Personal Guarantor Is Not Excused by the Creditor's Merger or by the Debtor's Conversion Into a Limited Partnership
LLC conversions and mergers can raise questions about an LLC’s existing contracts. Consider: two individuals guaranty an LLC’s debts to a limited partnership. Some time later, in unrelated transactions, (1) the limited partnership (the creditor) merges into an LLC, and (2) the debtor, an LLC, converts to a limited partnership. Later the debtor defaults and the creditor sues the guarantors to collect. The guarantors claim they are excused because the creditor they promised to pay is not the entity suing them on their guaranty, and the company whose debts the creditor is trying to collect is a different entity than the company whose debts they guaranteed. The guaranty contract is silent on conversions and mergers and does not state that the contract covers the parties’ “successors and assigns,” as many contracts do.
This unwieldy scenario was presented to the Texas Court of Appeals in Wasserberg v. Flooring Services of Texas, LLC, No 14-11-00736, 2012 WL 3016861 (Tex. Ct. App. July 24, 2012). After thoroughly reviewing the arguments, the court found that the conversion and the merger did not excuse the guarantors from their guaranty contract.
Background. Flooring Services of Texas, LP (Flooring LP), a limited partnership, was a provider of flooring products and services for homes built by Waterhill Company, LLC (Waterhill LLC). In 2002 Jonathan Wasserberg and Jason Felt personally guaranteed payment of Waterhill LLC’s debts to Flooring LP, and thereafter Flooring LP continued to provide flooring to Waterhill LLC.
In 2003 Waterhill LLC converted to Waterhill Companies Limited (Waterhill LP), a limited partnership. In 2007 Flooring LP merged into Flooring Services of Texas, LLC (Flooring LLC). Thus the LLC converted to a new limited partnership, and the old limited partnership merged into a new LLC.
Later, Flooring LLC sued Waterhill LP for payment for flooring it had provided, and sued Wasserberg and Felt on their guaranties. The trial court ruled in favor of Flooring LLC on its claim against Waterhill LP, and ruled against Wasserberg and Felt on their guaranties. Wasserberg and Felt appealed.
The gist of Wasserberg and Felt’s argument was that they were not liable on their guaranties for debts owing by Waterhill LP to Flooring LLC because “neither the party seeking to enforce the guarant[ies] nor the party whose performance was guaranteed is named by the existing document.” Wasserberg, 2012 WL 3016861, at *2.
Debtor’s Conversion from an LLC to a Limited Partnership. The Court of Appeals first reviewed the rule of strictissimi juris, which mandates that “a guarantor may require that the terms of his guaranty be strictly followed, and that the agreement not be extended beyond its precise terms by construction or implication.” Id. The court then examined the applicability of Wasserberg’s and Felt’s guaranties to debts incurred by Waterhill LP. Wasserberg and Felt contended that their guaranties only covered debts incurred by Waterhill LLC, and that after Waterhill LLC converted to Waterhill LP, Waterhill LLC no longer existed. Id. at *3.
The court disagreed, however, with the proposition that the LLC no longer existed after it converted to a limited partnership. According to its Articles of Conversion, Waterhill LLC had converted to Waterhill LP under the authority of the Texas Revised Limited Partnership Act and the Texas Business Corporation Act. The Revised Limited Partnership Act at that time provided that “[w]hen a conversion of a converting entity takes effect … the converting entity shall continue to exist, without interruption, but in the organizational form of the converted entity rather than in its prior organization form.” Id. (for the equivalent current version see Tex. Bus. Orgs. Code § 10.106(1)).
According to the court, “the Articles of Conversion and Texas law constitute proof that Waterhill Company, LLC continued to exist in the organizational form of [Waterhill LP] when the goods and services at issue were provided.” Id. The guaranties were therefore applicable to debts incurred by Waterhill LP after the conversion.
Creditor’s Merger of Limited Partnership Into an LLC. Wasserberg and Felt also argued that Flooring LLC could not enforce the guaranties because the guaranty contracts did not name Flooring LLC, and because the guaranty contracts did not have language applying the contracts to Flooring LP’s “successors or assigns.” Id. at *4.
