but never cited the relevant statutes.)
The Supreme Court in Iron Mound was driven to its decision by the statutory termination and non-existence of the LLC. The case likely would have come out differently if the Kansas LLC Act allowed an LLC’s winding up to continue indefinitely. In that event the lack of clarity in the operating agreement’s payment terms for Nueterra’s management agreements presumably would have led the court to reverse the trial court’s summary judgment, resulting in a trial over the intent of the parties.
A thought experiment points out the how the Kansas termination rule can lead to unsatisfactory results. The Kansas statute requires that the certificate of cancellation be filed on completion of winding up, and Iron Mound could have viewed its receipt of the payment stream from Nueterra as part of the winding up. In that case it would have been justified in delaying filing the certificate of cancellation until the contractual relationship between Nueterra and MSC was finally terminated. And that would have meant that neither the operating agreement nor the LLC would have been terminated when the first MSC agreement expired and a new agreement between Nueterra and MSC was put in place. The court would then have had to confront the terms of the operating agreement, likely leading to a trial on the merits.
The Kansas LLC Act’s approach – mandatory termination of the LLC’s existence – is an unnecessary holdover from the common law approach to corporate dissolutions. See 3 Model Business Corporation Act Annotated § 1405 official cmt. (4th ed. 2013). Kansas is not alone in its approach – a number of other state LLC statutes have similar provisions. See, e.g., Delaware, Del. Code Ann. tit. 6, §§ 18-203(a), 18-201(b); New Hampshire, N.H. Rev. Stat. Ann. §§ 304-C:142, 304-C:19 (certificate of cancellation may optionally be filed after completion of winding up).
Many state LLC statutes allow a dissolved LLC’s winding-up process to continue indefinitely, and also provide procedures to cut off claims. Washington, Oregon, and the Revised Uniform Limited Liability Company Act all follow that approach. Indefinite continuation of winding up accommodates unexpected circumstances such as the late-discovered asset or long-lasting contracts.
This week Oregon became only the second state to authorize benefit LLCs, when Governor Kitzhaber signed House Bill 2296. Over a dozen states have authorized benefit corporations, but until now only Maryland had authorized benefit LLCs.
Benefit Corporations. Benefit corporations are intended to provide general public benefit in addition to the usual corporate principle of maximizing profits for the benefit of shareholders. They are new – in 2010 Maryland became the first state to pass benefit corporation legislation. There are variations in the state statutes, but they are based primarily on a model act proposed by B Lab. States that have passed benefit corporation legislation include California, Illinois, Massachusetts, New Jersey, New York, and Pennsylvania. A benefit corporations bill was introduced in the Delaware legislature earlier this year.
Being a benefit corporation is not a simple or easy thing. In addition to the usual corporate requirements, a benefit corporation must have a corporate purpose to create a material positive impact on society and the environment. The directors’ duties are expanded to require consideration of the effects of the business on society and the environment. The benefit corporation must publish and make publicly available an annual report on the benefit corporation’s overall social and environmental performance using a comprehensive, credible, independent, and transparent third-party standard.
Benefit corporations are a response to the corporate law principle that corporations exist to maximize shareholder profits, and that therefore corporate directors have a fiduciary duty to be guided by that principle and not by broader, societal concerns. Bill Callison refers to this standard corporate law principle as “a procrustean bed of unalterable rules.” J. William Callison, Putting New Sheets on a Procrustean Bed: How Benefit Corporations Address Fiduciary Duties, The Dangers Created, and Suggestions for Change, 2 Am. U. Bus. L. Rev. 85, 86 (2012).
Oregon’s New Law. Oregon’s new statute authorizes and sets forth the requirements for a “benefit company,” which can be either a corporation or an LLC. The requirements are similar to those of the model act for benefit corporations, with some variations. For example, the model act requires a two-thirds vote of shareholders, but the Oregon law requires only a majority vote of shareholders or members.
As with the model act, the Oregon law does not require any special terminology in the name of the benefit company. Dissenters’ rights are not available when an existing LLC or corporation converts to a benefit company. An LLC benefit company’s articles of organization or operating agreement may not vary the requirements of the Oregon law except to the extent they impose more stringent requirements.
Comment. Oregon’s benefit company approach will be useful for corporations, but it appears to be unnecessary for LLCs. LLCs, unlike corporations, are primarily contractual in nature. An LLC’s principal charter document is its operating agreement, which is a contract between its members.
LLCs are also an inherently flexible entity structure. Most LLC statutes recognize the importance of the members’ freedom to contractually establish the nature of their LLC. For example, the LLC acts of Delaware and Washington both state: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Del. Code Ann. tit. 6, § 18-1101(b); Wash. Rev. Code § 25.15.800(2). Most states allow an LLC’s operating agreement to limit a member’s or manager’s fiduciary duties. E.g., Del. Code Ann. tit. 6, § 18-1101(c).
State LLC statutes generally recognize that the purpose of an LLC can be almost any legal objective. The Delaware LLC Act, for example, states: “A limited liability company may carry on any lawful business, purpose or activity, whether or not for profit, with the exception of the business of banking.” Del. Code Ann. tit. 6, § 18-106(a).
These attributes show that an LLC is not a “one size fits all” entity. Given an LLC’s malleable nature, there should be no need for a statutory authorization to allow an LLC to be a benefit company, à la the Oregon approach. Most state LLC acts appear broad enough already to allow the members to specify all the characteristics of a benefit corporation in their articles of organization and operating agreement.
