New York Court Orders Dissolution of LLC - Recharacterizes Capital Contributions as Loans to Reach Equitable Result
An involuntary dissolution case was decided by the New York Supreme Court (the trial court) two weeks ago, on a petition for dissolution by one of the two members of a limited liability company. Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012).
Background. Mizrahi and Cohen’s LLC owned a four-story commercial office building, with the ground floor rented by Cohen’s optometry business and the second floor rented by Mizrahi’s dental practice. The LLC consistently operated at a loss from 2006, the first year the building was occupied. The losses were covered by the members’ periodic capital contributions, although the LLC’s operating agreement didn’t require any additional capital contributions after the initial contributions. The two members each had a 50% ownership interest in the LLC, and initially they contributed additional capital in equal amounts. After a few years, however, Cohen’s capital contributions became sporadic and Mizrahi contributed most of the capital necessary to keep the LLC from defaulting on its mortgage. Over a span of several years Mizrahi contributed approximately $900,000 more than Cohen.
Mizrahi sued for dissolution of the LLC and an accounting of the proceeds of the company. The New York LLC Act uses the familiar standard for judicial dissolution: “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” N.Y. Ltd. Liab. Co. Law § 702. (Washington and Delaware, for example, have similar provisions in their LLC statutes. RCW 25.15.275; Del. Code Ann. tit. 6, § 18-802.)
The Appellate Division held in 2010 that Section 702 requires that for dissolution to be ordered, the petitioner must show, “in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.” In re 1545 Ocean Ave., LLC, 72 A.D.3d 121, 131, 893 N.Y.S.2d 590 (N.Y. 2010).
Dissolution. The gist of the court’s analysis was that continuing the LLC was financially unfeasible because of (a) the significant losses incurred over the years, (b) Cohen’s failure to contribute equally in meeting the losses and his undermining the financial integrity of the LLC by unilaterally withdrawing $230,000 of his capital, and (c) the likelihood that it was only a matter of time, should Mizrahi exercise his right to refrain from making further capital contributions, until the LLC would default on its mortgage and the mortgage be foreclosed upon. Mizrahi, 2012 WL 104775, at *8.
The facts of the case and the court’s analysis are ably described in more detail by Peter Mahler in his New York Business Divorce law blog, here.
Accounting and Winding Up. Having determined that the LLC would be dissolved, the court discussed the accounting procedures to be followed and the winding up and distribution requirements of the LLC’s operating agreement. The operating agreement required that after payment to the LLC’s creditors and satisfaction of its liabilities, any remaining assets would be distributed to the members “according to their ownership interests,” i.e., 50% to each. There was no provision for returning a member’s capital, apparently on the assumption that the members would contribute capital in equal amounts, thus maintaining the 50/50 ratio for contributions as well as for their ownership interests.
But as it turned out, Mizrahi had contributed $900,000 more than Cohen. Ignoring that fact in the final 50/50 distribution would be consistent with the operating agreement but manifestly unfair. “[C]rediting the sums advanced by plaintiff to his capital account would work an inequitable result in that the Operating Agreement prevents the return of a Capital Contribution.” Id. at *11.
The court therefore ordered that Mizrahi’s capital contributions in excess of the amount of Cohen’s capital contributions would be treated as a loan to the LLC, to be repaid to Mizrahi as a debt of the LLC prior to the distributions to the members based on their 50/50 percentage of ownership. Id.
The court also ordered that Cohen’s $230,000 withdrawal from the LLC, whether treated as a loan or a capital withdrawal, would be applied to reduce the amount of any distribution to Cohen. Id. at *9.
The court’s resolutions of these two issues are clearly equitable and fair, but it is striking that the court gives no explanation or authority for either, other than its passing reference to avoiding an “inequitable” result. Trial courts have broad equitable powers, but one would have expected at least some citations to authority for the court’s application of those powers.
Washington LLC Member Files Bankruptcy - Court Reinstates His Membership Rights
Charles McSwain, a 53% member of Hawks Prairie Casino, LLC, a Washington LLC, filed a voluntary Chapter 11 bankruptcy petition in 2007. Hawks Prairie operates a gambling casino in Thurston County, Washington.