Wasserberg and Felt’s argument relied on Marshall v. Ford Motor Co., 878 S.W.2d 629 (Tex. Ct. App. 1994). The court in Marshall refused to enforce a guaranty of all payment obligations of Jomar Parts Warehouse to Ford Marketing Corporation, “for sales made by Ford Marketing Corporation to Jomar,” after Ford Marketing Corporation merged with Ford Motor Company. Marshall, 878 S.W.2d at 631-32. In Marshall, as in Wasserberg, the guaranty contract did not state that it would continue for the benefit of the successors or assigns of the named creditor. The Marshall court refused to enforce the guaranty beyond its precise terms, which explicitly covered only debts arising from sales made by Jomar to Ford Marketing Corporation.
The Wasserberg court distinguished Marshall, interpreting the language in Wasserberg’s and Felt’s guaranties to cover all credit extended to Waterhill LLC. Unlike the Marshall guaranty, the Wasserberg guaranties were not limited to debts arising from goods and services provided by Flooring LP. The court also rejected Wasserberg and Felt’s contention that when an entity seeks to extend a guaranty to actions by a successor entity, the guaranty must include language so stating. Wasserberg, 2012 WL 3016861, at *4.
Wasserberg and Felt also contended that Flooring LLC presented no evidence that it was the owner of the guaranty contracts. The court pointed out, though, that evidence of the merger of Flooring LP into Flooring LLC had been introduced, and that the applicable merger statutes state that all rights of the parties to a merger are vested in the survivor without the need for any formal transfer or assignment. Id. at n.5.
The Court of Appeals accordingly affirmed the trial court’s ruling, enforcing Wasserberg’s and Felt’s guaranties.
Comment. Wasserberg illustrates the difference between a merger and a conversion. The court easily dispatched the argument that when Waterhill LLC converted to Waterhill LP it became a different entity, by pointing out that the statute says that the converted entity continues to exist, without interruption, in its new organizational form. In other words, it’s a one-party transaction that is treated almost as inconsequentially as a name change (at least as far as third parties are concerned). The converting entity’s business, assets, rights, and liabilities are unchanged.
Mergers are different. They involve at least two entities, and the aggregate business, assets, rights, and liabilities of the resulting, merged company may be much different from those of either of the parties to the merger. The fact that the business of the merged company may be different from that of either party to the merger underpins the result in Marshall. The scope of a guarantor’s liability from guaranteeing the debts of a parts seller to a manufacturer could expand greatly if the manufacturer merged with a much larger company, resulting in greater purchases and greater guaranteed debt. There would be no comparable change flowing from the conversion of an LLC to a limited partnership, or vice versa.
Wasserberg also shows the importance of precise drafting in financial instruments. The guaranty in Wasserberg had stated that it covered all debts of Waterhill LLC to Flooring LP. If its language had instead covered only those debts of Waterhill LLC resulting from product sales by Flooring LP to Waterhill LLC, Marshall would have applied and the case probably would have come out differently.
Kansas recently became the latest state to authorize series limited liability companies. Governor Sam Brownback signed Substitute House Bill 2207 on March 29, 2012, amending the Kansas Limited Liability Company Act to authorize series LLCs. Sub. H.R. 2207. The bill will become law on July 1, 2012, and Kansas will then join the eight other states that have authorized series LLCs.
Series LLCs. A series LLC can partition its assets and members into one or more separate series, each of which can have designated members and managers, and can own its own assets separately from the assets of the LLC or any other series. The liabilities of each series will be enforceable only against the assets of that series, and each series can enter into contracts, sue, and be sued in its own name.
Multiple series within one LLC can be used to avoid some of the inefficiencies and costs involved with using multiple LLCs. For example, separate parcels of real estate could each be owned by a separate series, but all within one LLC. Or, the divisions of a business could be held within one LLC, but with each division in a separate series.
Other States. Delaware was the first state to authorize series LLCs, in 1996. Del. Code Ann. tit. 6, § 18-215. Since then Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah have enacted statutes similar to Delaware’s, although there are some differences. I previously wrote about series LLCs when Texas passed its series LLC law in 2009, here, and when the Internal Revenue Service proposed regulations for series LLCs, here.
Kansas Requirements. The Kansas statute is similar in many respects to the Delaware Act. Both authorize an LLC’s operating agreement to establish one or more designated series, and both provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
- the records of the series account for its assets separately from the assets of any other series or the LLC generally,
- the operating agreement states the liability limitations, and
- the certificate of formation, and in the case of a Kansas LLC, the articles of organization, give notice of the limitations on liability.
Series LLCs are relatively new. There are few reported opinions dealing with series LLCs, and the IRS’s proposed regulations have not yet been finalized. There are therefore many unresolved legal questions about series LLC issues such as taxation, bankruptcy, liability limitations, and piercing the veil, particularly when doing business in states outside the state of formation. Caution is advised when implementing a series LLC, given the uncertainty and lack of predictability inherent in their use.
