Utah's Conflicting Remedies - LLC Statute vs. Common Law
Members of an LLC are at loggerheads and one sues the other. The plaintiff decides that the remedies in the state LLC Act are inadequate. The plaintiff instead asks the court for damages under the common law, for repudiation of the LLC’s operating agreement and for breach of contract rather than for dissolution and an accounting under the LLC Act. That was the situation in OLP, L.L.C. v. Burningham, 2009 UT 75, 2009 WL 4406148 (Utah Dec. 4, 2009). The defendant in turn claimed that the plaintiff’s claims for repudiation and breach of contract were not allowable because the remedies under Utah’s LLC Act are exclusive. The court found otherwise and allowed the plaintiff’s contract claims.
Richard Wilson and Wayne Burningham formed OLP, L.L.C. as a Utah limited liability company, to purchase and operate an anti-reflective optical lens coating machine. They agreed to share equal control and ownership of OLP, and initially contributed equal amounts of capital. They agreed that Intermountain Coatings, a company owned by Burningham, would use the lens coating machine.
Acrimony between Wilson and Burningham soon reared its ugly head. They disagreed over how profits should be divided between OLP and Intermountain Coatings, and over whether the funds provided by Intermountain Coatings to OLP should be classified as a loan or as a capital contribution from Burningham.
Wilson eventually filed suit against Burningham and Intermountain Coatings for breach of fiduciary duty, repudiation of the contract, and breach of contract, and for an accounting of OLP’s expenses, revenues, profits, and losses. Burningham counterclaimed for dissolution of OLP. Burningham argued that in winding up OLP’s business, the members’ ownership interests should be determined and distributed according to each member’s capital account as provided in the LLC Act. Burningham’s theory was that Wilson’s claims should be resolved under the LLC Act’s dissolution procedures because those procedures are the exclusive remedy for claims between members.
The court pointed out that the LLC Act does not contain any explicit authorization or denial of common law claims, and examined a number of provisions in the LLC Act which imply that common law claims between members continue to apply. The court found that analogous partnership law allows common law claims between partners, without limiting remedies to equitable remedies. The court held that Utah’s LLC Act does not preclude common law claims between LLC members, such as claims for breach of contract, and that the remedies for such claims include equitable relief such as an accounting as well as damages.
The court rejected Burningham’s argument that dissolution is the sole remedy for wrongdoing between the members as being inconsistent with the jury’s finding that he had repudiated and abandoned the operating agreement. As the court said: “When one party effectively extinguishes a business agreement, whether it be a partnership agreement or a limited liability agreement, that party cannot rely on the agreement (or the default provisions of the LLC Act that supplement the agreement) to protect itself from the harm its actions have occasioned.” OLP, 2009 UT 75, ¶ 21.
The OLP decision is consistent with the approach of many courts to the rights and remedies of LLC members. For example, earlier this year I blogged on a New York decision which found that LLC members have a common law right to an equitable accounting, even though not explicitly authorized in the statute, here. I also described Idaho’s first case on fiduciary duties of LLC members, which found that fiduciary duties existed between managing members even though no such right was described in Idaho’s LLC Act, here. Courts generally seem to be reluctant to rule out common law rights of recovery or to exclude equitable remedies, in the absence of an explicit bar in their state’s LLC Act.
Low-Profit LLCs - The Newest Limited Liability Company Structure
This month Illinois became the latest state to pass enabling legislation for low-profit limited liability companies, or L3Cs, joining Vermont, Michigan, Utah and Wyoming. The new Illinois law becomes effective on January 1, 2010. According to the Nonprofit Law Blog several other states are considering adopting L3C laws.
An L3C is a limited liability company whose primary purpose is not to earn a profit but to “significantly further the accomplishment of one or more charitable or educational purposes.” E.g., Ill. Pub. Act 096-0126 (SB 0239). An L3C is not a nonprofit and is not precluded from earning a profit, but income or property appreciation may not be a significant purpose of the company. An L3C is a hybrid, a business entity formed to carry out charitable or educational purposes, and designed to attract philanthropic as well as private investment. In almost all respects other than its purpose, an L3C is treated like any other LLC, including income taxes.
To qualify as an L3C under the state laws, the LLC:
● must significantly further the accomplishment of one or more charitable or educational purposes within the meaning of IRC section 170(c)(2)(B);
● would not have been formed but for the accomplishment of the charitable or educational purposes;
● does not have as a significant purpose the production of income or the appreciation of property, although the fact that the company produces significant income or capital appreciation is not conclusive evidence of a profit motive; and
● does not have as a purpose the accomplishment of any political or legislative purpose.
These state law requirements parallel the Internal Revenue Code requirements for the target of a “program-related investment” by a private foundation. IRC § 4944(c). In addition, each of the five states requires that the name of the L3C contain either the abbreviation “L3C” or the words “Low-Profit Limited Liability Company.”
Vermont was the first state to pass legislation to authorize L3Cs, in April 2008. As of August 20, 2009 there were over 60 L3Cs formed in Vermont. In a little over a year four more states have amended their LLC Acts to authorize L3Cs. Illinois, the latest of the four, is a heavyweight in terms of its industry and commerce. L3Cs are here to stay and are growing in use and in public recognition.
There are two principal reasons why L3Cs are taking off. The first is the hope that L3Cs will attract program-related investments (PRIs) by private foundations. By combining philanthropic investment with private capital, L3Cs can offer the possibility of major social impact.
If an investment by a private foundation meets the Internal Revenue Code’s requirements for a PRI, the investment will count towards the foundation’s annual distribution requirements and will not jeopardize the foundation’s charitable purpose. IRC § 4944(c). PRIs by private foundations are not common occurrences today, in part because of the high transaction costs to the foundation in verifying that the target of the investment will meet the PRI requirements. The promoters of state laws authorizing L3Cs expect that foundations will be more willing to invest in companies organized as L3Cs.
A company’s status as an L3C under state law, however, is not adequate to qualify the L3C for a PRI. And if a private foundation makes an investment with an L3C and the investment turns out not to qualify as a PRI, the foundation can be assessed substantial taxes and penalties. The result is that unless and until the IRS issues guidance about qualifying L3Cs for PRIs, private foundations will likely conclude that they must continue to incur the transaction costs involved in determining the correctness of a specific PRI. Those costs often include expensive private letter ruling requests to the IRS.
These tax issues are well described in Allison Evans, Christine Petrovits & Glenn Walberg, L3C: Will New Business Entity Attract Foundation Investment?, 63 The Exempt Organization Tax Review 457 (2009). It appears that without regulatory guidance from the IRS or changes to the tax laws, private foundations will continue to be reluctant to make program-related investments in LLCs, whether or not they are structured as L3Cs.
Branding is the second reason why L3Cs appear to be attractive for companies with social missions. By being labeled as an L3C, companies send a signal to their customers, employees, vendors and communities that they have a charitable or educational purpose, even though they are not a nonprofit. The L3C movement appears to have tapped into this vein of entrepreneurial desire to provide public benefit.
We can expect continued growth in the number of states that authorize L3Cs and in the number of L3Cs being formed. That should increase the pressure for the IRS and federal regulators to come up with a more economically efficient way for L3Cs to qualify for program-related investments, so that private foundations will not be deterred from making investments in L3Cs compatible with the foundation’s mission.
Texas Joins the Series LLC Crowd
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?.jpg)
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.