Background. The President of Hawks Prairie, Tryna Norberg, knew of McSwain’s bankruptcy filing and continued to treat him as a voting member of the LLC until early 2009, when McSwain called on her to resign and threatened to call a meeting to appoint a new President. Shortly thereafter Hawks Prairie informed McSwain that he was dissociated from the LLC, and after that he received no further member communications from the LLC.
Several months later McSwain filed his plan of reorganization. The plan provided that upon its confirmation by the court, all of McSwain’s rights and interests in the LLC, as they existed immediately prior to the bankruptcy filing, would be automatically reinstated. That would restore his member voting rights and give him majority control of the LLC.
Norberg objected to confirmation on the grounds that full reinstatement of McSwain’s member interest was inconsistent with the LLC’s Operating Agreement and Washington law, and that under Bankruptcy Code Section 365(c)(1) McSwain was precluded from assuming the voting and other management rights of a member. Norberg sought a declaration that McSwain no longer possessed any management rights in the LLC, and that his interests in the LLC were solely those of an assignee, i.e., he had only the right to share in profits, losses, and distributions. Norberg v. Hawks Prairie Casino, LLC (In re McSwain), No. 07-43338, 2011 Bankr. LEXIS 3921, at *2 (Bankr. W.D. Wash. Oct. 6, 2011).
Washington’s LLC Act provides that an LLC member is dissociated, ceases to be a member, and takes on the status of an assignee upon the member’s insolvency or bankruptcy, unless the LLC agreement provides otherwise or the members all consent in writing. RCW 25.15.130(1)(d). (Many other states have similar provisions. E.g., Del. Code Ann. tit. 6, § 18-304.)
The Hawks Prairie Operating Agreement was clear: A member that files a voluntary bankruptcy is dissociated and treated as an assignee rather than as a member, unless all other members consent or 70% of the initial members consent. McSwain, 2011 Bankr. LEXIS 3921, at *7-8. Washington’s LLC Act therefore barred McSwain from being readmitted as a member without the requisite member vote, which was not forthcoming.
Bankruptcy Code. The Bankruptcy Code gives a bankruptcy trustee, or the debtor in possession in a Chapter 11 case (as in McSwain),the authority to assume, assign, or reject the executory contracts of the debtor, subject to several limitations. 11 U.S.C. § 365. The issue before the court was whether Bankruptcy Code Section 365(c)(1) prevented McSwain from assuming all his rights as a member. That section is concise:
(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if–
(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment[.]
11 U.S.C. § 365(c)(1).
The Ninth Circuit has ruled that this section “by its terms bars a debtor in possession from assuming an executory contract without the nondebtor’s consent where applicable law precludes assignment of the contract to a third party.” Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999). (In Catapult, the Ninth Circuit joined the Third and Eleventh Circuits in a circuit split on whether Section 365(c)(1) applies to an assumption by the debtor even if a third-party assignment is not contemplated – Catapult concluding that it does.)
Court’s Analysis. The McSwain court concluded that the LLC’s Operating Agreement was an executory contract, and that applicable nonbankruptcy law, i.e., Washington’s LLC Act, forbids its assignment. The court interpreted Catapult as imposing a third requirement: “assignment must be forbidden [by applicable nonbankruptcy law] because the identity of the nondebtor party is material.” McSwain, 2011 Bankr. LEXIS 3921, at *21. The court went on to say: “It is certainly possible that the identity of Hawks Prairie’s other members is material, such that McSwain could not assume the contract.” Id. at *22.
In the event, though, the court concluded it need not determine whether the identity of the members other than McSwain was material. Instead it decided the case on the grounds of an implied waiver by Norberg. From the beginning Norberg was fully aware of McSwain’s bankruptcy and knew that McSwain could be treated as an assignee under the Operating Agreement. She nonetheless permitted McSwain to exercise all the rights of a full member, including attending management meetings and voting on major transactions. Norberg had sent the members multiple emails, letters, and minutes of meetings that referred to McSwain as a member. The court concluded that by her actions Norberg impliedly waived her right to enforce the Operating Agreement’s dissociation provisions against McSwain. Id. at *24. Under the confirmed plan of reorganization, McSwain was therefore entitled to exercise his full membership rights in the LLC, including voting and management rights. Id. at *30.
Comments. The court’s waiver analysis is unexceptional and clearly seems to be the right result. The court’s discussion in dicta of the applicability of the Catapult rule, however, focuses on the identity of the other members in the LLC, and conjectures that if the LLC had a large number of passive members, their identity would not be material and McSwain would then be able to assume his rights as a member. Id. at *22-23.