Texas Court Follows Form Over Substance In Sorting Out Different Fiduciary Duties in Multi-Level LLC and Partnership
The Texas Court of Appeals struggled to reconcile conflicting fiduciary duty rules between two related entities, an LLC and a limited partnership, in Strebel v. Wimberly, No. 01-10-00227-CV, 2012 WL 112253 (Tex. App. Jan. 12, 2012).
Douglas Strebel and John Wimberly started a tax advisory business and formed Black River Capital, LLC, a Delaware limited liability company, in 2003. The business prospered, and on December 8, 2005 they restructured the business and amended and restated the LLC agreement. Strebel and Wimberly were the LLC members, with profit sharing ratios of 60% and 40% respectively. They and their wives were the managers, and Strebel was the Managing Manager and CEO with broad decision-making and management powers. Strebel was required to consult with the other managers before making certain major decisions, and to obtain Wimberly’s consent before taking certain other specific actions, including changes to Wimberly’s profit sharing ratio.
At the same time, they formed a new Texas limited partnership, Black River Capital Partners, LP, and transferred all of the LLC’s business assets to the limited partnership (LP). The LLC was the LP’s general partner, with broad power and authority to control the LP, and had a 1% profit share. The limited partners were Strebel, Wimberly, Strebel’s wife, and Eric Manley. Later Steve Houle also became a limited partner.
The LLC and the LP had completely different fiduciary duty rules. The LLC’s operating agreement stated that “the Managers shall have fiduciary duties to the Company and the Members equivalent to the fiduciary duties of directors of Delaware corporations.” Id. at *3 (emphasis added) . In stark contrast, the LP’s partnership agreement stated that “the General Partner shall have no duties (including fiduciary duties) except as set forth in th[e] Agreement,” and there were no other relevant provisions. Id. (emphasis added).
Problems between Strebel and Wimberly began to develop later. Strebel was in the driver’s seat as Managing Manager of the LLC, which in turn was the general partner of the LP. He also held a majority of the limited partners’ voting rights in the LP. Using his authority, Strebel retroactively reduced Wimberly’s profit share in the LP, and caused the LP in 2007 to award a $3 million bonus to himself and another $1 million in bonuses to limited partners Houle and Manley. Wimberly received no bonus. Id. at *5. Unhappy with these developments, Wimberly sued Strebel in 2007, alleging breach of fiduciary duty, unjust enrichment, oppression of a minority member, defamation, and breach of contract.
A jury trial returned a verdict in Wimberly’s favor. The jury found that Strebel had breached his fiduciary duties and awarded Wimberly damages of $2.9 million. Id. at *6. The trial court had instructed the jury that Strebel owed Wimberly fiduciary duties in his management of the business of the “Black River Entities,” because of their relationship at the LLC level (Strebel as Managing Manager and Wimberly as member) and at the LP level (both were limited partners). Id.
The Court of Appeals analyzed the fiduciary duties separately at the LLC level and at the LP level. Id. at *8. The court began with the LLC. Strebel had contended that the words in the LLC agreement “the Managers shall have fiduciary duties to the Company and the Members” meant that fiduciary duties were owed to the Members collectively, and that therefore no fiduciary duties were owed to any Member individually. Id. After a surprisingly lengthy discussion, the court disposed of that argument and pointed out that such an interpretation would in effect delete the words “and the Members” from the LLC agreement. The court agreed with the trial court that the LLC agreement imposed on Strebel, as the Managing Manager, fiduciary duties of due care, good faith, and loyalty to Wimberly as an individual member of the LLC. Id. at *9.
The limited partnership agreement, on the other hand, was clear that the LP’s general partner (the LLC) owed no fiduciary duties to the LP or its limited partners. The trial court had found, however, that Strebel owed Wimberly a fiduciary duty because they were both limited partners. The LP agreement was silent on whether there were any fiduciary duties between the limited partners. After a lengthy discussion of prior cases and a Baylor Law Review article, the court concluded: “We reconcile these cases by holding that status as a limited partner alone does not give rise to a fiduciary duty to other limited partners.” Id. at *13.