It may be that there is more of a need for an LLC benefit company statute in Oregon, because the Oregon LLC Act does not authorize as broad a purpose for LLCs as most states do: “a limited liability company formed under this chapter may conduct or promote any lawful business or purpose which a partnership, corporation or professional corporation as defined in ORS 58.015 may conduct or promote, unless a more limited purpose is set forth in the articles of organization.” Or. Rev. Stat. § 63.074. Oregon corporations may only engage in a “lawful business,” id. § 60.074, and a partnership is “an association of two or more persons to carry on as co-owners a business for profit,” id. § 67.005(7).
Thus Oregon appears to require that an LLC have a business, profit-oriented purpose. But rather than create benefit companies for LLCs, a more straightforward approach would have been to simply amend Oregon’s LLC Act to allow a broader range of LLC purposes.
Oregon Supreme Court Overrules Court of Appeals: LLC Manager with a Known Conflict of Interest Does Not Have Authority to Bind LLC
An LLC manager that causes its LLC to enter into a transaction where the manager has a conflict of interest can create havoc. Case in point: An Oregon LLC manager extended the term of a loan agreement between his LLCs and a borrower, but the manager was at the same time chairman of the board and treasurer of the borrower, as well as an investor in the borrower. When the LLCs’ members learned of it later, they attempted to reject the extension on grounds that, because of his conflict, the manager lacked authority to bind the LLCs to the extension.
The trial court dismissed the plaintiffs’ claims on summary judgment and the Court of Appeals affirmed. I wrote about the Court of Appeals’ decision and criticized part of its reasoning, here.
The Oregon Supreme Court reversed the Court of Appeals, holding that the manager’s conflict of interest invalidated the transaction unless the borrower could show at trial that the transaction was fair to the LLC. Synectic Ventures I, LLC v. EVI Corp., 2012 WL 6628093 (Or. Dec. 20, 2012).
The Loans. Three LLC investment funds (Synectic) loaned a total of $3 million to EVI Corporation in 2003. The written loan agreement required EVI to repay the loans by December 31, 2004, but EVI had the right to convert the loans into shares of EVI stock if it received additional financing of at least $1 million before the December 31 deadline.
The Conflict. The Synectic LLCs were managed by Craig Berkman, through entities he controlled. Berkman was involved with parties on both sides of the loans, because he was also the chairman, treasurer, and a shareholder of EVI.
The Amendment. In September 2004 Berkman executed an amendment to the loan agreement on behalf of Synectic that extended EVI’s repayment deadline one year, until December 31, 2005. He also executed a Unanimous Consent on behalf of EVI’s board of directors, which approved the amendment.
The Synectic members were not aware of the amendment at the time it was made and did not discover its existence until early 2005. Berkman was removed as manager in the meantime, in December 2004. In August 2005 the Synectic members notified EVI that the amendment was unauthorized and that EVI was in default on the loan.
EVI raised $1 million in additional investment before December 31, 2005, from another fund managed by Berkman, and purported to convert the loan into equity. The Synectic LLCs filed suit to recover on the loan agreement, based on EVI’s nonpayment as of the original due date. EVI defended on grounds that the loan amendment extended the maturity date, and that the loan had been properly converted into EVI stock.
Supreme Court. The Supreme Court began by reviewing Oregon’s LLC Act and the parties’ operating agreements. The LLCs were manager-managed, and the court concluded that Berkman was their manager and had authority under the statute and the operating agreements to cause the LLCs to enter into contracts such as the amendment to the loan agreement. The LLCs contended, however, that Berkman lacked authority to enter into this particular transaction, the amendment, because he had a conflict of interest.
The court agreed: “An agent ordinarily lacks authority to act on behalf of a principal in a transaction in which the agent has a conflict of interest.” Id. at *6. The court also observed that Berkman had a conflict of interest because as manager of the LLCs and chairman and treasurer of EVI he was acting as agent for two principals with conflicting interests. But the court then pointed out that Oregon’s LLC Act permits self-interested transactions so long as they are fair to the LLC. Id.; Or. Rev. Stat. §§ 63.155(6), 63.155(9)(b).
The court saw the fairness or lack of fairness of the amendment as a factual issue and held that “there was a genuine issue of material fact regarding whether Berkman had a conflict of interest that breached his duty of loyalty in a manner that deprived him of authority to enter into the amendment.” Id. at *7.
The defendants contended that the parties’ operating agreements permitted Berkman to act on behalf of the LLCs notwithstanding any conflict of interest. The agreements provided in Section 3.2 that “[a]ny Member … may engage independently or with others in other business and investment ventures of every nature and description and shall have no obligation to account to the Company for such business or investments or for business or investment opportunities.” Id. at *7. Berkman was referred to in the operating agreements as the “Managing Member,” and the defendants argued that he was therefore allowed by Section 3.2 to act despite his conflict of interest.
The argument that Section 3.2 exculpated Berkman from his conflict of interest was accepted by the Court of Appeals, but in my prior post I pointed out the illogic: Section 3.2 applied to members, but Berkman had a conflict while acting as a manager, not as a member. The Supreme Court likewise rejected the argument that Section 3.2 had any relevance to Berkman’s actions as a manager. Id. at *10.