Catapult, on the other hand, relied on the policy of the nonbankruptcy law that restricts assignment, not on the degree to which the policy applied to the facts of the specific case. Catapult describes Section 365(c)(1) as stating “a carefully crafted exception to the broad rule – where applicable law does not merely recite a general ban on assignment, but instead more specifically ‘excuses a party … from accepting performance from or rendering performance to an entity’ different from the one with which the party originally contracted, the applicable law prevails…. Only if the law prohibits assignment on the rationale that the identity of the contracting party is material to the agreement will subsection (c)(1) rescue it.” Catapult, 165 F.3d at 752.
The dissociation provisions of the LLC Act fit that description well. They preserve the economic rights of the dissociated member, but prevent the dissociated member from interfering in the management of the LLC. This is consistent with the “know your partner” principle, which is reflected in multiple provisions of most state LLC Acts, such as limitations on assignment and the rules on charging orders.
McSwain reached the right result because of Norberg’s implied waiver. But McSwain’s focus on the specific facts of the LLC and its members, rather than the rationale of the nonbankruptcy law that prohibits assignment, is inconsistent with Catapult and should not be relied on.
Given the increasing use of LLCs in business organizations, it seems likely that disputes over the interaction between Bankruptcy Code Section 365(c)(1) and the dissociation provisions of state LLC Acts will continue to arise as LLC members have occasion to file Chapter 11 bankruptcies. There will be further developments.
An LLC's Single Member Cannot Represent It in a Washington Court - An Attorney Is Required
The common-law rule is that a corporation appearing in court must be represented by an attorney. That’s the rule in Washington and all federal courts. Not surprisingly, earlier this year Washington applied that rule to limited liability companies. Marina Condo. Homeowner’s Ass’n v. Stratford at the Marina, LLC, 161 Wn. App. 249, 263, 254 P.3d 827 (2011).
One might have thought that the Marina decision would have foreclosed the issue, but the plaintiff in Dutch Village Mall, LLC v. Pelletti, 162 Wn. App. 531, 256 P.3d 1251 (July 5, 2011), an LLC with a single member, contended that its sole member should be able to represent it in court.
The Dutch Village LLC owned a shopping mall and sued a tenant. The LLC’s complaint was signed by its sole member, Jay Lei. The defendant moved to strike the complaint on the grounds that it had to be signed by an attorney. The trial court granted the motion and the Court of Appeals accepted review. Lei argued for an exception:
Lei contends the right to appear pro se belongs to a single-person LLC as much as a person because the single owner is likewise acting solely on his own behalf, making all the decisions and taking all the risks, much like a sole proprietor. Lei contends the separate legal entity status of a single member LLC is a technicality that the court should disregard.
Id. at 536.
The court rejected Lei’s argument. First, said the court, allowing nonlawyers to conduct litigation creates burdens for the other party and for the court, resulting in poorly drafted pleadings, inadequate presentations of motions, and proceedings that are unduly prolonged and numerous. Id. at 538. (This does seem to reflect a hostility to pro se litigants, even when the litigant is an individual and therefore fully entitled to represent him- or herself.) Additionally, said the court, a lay litigant lacks many of an attorney’s ethical responsibilities. The court referred to the “elaborate and inappropriate claims pleaded by Lei in this case and his refusal to withdraw a moot and pointless motion for default.” Id.
Second, the court was troubled by the inconsistency between disregarding the entity for the member’s convenience (thereby obviating the need for a lawyer in court), and respecting it for other issues (the LLC’s liability shield). For example, if the defendant successfully counterclaimed against the LLC, Lei presumably would be unwilling to disregard the LLC and accept personal liability.
The court also pointed out that a rule allowing single-member LLCs to appear in court without an attorney would likely result in disputes over the LLC’s claim to have only one owner. What if the LLC’s ownership changed in the middle of a lawsuit? Could a plaintiff assign its claim to a single-member LLC, thereby eliminating the need to hire a lawyer to represent it in court?
The court’s refusal to allow the LLC to be represented in court by its single member is unexceptional and consistent with the rules on corporations. It is also consistent with the lawyer licensing system and the body of rules that protect lawyers’ monopoly on legal services. The system is usually justified by the need to protect the public from incompetent or unethical legal representation, but the Dutch Village case shows that the convenience of the courts is also a factor in supporting the rule.