The court’s determination that there were no fiduciary duties owed by the LP’s general partner or any limited partner effectively destroyed Wimberly’s cause of action, because the court focused only on the harm to Wimberly directly resulting from the actions of the LLC as it controlled the LP, and ignored the obligations of the LLC’s manager to its members as he directed the LP’s activities:
[W]e conclude Wimberly’s claims relate to actions taken by Strebel as the controlling manager of the general partner (i.e., Black River, LLC) against Wimberly as a limited partner in Black River LP while operating under the LP agreement. The contractual disclaimer of fiduciary duties in the Black River LP Agreement thus forecloses Wimberly’s recovery on his breach of fiduciary duty claim.
Id. at *15. The court reversed the trial court’s finding on the breach of fiduciary duty claim, and remanded for further proceedings on Wimberly’s oppression of a minority member claim. Id. at *18.
Unfortunately, the court’s analysis exalted form over substance. The LLC’s only business was to control the LP – all of the LLC’s assets had been assigned to the LP. The LLC’s Managing Manager Strebel owed the LLC’s members the duties of good faith and loyalty. How could the LLC’s manager satisfy the duty of loyalty he owed to the members other than ensuring, as the LLC directed the LP, that the LP’s limited partners who were also LLC members were treated fairly and in good faith?
The court in its analysis relied on the chestnut that applying the LLC’s fiduciary duties to the actions taken by its manager in directing the LP “would render meaningless the express disclaimer of fiduciary duties in the limited partnership agreement under which that the parties were operating.” Id. at *17. But that’s not correct, because three of the limited partners (Manley, Houle, and Strebel’s wife) were not members of the LLC, and for them the disclaimer was highly meaningful.
This case shows the analytical difficulties that can arise in sorting out the obligations of managers in multi-entity, multi-level structures. It’s also a lesson for the lawyer advising clients about such structures to be wary of inconsistent standards and obligations.
Texas Court Rejects Claim by Unpaid Creditor That Two LLC Organizers Were Liable as General Partners
LLC organizers sometimes refer to themselves loosely as “partners” during the preliminary stages of a development project, before they get around to forming their limited liability company, but those words can come back to haunt them. Say, for example, that during the pre-formation phase, one of the organizers signs a contract in his own name, intending that the LLC carry out the contract. The LLC is formed, but then the project doesn’t go forward, the parties fall out, and the organizer that signed the contract can’t pay. In that case the creditor on the contract may seek payment from both the contract signer and the other organizer, on the theory that the organizers were partners and therefore were both liable.
The Lawsuit. That scenario played out in Lentz Engineering, L.C. v. Brown, No. 14-10-00610-CV, 2011 Tex. App. LEXIS 7723 (Tex. App. Sept. 27, 2011). William Wilkins and Alden Brown were planning to purchase and develop a real estate project. Wilkins entered into a contract to purchase the property, and Brown and Wilkins met with an attorney in February 2005 and agreed to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.
During the summer Brown became suspicious of Wilkin’s conduct and attempted to recover his money and obtain title to the property. Meanwhile, Wilkins entered into a contract in his own name with Lentz Engineering for engineering services. Lentz performed its work under the contract but was not paid.
Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership. Wilkins defaulted on the lawsuit but Brown defended on the ground that he and Wilkins were not partners.
Judicial Admission. Brown’s first difficulty was self-inflicted. Lentz contended that Brown had judicially admitted in a motion for summary judgment that a partnership existed between Brown and Wilkins. For example, Brown’s motion stated: “Although Wilkins and Brown entered into a partnership to acquire the Manvel property, that partnership was not formed until March 2005.” Brown also made other, similar statements in his motion. Id. at *4-5.
The court dismissed the “judicial admission” contention, because Brown had taken a contrary position in other pleadings and even in the same summary judgment motion. To be considered a judicial admission, a party’s statement must be clear, deliberate, and unequivocal, and Brown’s contradictory statements didn’t satisfy that standard.
Partnership Formation. The court then considered the main argument, i.e., whether Brown and Wilkins had formed a partnership. The Texas statute’s definition of a general partnership is similar to that of most states: an association of two or more persons to carry on a business for profit as owners, regardless of whether the persons intend to create a partnership or whether the association is actually called a “partnership.” Tex. Bus. Orgs. Code Ann. § 152.051(b).
Facts and Circumstances. Whether a partnership exists depends on all the facts and circumstances. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *9. The factors considered in determining if a partnership has been created include:
(a) sharing of profits of the business;
(b) sharing of losses or liability for claims;
(c) contributing or agreeing to contribute money or property to the business;
(d) participating in control of the business; and
(e) expressing an intent to be partners in the business.