The defendants also argued that under the operating agreements they were entitled to rely on Berkman’s apparent authority without making any further inquiry. The court disagreed, pointing out that because Berkman was chairman of the board and treasurer of EVI, everything he knew was imputed to EVI and it was therefore well aware of the conflict and Berkman’s resulting lack of authority. Id. at *11.
Bringing out the final arrow in their quiver, the defendants claimed that the LLCs’ seven-month delay in objecting to the amendment amounted to a ratification by silence of the unauthorized amendment. The court said that was an issue of fact, to be decided at trial. The court accordingly reversed the decision of the Court of Appeals and the trial court’s judgment, and remanded for trial.
Comment. Lack-of-authority cases often involve two innocent parties, one of whom will bear the loss resulting from the manager’s unauthorized activities. I have previously written about such cases from Missouri (members bore the loss when manager without authority caused LLC to borrow money and encumber LLC’s real estate, and then misappropriated the loan proceeds), and from Mississippi (bank bore the loss when manager without authority caused LLC to convey real estate to manager’s separate company, and then borrowed money from bank, secured by lien on the real estate).
Synectic was in some ways an easier case because it did not involve two innocent parties. The LLCs’ members were innocent because they had no knowledge of Berkman’s execution of the amendment until months afterward. But EVI was not an innocent party – Berkman’s knowledge of his conflict and lack of authority was imputed to EVI because of his role as EVI’s chairman and treasurer.
North Carolina Court Resolves Conflict Between LLC Act Rules on Member Withdrawals and Assignments to Non-Members
A North Carolina court last month was faced with troubling issues involving assignments of LLC member interests and changes of control. There was no dispute that the assignments conveyed the assigning members’ economic rights. The question was whether the associated control rights (management and voting) were retained by the assignor, conveyed to the assignee, or left inchoate and unusable by either the assignor or assignee until and unless the assignee was admitted as a member. The court in Blythe v. Bell, No. 11 CVS 933, 2012 WL 6163118 (N.C. Super. Dec. 10, 2012), had to resolve conflicting provisions of North Carolina’s LLC Act applicable to assignments and member withdrawals.
Drymax Sports, LLC was formed as a North Carolina limited liability company in 2003 by Hickory Brands, Inc. (HBI) and four individuals. The members and their initial percentage holdings were:
William Blythe 40%
Nissan Joseph 20%
Rob Bell 5%
Virginia Bell 5%
In 2007 HBI assigned all of its interest in equal parts to Rob Bell and Virginia Bell. In 2008 Joseph assigned his interest to HBI.
By 2011 a number of disputes between the members had arisen, and Blythe filed a lawsuit against the other members. After completion of pre-trial discovery, the parties filed cross-motions for summary judgment on the effects of the two assignments. The Blythe opinion is the trial court’s ruling. (The Blythe court is a specialized North Carolina Business Court, which handles cases involving complex and significant corporate and commercial law issues.)
Control Dispute. The motions were essentially a fight for control of Drymax. Blythe contended that the assignments by HBI and Joseph divested them of control but did not convey control rights to the assignees because the assignments were not approved by unanimous member consent. Id. at *5. That would leave only Blythe, Rob Bell, and Virginia Bell with control rights, resulting in Blythe’s effective voting control being increased from 40% to 80%, even though his economic interest would remain at 40%.
The defendants contended that HBI’s assignments to Rob Bell and Virginia Bell did not require unanimous member approval because they already were members, and that the assignments therefore conveyed control rights. The defendants also argued that Joseph’s assignment to HBI (which was at that time a non-member) did not convey control rights, and that Joseph retained his control interests because HBI was not admitted as a member. Id. at *6.
The court found that there was no operating agreement and that therefore the effects of the assignments were determined by the default provisions of the North Carolina Limited Liability Company Act. Section 57C-5-02 provides that an LLC interest is assignable but that an assignee receives only the economic rights, i.e., the right to receive the distributions and allocations to which the assignor would have been entitled. Section 57C-5-04(a) provides that an assignee may become a member by complying with the operating agreement (if there is one) or by the unanimous consent of the members, and that an assignee who becomes a member has the rights of a member, including voting control, with respect to the interest assigned.
Section 57C-5-02 disenfranchises members who assign all of their member interests: “Except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of his membership interest.” This rule is phrased as an absolute – it does not depend on whether the assignee is admitted as a member.
These two sections, when read together, appear to require that if a member assigns all of its interest to an assignee that is not admitted as a member, neither the assignor nor the assignee will be able to vote or use any control rights associated with the transferred interest.
The court also referred to Section 57C-5-06, which states: “A member may withdraw only at the time or upon the happening of the events specified in the articles of organization or a written operating agreement.” Withdrawal is not defined in the LLC Act, but the court characterized this section as a limit on a member’s right to terminate its membership. Id. at *5.
Conflicts in the LLC Act. The court was faced with the following rules: (i) a non-member assignee of an LLC interest who is not admitted as a member cannot vote the interest; (ii) an assignor of 100% of its LLC interest is no longer a member, and therefore has no right to vote that interest; and (iii) a member cannot withdraw from the LLC unless allowed by the articles of organization or a written operating agreement. But if the assignor is not able to vote the assigned interest, hasn’t it effectively withdrawn in violation of rule (iii)? And if neither the assignor nor the assignee can vote the assigned interest, then is it correct that no one can vote it and therefore there could be control shifts among the remaining members?