Washington LLCs: Dissenters' Rights and Attorneys' Fees
The Washington Supreme Court recently reversed a trial court and Court of Appeals decision on an award of attorneys’ fees to an LLC dissenter. Humphrey Indus., Ltd. v. Clay St. Assocs., LLC, No. 82687-1, 2010 Wash. LEXIS 1004 (Wash. Nov. 10, 2010). The Humphrey case stands out because there are so few reported cases on LLC dissenters’ rights, and because the five-to-four decision required the LLC to comply strictly with the statute’s 30-day period for paying the dissenter the value of its LLC interest. Clay Street Associates, LLC was formed in 1997 to hold a single real estate property. In 2004 most of the members decided to approve a sale of the property. The LLC agreement required unanimous member approval, and member Humphrey Industries, Ltd. refused to approve the sale. Circumvention of Unanimity. The other members then eliminated the unanimity requirement by approving a merger of the LLC into a new LLC that did not require unanimity for a sale of the property. (Unless the LLC agreement provides otherwise, a merger requires the approval of only a majority of the member interests, measured by their capital contributions to the LLC. RCW 25.15.400.) Members have the right to dissent from a merger of a Washington LLC and obtain the fair value of their member interest in cash. RCW 25.15.430. Humphrey exercised its dissenter’s right and demanded the fair value of its LLC interest. Dissenters’ Rights. Dissenters’ rights, sometimes called appraisal rights, originated with corporations: Essentially, an appraisal is the method of paying shareholders for taking their property; it is the statutory means whereby shareholders can avoid the conversion of their property into other property not of their choosing and is given to shareholders as compensation for the abrogation of the common-law rule that a single shareholder could block a merger. The purpose of these statutes is to protect the property rights of dissenting shareholders from actions by majority shareholders that alter the character of their investment. 12B William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 5906.10, at 386-87 (rev. vol. 2009) (footnotes omitted). Some but not all of the states have provisions for dissenters’ rights in their LLC Acts. For example, besides Washington, California, Florida, Minnesota, and New York have statutory provisions for LLC dissenters’ rights. Delaware’s LLC Act has no provision for dissenters’ rights, but it authorizes an LLC’s operating agreement or a merger agreement to provide contractual appraisal rights. DLLCA § 18-210. The Merger. The LLC’s merger became effective December 7, 2004. The LLC was required by the statute to pay Humphrey the fair value of its member interest within 30 days, RCW 25.15.460(1), but the LLC lacked funds. It proceeded to sell the real estate, and on May 27, 2005 paid Humphrey its estimate of the fair value of Humphrey’s member interest as of the merger date, plus interest. Humphrey disputed the LLC’s valuation and demanded a larger amount. Litigation ensued, the LLC made a settlement offer, settlement talks broke off, and the litigation went to trial. The trial court found that the LLC had undervalued Humphrey’s interest and ordered the LLC to pay Humphrey an additional $60,588. Attorneys’ Fees. Then the parties argued over attorneys’ fees. The statute says that in a proceeding over the valuation of a dissenter’s member interest, the court may assess attorneys’ fees and expert fees: (a) Against the limited liability company and in favor of any or all dissenters if the court finds the limited liability company did not substantially comply with the requirements of this article; or RCW 25.15.480(2). These provisions are similar to those in the Model Business Corporation Act and in many state corporate statutes. E.g., RCW 23B.13.310. Trial Court Ruling. The trial court found that the LLC had violated the Act by not paying Humphrey for its interest within 30 days of the merger as required by RCW 25.15.460(1). But, said the court, the LLC had “substantially complied” because it lacked the funds to pay, moved expeditiously to sell the real estate to generate funds to pay Humphrey, and paid interest on the delay period. Further, the trial court found that Humphrey acted arbitrarily, vexatiously, and not in good faith in pursuing its dissenters’ rights claim. It therefore awarded attorneys’ fees and expenses to the LLC. Humphrey appealed and the Court of Appeals affirmed. Supreme Court Weighs In. The Washington Supreme Court in Humphrey saw the 30-day payment requirement differently. The court characterized the purpose of the 30-day requirement as ensuring that dissenters have immediate use of the money which the LLC estimates to be the value of their member interests. Humphrey, 2010 Wash. LEXIS 1004, at *13-14. Humphrey should have received payment within 30 days of the merger date; instead the LLC sent the funds almost six months later. “A six-month deferral of payment is not ‘substantial compliance’ with a statute