Tex. Bus. Orgs. Code Ann. § 152.052. Note that the first three factors – sharing profits, losses, and contributions – are present in almost every LLC. The fourth factor, participating in control, is present in all member-managed LLCs and in some manager-managed LLCs. Only the last factor, expressing an intent to be partners, is not present in an LLC.
The court found uncontroverted evidence of only two of the factors, splitting profits and participating in control of the business. There was contradictory evidence about expressions of intent to be partners. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *12-14.
Going the other way, both Wilkins and Brown expressed their intent to form an LLC, they opened a bank account in the name of the LLC, and the Certificate of Organization for the LLC was filed before the date on which Wilkins signed the contract with Lentz Engineering. Id.
The relative timing of filing the Certificate of Organization and signing the contract seems to have carried extra weight with the court:
Although courts have held promoters of a company may be liable on contracts made by other promoters prior to formation of the company as if the promoters were partners, Lentz has not cited any authority to suggest that liability should be imposed on one promoter because of another promoter's conduct after the formation of the company.
Id. at *15. The court concluded that the evidence did not conclusively establish the existence of a partnership and that the trial court’s finding of no partnership was not against the great weight and preponderance of the evidence. The trial court’s ruling in favor of Brown was affirmed.
Lessons Learned. The substantial overlap between an LLC and the five factors listed in the Texas statute is a little scary. New business organizers who refer to each other as partners, before the LLC is created, may rue the day they used that terminology. They may have already discussed and agreed on the first four factors, and if they introduce each other as partners, the stage is set. If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.
How to avoid this outcome? Expunge the word “partners” from any description of the organizers. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.
Organizers should strive to form the LLC early. Any contracts should not be signed until after the LLC is formed, and then they should be signed in the name of the LLC.
Texas has joined the seven other states that have authorized series LLCs. The Texas bill authorizing series LLCs was signed by Governor Perry in May and will become effective on September 1, 2009. S.B. 1442. The states that currently authorize series LLCs are Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee and Utah.
Most state LLC acts allow an LLC to provide for classes of members with different member rights per class. But a series LLC can go further by establishing multiple series of assets, members and managers. The debts and obligations of a series will be enforceable only against the series’ assets, and will not be enforceable against the other series in the LLC or against the LLC generally, and vice versa. The members associated with a series can be given separate rights and duties with regard to the assets of the series.
The separation of assets and partitioning of liabilities between series, all within one LLC, can avoid many of the inefficiencies and costs associated with multiple related entities. For example, a series LLC could be used to hold multiple parcels of real estate, each in a separate series and all within the one LLC. Or, separate divisions of a business could be held by one LLC, but with each division in a separate series.
The Texas statute is similar in many respects to the Delaware act. Both authorize an LLC’s operating agreement to establish one or more designated series. Both acts provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
(a) the records of the series account for its assets separately from the assets of any other series or the LLC generally,
(b) the operating agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Series LLCs can be useful, but there are legal uncertainties involved in their use. Series LLCs are relatively new – Delaware was the first state to authorize series LLCs, in 1996, and there is almost no case law on them. Major areas of uncertainty involve taxation, bankruptcy, and doing business in multiple states.
There are many open tax questions with regard to series LLCs. Although the Internal Revenue Service issued a Private Letter Ruling in 2008 and clarified that each series’ federal tax characterization is determined independently, other state and federal tax questions remain.
It is unclear whether an LLC series will be treated as a debtor in federal bankruptcy court, or whether the bankruptcy court will ignore the series and only consider the entire LLC. The result may depend on whether the relevant state law will treat the series as a separate entity with its own liability shield.
Including Texas there are now eight states whose LLC acts authorize series LLC, but that leaves 42 other states with no series provisions in their acts. It is not at all clear what the courts of a non-series state would do when faced with a claim by a local creditor against an out-of-state series LLC formed under the laws of, say, Delaware. Will the non-series state honor the series structure and respect the internal liability shield? Would a non-series state even allow a series of an LLC formed under the laws of another state to register to transact business in the non-series state?
The law of series LLCs is an infant, still a little unsteady on its feet. But at one time LLCs were new and LLC law was the infant. There were many articles back then pointing out the uncertainties and risks of using LLCs when they were first adopted by Wyoming in 1977 and later by other states. Many conservative lawyers recommended against using LLCs in the early years of their authorization by the various states, but eventually all the states authorized LLCs. Today LLC law is more mature and LLCs are the most popular entity form for new businesses. History predicts that the question for series LLCs is not whether they will become routinely used, but when.