The court concluded that the rule against withdrawal trumps the rule that the assignor of 100% of its interest is no longer a member. It held that (a) HBI’s assignments to Rob Bell and Virginia Bell transferred HBI’s economic and control rights to them because the Bells were already members at the time of the assignment, and (b) Joseph’s assignment to HBI did not cause Joseph to lose his member control rights with regard to the assigned interest because HBI was at that time not a member. Id. at *8. Therefore no voting control was suspended – HBI’s assignments to the Bells transferred control because they already were members, and Joseph retained control regarding his assignment because HBI was not a member. Blythe’s 40% interest continued to represent 40% of the voting.
The court based both prongs of its ruling on the LLC Act’s prohibition on unilateral member withdrawal: “Plaintiffs’ construction providing otherwise would conflict with Section 57C-5-06 … because under Plaintiffs’ construction, a member could voluntarily assign all his interest and immediately cease being a member without the need for any other member’s consent…. The court cannot find a fair reading of the Act, reconciling all its provisions, that reflects a legislative purpose that allow[s] a member to cease being a member leaving his prior control interest inchoate.” Id.
The Court’s Ruling. The Blythe court was on the horns of a dilemma. It was faced with a square conflict between Section 57C-5-06 (a member may withdraw only if allowed by the articles of organization or a written operating agreement) and Section 57C-5-02 (except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of its membership interest).
Joseph assigned all of his interest. Under the statute he therefore ceased to be a member, but he was also barred from withdrawing as a member. The court sliced the Gordian knot by holding that Joseph did continue as a member and retained the control rights associated with the interest assigned, until his assignee is admitted as a member.
The court’s decision resolved the conflict for Joseph’s assignment, but the court ignored the same conflict inherent in HBI’s assignment of all of its interest to Rob Bell and Virginia Bell. Because the Bells were already members they received control rights as well as economic rights for the interests they received from HBI. The court made no mention of the fact that HBI’s assignment and the associated transfer of the control rights to the Bells amounted to a withdrawal by HBI, in conflict with the LLC Act’s bar on withdrawal.
An alternative approach would have been for the court to simply enforce Section 57C-5-02’s requirement that a member ceases to be a member upon assignment of all of its membership interest. If such an assignment amounts to a prohibited withdrawal, then the other members could assert a cause of action for that violation of the statute and sue for damages.
Other Statutes. The statutory provisions that the Blythe court wrestled with are not an anomaly. Delaware and Washington both have essentially the same rules as North Carolina regarding assignments and withdrawal, including the same conflict between the assignment rules and the “no withdrawal” rule. And it appears that neither has a reported opinion dealing with a similar fact pattern where there is no LLC agreement.
Solution. These statutes should be amended to eliminate this conflict. One approach that would do minimal violence to the existing rules would be to recognize that the prohibition on withdrawal is not as important for most LLCs as it is to partnerships. By simply changing the default rule so that withdrawal is allowed unless prohibited by the LLC agreement or certificate of formation, the statutory conflict that Blythe dealt with would be eliminated. LLCs would still be able to limit withdrawal in their LLC agreements if desired.
The Oregon LLC Act is a good example of that approach. Oregon’s rules on LLC assignments are essentially the same as those of Washington, Delaware, and North Carolina, except that a member may voluntarily withdraw from an LLC on six months’ notice unless prohibited by the LLC’s articles of organization or operating agreement. Or. Rev. Stat. § 63.205.
The link between capital contributions to an LLC and the LLC’s purpose is usually clear. The contributions from the members support the LLC’s purpose and are in proportion to the members’ interests in the LLC. Similarly, the increase in value of the LLC’s assets is shared among the members in proportion to their interests. But in a recent case before the Oregon Court of Appeals, one member objected when the required capital contributions were used to directly benefit individual members, as well as benefiting the LLC. Awbrey Towers, LLC v. Western Radio Servs., Inc.,278 P.3d 44 (Or. Ct. App. 2012).
Background. Awbrey Towers, LLC was formed in 2000 to purchase a 19-acre antenna site located on Awbrey Butte in Bend, Oregon. The LLC’s operating agreement stated that its purpose was to “[a]cquire, own and operate an antenna site on Awbrey Butte in Bend, Oregon” and to “[e]ngage in such other activities as are related or incidental to the foregoing purpose and such additional purposes as may be determined from time to time by the Members.” Id. at 46 (brackets in original). Each of the seven LLC members owned a communication tower on the site and leased the land for its tower from the LLC. Each apparently held a one-seventh interest in the LLC.
The LLC’s operating agreement allowed the LLC to require additional capital contributions from the members “as may be necessary to service any debt incurred in connection with the acquisition of the Tower Site and such additional capital needs of the Company as determined by a vote of the Members.” Id.
By late 2001 two members were preparing conditional use permit applications for the City of Bend in order to make changes to their towers, and another member, Western Radio Services, Inc., applied for a building permit from the City to build a new tower. It soon became clear to the members that all seven contemplated building new towers or expanding their towers at some point, so five of the members met with the City to discuss its permitting process. The City indicated that it did not want to deal with the conditional use permit applications separately. It informed the members that it would not accept permit applications from any member until a ten-year master plan for development of the entire site was submitted, and it denied Western Radio’s building permit application. Id.