that unambiguously requires payment ‘within thirty days.’” Id. at *17. The court therefore reversed the Court of Appeals’ determination that the LLC had substantially complied with the LLC Act, and remanded to the trial court to determine whether Humphrey should be awarded attorneys’ fees based on the LLC’s noncompliance with the Act’s 30-day payment requirement. Id. at *20. The court also reversed the award of attorneys’ fees to the LLC. The trial court had concluded that Humphrey had acted arbitrarily, vexatiously, and not in good faith, based on its refusal to accept a settlement offer that would have provided more to Humphrey than it received from the trial court’s valuation award, and based on Humphrey’s conduct in other lawsuits against the LLC. The Supreme Court pointed out that evidence of conduct or statements in settlement negotiations is not admissible to prove the validity or invalidity of a claim or its amount. The court opined that even if the evidence was admitted for a permissible purpose, the record did not establish that Humphrey’s actions were arbitrary, vexatious, or in bad faith. Id. at *21. Ill-Motivated Merger. In a strange aside, the court stated: “If any acts were in bad faith, they were committed by the other members of Clay Street, who sought to bypass the dissenters’ rights statute and section 8.1 of their own LLC Agreement, which specifies that the property ‘shall not be sold, conveyed, and/or assigned without the mutual consent of each of the members.’” Id. at * 21-22 (ellipsis omitted). But after all, the members’ agreement did not require unanimous approval of a merger, and the LLC Act allows the surviving LLC to have different terms in its operating agreement. Where’s the bad faith in taking action allowed by the statute and the LLC agreement, in order to sell an asset and distribute the net proceeds to the members as their interests lie? Delaware’s doctrine of independent legal significance, DLLCA § 18-1101(h), would support the validity of using a merger to eliminate a unanimous voting requirement, but Washington’s LLC Act has no such provision. Holding. The court therefore reversed the trial court’s award of attorneys’ fees against Humphrey, and remanded for consideration of whether, in light of the LLC’s failure to substantially comply with the Act, Humphrey is entitled to attorneys’ fees. Dissent. The dissent contended that the legislature would have been well aware that in some cases 30 days is a short time to accomplish the accounting, appraisal, and other steps required to accomplish a merger and transfer property and assets, and that therefore the legislature must have intended the “substantial compliance” requirement to apply to the 30-day payment period as well as to the other provisions of the dissenters’ rights section. Humphrey, 2010 Wash. LEXIS 1004, at *26-27 (Chambers, dissenting). The majority riposted in a footnote that prudent planning is the answer: “It is likely that the legislature chose 30 days assuming that merging business entities would have the prudence and good faith to lay the groundwork for selling property well before a merger became effective, or seek other financing, so as to meet the statutory requirement.” Id. at * 18 n.11 (majority opinion). Lessons. The obvious lesson for any Washington LLC planning a merger is that if any members dissent, the LLC must be prepared to pay the dissenting members the fair value of their interests within 30 days of the later of the date the merger becomes effective or the date the member’s payment demand is received. The other lesson is a cautionary note for drafters of LLC agreements. A requirement that all members consent before specified actions are taken is not adequate unless mergers also require unanimous consent. The LLC agreement in Humphrey did not require unanimity for a merger, and the LLC was therefore able to merge and eliminate the unanimous voting requirement. A member resisting a unanimous vote will have dissenters’ rights if the LLC uses a merger to get around the voting requirement, but that may be small consolation to the dissenting member.
(b) Against either the limited liability company or a dissenter, in favor of any other party, if the court finds that the party against whom the fees and expenses are assessed acted arbitrarily, vexatiously, or not in good faith with respect to the rights provided by this article.
Sometimes an LLC's Signature on a Contract Can Result in a Member's Personal Liability
Most business people know that if they want to avoid personal liability when they sign a contract on behalf of an LLC, they should use the name of the LLC and their title. A typical example would be:
ACME LLC
______________________
By: John Smith, Member [For a member-managed LLC]
But what’s the result if language in the contract states that the signing member is personally liable? In Losh Family, LLC v. Kertzman, 155 Wn. App. 458, 228 P.3d 793 (April 12, 2010), the Washington Court of Appeals recently ruled that the language in the contract can overrule the form of signature.