The members concluded that the master plan required by the City would affect all the members’ interests and decided that the LLC should develop and submit the plan. Western Radio objected on the grounds that the master plan was necessary only for the conditional use permits required of the other six members, not for the type of tower that Western Radio desired to build. The other members nonetheless approved the LLC’s development of the master plan and its payment of the necessary legal and engineering expenses.
The LLC made a series of capital calls over the next several years, mainly in connection with the master plan. The members, other than Western Radio, voted in favor of resolutions approving the capital calls. Western Radio paid some of the requested amounts but withheld expenses for the master plan. Id. at 46-47.
Eventually the LLC sued Western Radio for its unpaid capital contributions. Western Radio argued at trial that the capital calls were invalid because they were intended to cover engineering and legal costs incurred by individual members for their own benefit, not for the benefit of the LLC, and therefore constituted illegal distributions in kind for the benefit of individual members.
The trial court found for the LLC and entered judgment in the amount of $51,310 against Western Radio, and also awarded the LLC its attorneys’ fees. Id. at 47.
Court’s Analysis. The heart of Western Radio’s argument was that the majority members improperly benefited themselves by making capital calls for expenditures that benefited those members but did not benefit the LLC or Western Radio. The Court of Appeals, however, pointed to trial testimony showing that expenditures supporting the master plan allowed the members to further develop the property, thereby increasing its value. Because the LLC owned the property, this testimony supported the trial court’s finding that the expenditures benefited the LLC. Id. at 48.
Western Radio argued that the LLC’s expenditures on the plan benefited the other members but not Western Radio and therefore were improper. The court rejected that argument because Western Radio’s President testified at trial that the City would not consider Western Radio’s building permit applications without a master plan for the site, which meant that the LLC’s expenditures on the master plan benefited Western Radio as well as the other members.
The Court of Appeals also affirmed the trial court’s other theory – “that defendant had ratified the expenditures in question by acquiescing in the informal procedures by which the members had reimbursed plaintiff for all sorts of expenses, including those that defendant acknowledged it should pay.” Id. The trial testimony showed that when the LLC’s income was inadequate to pay its bills, the LLC’s manager would often simply ask each member to deposit one-seventh of the amount of the bills into the LLC’s bank account, without a member authorization for a formal capital call.
Attorneys’ Fees. Western Radio objected to the trial court’s award of attorneys’ fees, which was based on the operating agreement and on the relevant Oregon statute. The operating agreement provided:
Attorneys’ Fees. In the event any Member brings an action to enforce any provisions of this Operating Agreement against the Company or any other Member, whether such action is at law, in equity or otherwise, the prevailing party shall be entitled, in addition to any other rights or remedies available to it, to collect from the non-prevailing party or parties the reasonable costs and expenses incurred in the investigation preceding such action and the prosecution of such action, including but not limited to reasonable attorney’s fees and court costs.
Id. at 49. The LLC acknowledged that this paragraph, by its terms, applies only if the lawsuit in question is initiated by a Member. The LLC based its claim, however, on Or. Rev. Stat. § 20.096(1) (2007), which at that time stated:
In any action or suit in which a claim is made based on a contract, where such contract specifically provides that attorney fees and costs incurred to enforce the provisions of the contract shall be awarded to one of the parties, the party that prevails on the claim, whether that party is the party specified in the contract or not, shall be entitled to reasonable attorney fees in addition to costs and disbursements.
Western Radio contended that the issue was not mutuality of remedy and that the statute was not relevant – the paragraph in the operating agreement was mutual and provided for the prevailing party to recover its attorneys’ fees. It argued, rather, that the language “[i]n the event any Member brings an action to enforce [the agreement]…” was a pre-condition to any party having a right to recover fees, and that because the LLC had brought the suit it could not recover attorneys’ fees. 278 P.3d at 49.
Relying on Jewell v. Triple B. Enterprises, Inc., 626 P.2d 1383 (Or. 1981), and subsequent cases, the court held that under the statute, whenever a party to a contract with an attorneys’ fees clause brings the kind of action contemplated by the clause, regardless of who brought the suit, the prevailing party can recover its attorneys’ fees. The court accordingly upheld the award of attorneys’ fees to the LLC. 278 P.3d at 51.
Comment. The court upheld the LLC’s expenditures on the master plan on the grounds that (a) the LLC itself benefited because the master plan made the LLC’s antenna site more valuable, and (b) each of the members enjoyed some benefit. This may be a sort of “rough justice,” but it ignores the potential disparity of benefit from one member to another. The City required the master plan as a precondition to accepting applications for the members’ conditional use permits and for Western Radio’s building permit. Presumably the permits would have different utility to the various members, but the opinion implicitly treats the benefit to each member as equal.
The drafting lesson from the dispute over the attorneys’ fee clause is straightforward. If the attorneys’ fee clause in an LLC agreement is intended to include any potential suit brought by the LLC, it could read, for example: “In the event that any dispute between the Company and any Member or between any Members should result in litigation or arbitration, the prevailing party in such dispute shall be entitled to recover its reasonable fees, costs and expenses, including without limitation its reasonable attorneys’ fees and expenses.”
Oregon Workers' Compensation Law Does Not Shield Employer LLC's Managing Member from Negligence Claim by Injured Worker
The Oregon Court of Appeals recently held that the exclusive remedy provision of Oregon’s workers’ compensation law does not shield an employer LLC’s managing member from a negligence claim by the LLC’s injured worker. Cortez v. NACCO Materials Handling Grp., Inc., No. A144045; 050302632, 2012 WL 758895 (Or. App. Feb. 29, 2012).
Background. Workers’ compensation insurance provides reasonably quick and sure payments to workers injured on the job, regardless of whether or not the employer is negligent. Payments cover medical expenses and disability, but the tradeoff for not requiring the employee to prove negligence is that the amounts are fixed and limited. Workers’ compensation statutes normally provide that the worker’s claim under the statute is the worker’s exclusive remedy against the employer, other employees, and the officers and directors of the employer.
The Case. In Cortez the plaintiff was injured while employed by Sun Studs, LLC, an Oregon limited liability company. Later he filed for and obtained workers’ compensation benefits from Sun Studs’ insurer. He then sued Sun Studs’ sole member, Swanson Group, Inc., for (a) negligence, (b) violations of Oregon’s Employer Liability Law (ELL), Or. Rev. Stat. § 654.305 to 654.336, and (c) noncompliance with the workers’ compensation statute, Or. Rev. Stat. § 656.017. Sun Studs was member-managed and Swanson Group was therefore its sole managing member.
The plaintiff conceded at trial that he could not prove noncompliance with the workers’ compensation statute, and the trial court dismissed his negligence and ELL claims based on the exclusive remedy provision of Oregon’s workers’ compensation statute.
The question before the Court of Appeals was therefore whether the exclusive remedy language in Oregon’s workers’ compensation statute protected the LLC’s managing member from the plaintiff’s negligence and ELL claims. The statute says:
The exemption from liability given an employer under this section is also extended to the employer’s insurer, the self-insured employer’s claims administrator, the Department of Consumer and Business Services, and the contracted agents, employees, officers and directors of the employer, the employer’s insurer, the self-insured employer’s claims administrator and the department ….
Or. Rev. Stat. § 656.018(3) (emphasis added). The court phrased the issue as “whether the legislature intended to include ‘members’ of limited liability companies among those exempt from liability under the exclusive remedy provisions of ORS 656.018.” Cortez, 2012 WL 758895, at *2.
The Court’s Analysis. The court first noted that an LLC is a legal entity distinct from its members, so that even if the exclusive remedy provision applies to an LLC as an employer, it does not necessarily apply to the LLC’s members. Id. at *3. The court then pointed out that when the legislature enacted Oregon’s LLC Act, it included a provision that extended the coverage of certain other statutes to LLC members and managers: “Whenever a section of Oregon Revised Statutes applies to both ‘partners’ and ‘directors’, the section shall also apply: … [i]n a limited liability company without managers, to the members of the limited liability company.” Id. at *4 (quoting Or. Rev. Stat. § 63.002). The list of entities and persons in the exclusive remedy statute includes directors but not partners, so § 63.002 was nonapplicable. The court saw that omission as further evidence that the legislature had not intended to exempt LLC members from liability under § 656.018(3).
The court also reasoned by analogy to corporate shareholders, citing Fields v. Jantec, Inc., 317 Or. 432, 857 P.2d 95 (1993). “Thus, a shareholder, as an owner of a corporation, does not fall under the protection of the exclusive remedy provision in ORS 656.018(3). By analogy, a member, as an owner of an LLC, also does not fall under the protection of the exclusive remedy provision in ORS 656.018(3).” Cortez, at *4.The court did not discuss the fact that Swanson Group, the LLC’s managing member, was both a member and a manager, much like the sole shareholder in Fields who was also an officer and director.
The defendant also claimed that it was not liable because of § 63.165 of the LLC Act, which states that “[a] member or manager is not personally liable for a debt, obligation or liability of the limited liability company solely by reason of being or acting as a member or manager.” The court pointed out that § 63.165 does not shield an LLC member from its own tortious conduct. Cortez, at *5.
The court’s final conclusion was that neither the exclusive remedy provision of the workers’ compensation statute, § 656.018(3), nor the liability limitation of the LLC Act, § 63.165, shielded Swanson Group from the plaintiff’s negligence claim. The court dismissed the plaintiff’s ELL claim on other grounds, and remanded the case to the trial court to resolve the plaintiff’s negligence claim.
Comment. The court began its analysis by mistakenly framing the issue as “whether the legislature intended to include ‘members’ of limited liability companies among those exempt from liability under the exclusive remedy provisions” of the statute. Cortez, at *2. This characterization oversimplifies by ignoring the distinction between members of a member-managed LLC and members of a manager-managed LLC. The former are both owners and active managers of the LLC. The latter are only owners.
Oregon’s LLC Act defines a manager-managed LLC as an LLC that is designated as a manager-managed LLC in its articles of organization or whose articles of organization otherwise expressly provide that the LLC will be managed by a manager or managers. Or. Rev. Stat. § 63.001.
A member-managed LLC, on the other hand, is defined simply as an LLC other than a manager-managed LLC. Id. Swanson Group was the sole member of a member-managed LLC. Cortez, 2012 WL 758895 at *1.
Members of a member-managed Oregon LLC are “managers” under the LLC Act and have full rights to control the management and conduct of the LLC. Or. Rev. Stat. § 63.130(1)(a), 63.130(7). More significantly, a member of a member-managed LLC is an agent of the LLC and the act of such a member on behalf of the LLC binds the LLC.