William and Teresa Grover formed Grover International, LLC in 2005 and shortly thereafter acquired a business. In connection with the acquisition they received an assignment of the seller’s real estate lease. Their LLC signed the assignment using a conventional corporate style of signature, as “Grover International, LLC by William Grover member.” Losh Family, LLC, 155 Wn. App. at 461.
So far so good. But the lease assignment said that the lease was assigned to “William and Teresa Grover as individuals, dba Grover International, LLC” (“dba” of course being the customary abbreviation for “doing business as”). Id. The lease assignment in fact referred five different times to the assignee as “William and Teresa Grover as individuals, dba Grover International, LLC.” Id. at 463.
In 2006 the Grovers sold their business, and the new buyer later defaulted on the lease. The owner of the real estate sued the Grovers, the LLC, their seller and their buyer. The trial court ruled on summary judgment that all defendants were liable jointly and severally, including William and Teresa Grover individually.
The Court of Appeals expeditiously determined that the language in the assignment referred to the Grovers personally and that the LLC’s signature did not limit the assignment’s imposition of personal liability on the Grovers. The court referred to the “long established principle that where an agreement contains language binding the individual signer, ‘additional descriptive language added to the signature does not alter the signer’s personal obligation.’” Id. at 464 (quoting Wilson Court Ltd. v. Tony Maroni’s, Inc., 134 Wn.2d 692, 700, 952 P.2d 590 (1998)).
The Losh fact pattern is the sort that lawyers involved in mergers and acquisitions hate to see. Inconsistent agreements tend to be disputed and to yield unpredictable results. The Losh contract was seriously inconsistent, and under one interpretation the Grovers would be personally liable for a lease obligation under a document that they signed only in a representative capacity. And indeed, so ruled the court.
Mr. Grover likely took no consolation from the court’s admonition that if he “did not want to be personally bound on the assignment, he should have insisted on the elimination of the language within the agreement that designated the assignee as ‘William and Teresa Glover as individuals’” (which ignores the balance of the phrase, “dba Grover International, LLC”). Id.
It is puzzling that the Losh court did not analyze the conflicting language in the contract as an ambiguity that would allow the admission of extrinsic evidence. The court ignored the large body of law which recognizes that an ambiguous or contradictory contract may be clarified by the admission of extrinsic evidence to determine the parties’ intent. E.g., Berg v. Hudesman, 115 Wn.2d 657, 801 P.2d 222 (1990).
The court also ignored the fact that the contract’s identification of the parties was not a completely clear statement that personal liability was intended. The contract language did not refer simply to the Grovers individually, but also referred to the Grovers doing business as Grover International, LLC, which at the time was an existing LLC. The phrase “doing business as” is usually used only for situations where a corporation or LLC does business under an alternate name. In Losh, however, the dba referred to an existing and separate entity, not just an alternate name for the Grovers.
The court’s ruling illustrates how simple inconsistencies in a contract quicken the blood of gimlet-eyed litigators and lead to arguable judicial decisions.
Straightening Out Kinks in Washington's LLC Law
Last month Governor Gregoire signed into law a bill amending Washington’s Limited Liability Company Act (Act). The amendments address the confusion introduced by last year’s Supreme Court ruling in Chadwick Farms Owners Ass’n v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), and eliminate a nonsensical provision that was injected into the Act in 2009. The amendments will take effect June 10, 2010.
Chadwick Farms dealt with dissolution and winding-up issues. The court held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate. The court also held that those who improperly wind up the LLC can be personally liable to the LLC’s creditors. I analyzed the court’s reasoning and some of the questions raised, here.
The bill’s amendments substantially change the Act’s dissolution procedures. Under the current Act, a Washington LLC’s dissolution is a private action that can be taken by unanimous member consent, or that occurs as specified in the certificate of formation or LLC agreement. Wash. Rev. Code § 25.15.270. No public filing is required upon dissolution, but upon completion of winding up, the LLC’s certificate of formation must be cancelled by filing a certificate of cancellation. Wash. Rev. Code § 25.15.080.