Conversely, members of a manager-managed LLC have no right to participate in the management and control of the LLC and are not agents of the LLC. (The rights of members in the two types of LLCs are subject to modification in the articles of organization or operating agreement, but the court in Cortez did not refer to any such provisions of either.)
Thus, members of a member-managed LLC act as agents and representatives of the LLC when they manage it and conduct its business and affairs. And it is representatives of the employer that the key language in the exclusive remedy focuses on: “the contracted agents, employees, officers and directors of the employer.” Or. Rev. Stat. § 656.018(3).
It seems clear that an LLC’s manager is the type of representative that § 656.018(3) is intended to cover. But as the Cortez court pointed out, courts must neither insert in the statute what has been omitted nor omit what has been inserted. Cortez, at *2. The court seems to have ignored, however, the reference in the statute to agents. The LLC Act defines each member of a member-managed LLC as an agent of the LLC, so under a proper understanding of Swanson Group’s status as the sole managing member of the LLC, it should have been shielded from the plaintiff’s negligence claim.
An LLC member ordinarily is not liable for the debts and liabilities of an LLC simply by virtue of being a member. E.g., Wash. Rev. Code § 25.15.125; Or. Rev. Stat. § 63.165. Many states, however, impose personal liability for unpaid taxes on those within a business who have authority for paying taxes withheld from employee wages, or for paying sales taxes collected from customers. If one of those statutes applies, being a member of the LLC will not shield the employee, manager or officer from the statute’s reach.
Kelly Haugen, a 10% member of an Oregon LLC, was assessed liability by the Oregon Department of Revenue for the LLC’s failure to pay Oregon income taxes withheld from employee wages. Haugen v. Dep’t of Revenue, No. TC-MD 100052C, 2011 Ore. Tax LEXIS 187 (Or. T.C. Apr. 26, 2011). The LLC was manager-managed, and Haugen was not the LLC’s manager. Haugen occasionally signed checks for the LLC, and a form filed by the LLC with the state indicated that Haugen was responsible for hiring and firing employees. Id., at *2-3. The Department of Revenue asserted liability against Haugen because of his part ownership of the LLC and because he signed checks for the business. Id. at *6.
Oregon requires employers to withhold and pay Oregon income taxes from wages paid to employees. Or. Rev. Stat. § 316.167. Personal liability for unpaid tax withholdings is imposed on “[a]n officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee or member is under a duty to perform the acts required of employers by ORS 316.167 ….” Or. Rev. Stat. § 316.162(3)(b).
Finding a paucity of case law on the liability of LLC members, the Haugen court analogized Haugen’s status to that of a corporate officer for the purpose of determining liability. Haugen, 2011 Ore. Tax LEXIS 187, at *6. The court applied prior Oregon case law involving corporate officers, and found that Haugen would be liable if he had the actual authority and control to pay or direct payment of the tax withholdings. Id. at *7. The evidence indicated that Haugen did not have authority to unilaterally sign checks or make important financial decisions – he had authority to sign checks only under the direction of the 90% owner and manager, after obtaining specific consent to sign each check. Also, Haugen did not have general authority as a member, because the LLC was manager-managed, and Haugen was not a manager.
The court concluded that because Haugen “was not in a position to pay the withholdings or direct the payment of the withholdings at the time the duty arose to withhold or pay over the taxes,” he was not an “employer” under Or. Rev. Stat. § 316.162. Haugen, 2011 Ore. Tax LEXIS 187, at *11-12. The court therefore canceled the Department of Revenue’s Notice of Liability against Haugen.
Kelly Haugen escaped liability for the unpaid taxes because of his lack of authority. Had his been a member-managed LLC, or if he had had discretion to sign checks without prior approval, the court presumably would have upheld the tax assessment against him.
Many of the comparable statutes from other states are at least as strict in finding managers and check signers to be personally liable for failure to pay tax withholdings and sales taxes over to the state. The strict approach is not surprising, given that in these cases the business has in effect been a tax collector for the state and (at least in the state’s view) is holding the state’s money. The Haugen case should be a wake-up call for LLC managers and check signers to avoid the temptation of financing the business in troubled times by holding on to tax withholdings or sales taxes.
When an LLC manager signs a contract on behalf of the LLC there is usually no question whether the LLC is bound by the manager’s signature. But consider – what’s the result when the manager is an investor and an officer of the other party to the contract, and the LLC members disapprove of the contract and attempt to reject it on grounds that the manager lacked authority to enter into the contract because of the manager’s conflict of interest? The Oregon Court of Appeals was faced with this scenario in Synectic Ventures I, LLC v. EVI Corp., No. A139879, 2011 Ore. App. LEXIS 337 (Or. Ct. App. Mar. 16, 2011).
The Loan. Three LLC investment funds (Synectic) loaned $3 million to EVI Corporation pursuant to a 2003 loan agreement. The loan agreement called for repayment by December 31, 2004, but EVI had the right to convert the debt into equity in the form of EVI stock if it received additional investments of at least $1 million before the December 31 deadline.
Conflict of Interest. The Synectic LLCs were managed by Craig Berkman, at first directly and later through management firms he controlled. Berkman was involved with both parties to the loan. In addition to being Synectic’s manager, Berkman was also the board chairman and treasurer of EVI, and held EVI warrants and stock options.