The amendments eliminate the entire concept of cancelling the certificate of formation. Effective June 10, 2010 there will be no requirement or ability to file a certificate of cancellation. Instead, a dissolved LLC may elect to file a certificate of dissolution with the Washington Secretary of State. Filing a certificate of dissolution is not mandatory, but if it is filed it commences a three-year survival period, after which claims may not be brought by or against the LLC or its managers or members.
If no certificate of dissolution is filed, claims by or against the LLC or its managers or members are not time-limited, except by any applicable statutes of limitations. Presumably most dissolving LLCs will file the certificate of dissolution in order to start running the three-year period.
The amendments also address the winding-up procedures for a dissolved LLC. A new procedure was added: an LLC that has filed a certificate of dissolution may give notice of the dissolution to known claimants and require that claims be asserted within 120 days of the notice. Claims not asserted within the time limit are cut off. If a claimant responds and the LLC then rejects the claim, the claim will be barred unless the claimant commences a legal action to enforce the claim within 90 days of the LLC’s rejection.
The new bill also addresses a 2009 amendment to the Act, currently codified in Wash. Rev. Code § 25.15.293, which I discussed here. The 2009 change made no sense, and the new bill simply deletes it.
The members of the Washington Bar Committee on the Law of Partnerships and LLCs, ably chaired by Brian Todd, as well as the Washington legislators who worked on this bill, are to be commended for their efforts. The new approach to LLC dissolution is a decided improvement over that of the prior Act.
LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
A First -- New York Applies De Facto Corporation Doctrine to LLCs
New York’s highest court, the Court of Appeals, held last month that the doctrine of de facto corporations applies to LLCs. In re Hausman, No. 08854, 2009 NY LEXIS 4145 (Dec. 1, 2009). “De facto corporations” is an equitable doctrine that can be applicable when founders have attempted to form a corporation but failed to fully comply with the statutory requirements. The New York court is apparently the first appellate court in the nation to resolve this issue (other than the Fifth Circuit in Western Sec. Corp., 303 F. App'x 173 (5th Cir. 2008), an opinion that the Fifth Circuit has determined should not be published and which for most purposes is not precedent.)
It sometimes happens that founders of a corporation or LLC to enter into contracts, incur debts or take other actions on behalf of the entity before its formation. But if an agent enters into a contract on behalf of a non-existent entity, under agency law the other party to the contract will usually be able to hold the agent personally liable. The de facto corporation doctrine can permit judicial recognition of the entity’s existence, thereby avoiding personal liability of the agent.
In most states, including New York, an LLC begins to exist when its articles of organization or certificate of formation are filed with the appropriate state agency. E.g., N.Y. Ltd. Liab. Co. Law § 203. But occasionally founders jump the gun and act on behalf of the LLC before the filing is made, sometimes by mistake and sometimes knowing that the articles were not yet filed.
When creditors later claim that the founders are personally liable for contracts entered into before the LLC existed, the founders may defend on the grounds that a de facto corporation existed. There are also other situations, such as in Hausman, where the effectiveness of a conveyance or some other action will depend on whether the LLC existed at the time of the action, and the de facto corporation doctrine may then come into play.
Hausman was a probate proceeding. Lena Hausman’s will left real estate to her son and daughter and to the children of two predeceased sons. Before her death, the son and daughter executed articles of organization and prepared an operating agreement for a New York LLC. Lena Hausman then deeded the real estate to the son and daughter’s LLC, but the articles of organization for the new LLC were not filed with the New York Department of State until 14 days later.
Lena Hausman died seven months later and her will was admitted to probate. In the probate proceedings, the children of the predeceased sons claimed that the real estate should pass by will because Lena’s deed did not convey the real estate to a valid LLC. They pointed out that the LLC did not exist at the time of the deed. The probate court concluded that the deed to the LLC was valid because the LLC was a de facto corporation when the deed was executed.
The Court of Appeals held that the de facto corporation doctrine is applicable to LLCs. “The statutory schemes of the Business Corporation Law and the Limited Liability Company Law are very similar, and we see no principled reason why the de facto corporation doctrine should not apply to both corporations and limited liability companies.” Hausman at *3. The court cited to no other authority, but implicitly recognized that the equitable considerations which support the doctrine for corporations apply to LLCs as well.