Amendment. In September 2004, as the year-end due date of the loan approached, Berkman executed an amendment to the loan agreement on behalf of Synectic that extended EVI’s repayment date one year, to December 31, 2005. Berkman also approved the amendment in his capacity as an EVI board member. The Synectic members were unaware of the amendment at the time it was made. Berkman was removed as manager in December 2004, and in 2005 Synectic learned of the amendment and notified EVI that the amendment was not authorized and that EVI was in default on the loan.
EVI raised $1 million in additional investment before December 31, 2005 and converted the loan into equity, thereby avoiding default (if the amendment was binding on Synectic).
Synectic sued EVI to collect on the loan, and EVI defended on grounds that it was not in default under the amended loan. The trial court concluded that the amendment was valid and binding on Synectic and that EVI was therefore not in default.
Authority. The Court of Appeals began with a look at Or. Rev. Stat. § 63.140(2)(a), which provides in part:
Each manager is an agent of the limited liability company for the purpose of its business, and an act of a manager, including the signing of an instrument in the limited liability company's name, for apparently carrying on in the ordinary course the business of the limited liability company, or business of the kind carried on by the limited liability company, binds the limited liability company unless the manager had no authority to act for the limited liability company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority.
This section provides for the manager’s apparent authority in the ordinary course of the LLC’s business. Many state LLC acts have similar provisions for managers and members (if the LLC is member managed), e.g., Washington, Utah, and New York. Both the Uniform Partnership Act and the Uniform Limited Partnership Act have similar provisions for the apparent authority of general partners.
Under Or. Rev. Stat. § 63.140(2)(a), if the manager has no authority and the third party has knowledge of the lack of authority, the principal will not be bound. The court therefore reviewed Synectic’s operating agreements to determine Berkman’s authority, and concluded that the agreements gave Berkman the exclusive authority to manage the business of the LLCs and to take action without the consent of the members. The operating agreements also provided that third parties could rely on Berkman’s authority to bind the LLCs without further inquiry. Synectic, 2011 Ore. App. LEXIS 337, at *12-13. Under these provisions it appeared to the court that the amendment was within the authority granted to Berkman in the operating agreements: “As such, at first blush it would appear that Berkman’s act of executing the amendment was within the express authority granted to him in the operating agreements.” Id.
Synectic argued that Berkman’s actual authority was limited by letter agreements Berkman had entered into with some of Synectic’s investors, and by his acts of self-dealing and breach of fiduciary duties. Id. at *13.
The court held that the letter agreements did not limit Berkman’s authority because they were between Berkman and some of the Synectic members, but not with Synectic. If the letter agreements obligated Berkman to those members, any breach was between him and them and did not affect his authority to act for Synectic. Id. at *17.
Fiduciary Duties. Synectic’s operating agreements obligated Berkman to carry out his duties in accordance with the standard of conduct specified for LLC managers in the Oregon LLC Act, which includes the duty of care and the duty of loyalty. Or. Rev. Stat. § 63.155. Synectic contended that Berkman’s breaches of those duties without member approval invalidated his execution of the amendment. But before the court considered whether Berkman had breached his fiduciary duties, it examined whether the remedy requested by Synectic would be available even if Berkman had breached his duty.
The court concluded that the language of Or. Rev. Stat. § 63.140(2)(a) controlled: the act of a manager binds the LLC “unless the manager had no authority to act for the limited liability company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority.” Berkman had the express authority under the operating agreements to enter into the amendment. Synectic took no action to limit his authority, and the loan extension was within the ordinary course of the LLC’s business. Even if knowledge of Berkman’s self-dealing were imputed to EVI, any inquiry by EVI would only have led to the conclusion that Berkman had authority to execute the amendment. Synectic, 2011 Ore. App. LEXIS 337, at *23-24.
In short, Berkman had actual, unqualified authority under the operating agreements, and his act of executing the amendment therefore was binding on Synectic even if it was a breach of his fiduciary duties.
Conflict of Interest. Synectic also pointed out that under Or. Rev. Stat. § 130(2)-(4), a transaction involving an actual or a potential conflict of interest between a member or a manager and the LLC requires the consent of a majority of the members, unless the operating agreement provides otherwise. The Synectic operating agreements clearly allowed members to have conflicts of interest, but said nothing about actual or potential manager conflicts.
Strangely enough, the court found that Berkman’s alleged conflict between his role as Synectic’s LLC manager and his role as EVI’s board member and treasurer was excused by the Synectic operating agreements. While it is correct that Berkman was a member, Synectic’s allegation was that Berkman had a conflict because of his status as a manager, not as a member.
The court’s opinion says not a word about why the operating agreements’ waivers of member conflicts should apply to Berkman in his capacity as manager. Berkman was acting as Synectic’s manager when he signed the amendment, not as a member. For an operating agreement to allow members to have a conflict of interest is a far cry from allowing a manager to have a conflict of interest – non-managing members are passive and don’t make the management decisions that could be affected by a conflict of interest. Synectic may still be trying to puzzle this one out.
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:
Arizona; Senate Bill No. 1503
Arkansas; Senate Bill No. 5
Hawaii; Senate Bill No. 674
Indiana; Senate Bill No. 501
Kentucky; House Bill No. 110
Maryland; House Bill No. 552
Montana; House Bill No. 415
New York; Senate Bill No. 3011
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.
The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.
The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.)
The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.
Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).
The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.
The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.
Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.
The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.
The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.
The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.