The Court of Appeals pointed out that the de facto corporation doctrine requires (1) a law under which the entity might be formed, (2) an attempt to form the entity, and (3) an exercise of the entity’s powers thereafter. Under the facts in Hausman, the court concluded that the second prong was not satisfied¾even though the doctrine was applicable, no de facto LLC existed because there had been no attempt to file the articles of organization until weeks after the deed conveying the real estate was executed.
It is worth noting that many other states have abolished the doctrine of de facto corporations. See, e.g., Equipto Div. Aurora Equip. Co. v. Yarmouth, 134 Wn.2d 356, 367, 950 P.2d 451 (1998). Many of those states have adopted variations of the Model Business Corporation Act, which is intended to abolish the de facto corporation doctrine. See Model Bus. Corp. Act §§ 2.03, 2.04 (2008). Presumably the states that have abolished the de facto corporation doctrine would not apply it to LLCs.
Washington Bobbles a Recent Amendment to the LLC Act
The 2009 Regular Session of the Washington Legislature amended the LLC Act, effective July 26, 2009. 2009 Wash. Sess. Laws Chap. 437. Two changes to the LLC Act were implemented. One was straightforward: the time period for an administratively dissolved LLC to seek reinstatement was extended from two years to five years.
The other change is problematic. The new section of the Act allows a voluntarily dissolved LLC to apply to the Secretary of State “for reinstatement” within 120 days after the effective date of the dissolution. If an application for reinstatement is made under the new law, and assuming the LLC’s name is available, the Secretary of State is directed to reinstate the LLC, in which case the reinstatement relates back to and takes effect as of the date of dissolution. (If the name is not available, the application for reinstatement must include an amendment to the certificate of formation to change the name.)
The problem with this new law is that it simply doesn’t make sense. When a Washington LLC is dissolved, nothing is filed with the Secretary of State. Dissolution of an LLC can be achieved by the written consent of all members, and then its affairs must be wound up. RCW 25.15.270. Dissolution is a change of status that begins the winding-up process, but it is not a public event.
Why would a voluntarily dissolved LLC apply for reinstatement? What is it that would be reinstated? Not the certificate of formation, since it is not affected by the LLC’s dissolution.
Even stranger, this new law requires that if no application for reinstatement is made within 120 days of the date of an LLC’s voluntary dissolution, the Secretary of State “shall cancel” the LLC’s certificate of formation. But since the voluntary dissolution of an LLC does not require a public filing, the Secretary of State will not be aware of an LLC’s dissolution, and therefore in almost all cases would be in no position to take action to cancel the dissolved LLC’s certificate of formation.
The consequences of canceling an LLC’s certificate of formation can be severe, since if the LLC’s certificate of formation is cancelled, the LLC ceases to exist. RCW 25.15.070(2)(c). And as I recently discussed in a post about Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009), the Washington Court has held that canceling an LLC’s certificate of formation not only terminates its existence, but also abates all pending lawsuits by or against the LLC. There is currently no method under the Act to reinstate a cancelled certificate of formation.
It appears that the new section was intended to authorize an LLC to reinstate its certificate of formation within 120 days after filing a certificate of cancellation. The staff of the Secretary of State’s office has told me that they recognize the problems with the new statutory section and don’t intend to begin cancelling certificates of formation 120 days after voluntary LLC dissolutions. They are considering interpreting the new section to authorize applications for reinstatement of cancelled certificates of formation, but it’s hard to find that language in the session law.
I think it’s a safe prediction that this new law will be up for revision at the next session of the Legislature.
Washington Supreme Court: LLC Can Terminate All Lawsuits by Filing Certificate of Cancellation - Personal Liability for Improper Winding Up
On May 14, 2009 the Washington Supreme Court ruled five to four that a Washington LLC cannot sue or be sued once its certificate of formation has been canceled, and any pending lawsuits by or against the LLC abate upon cancellation of the certificate of formation. The result is the same whether the certificate of formation is canceled by the LLC’s voluntary filing of a certificate of cancellation, or by the Secretary of State because of the LLC’s failure to pay its license fees, have a registered agent, or file its annual report. The court also held that those who improperly wind up an LLC can face personal liability to the creditors of the LLC. Chadwick Farms Owners Ass’n v. FHC LLC (May 14, 2009).
The result seems a little startling, to say the least, and the ruling’s potential for abuse is obvious. A defendant LLC in the middle of a lawsuit, where the tide is turning against it, can file a certificate of cancellation and end the lawsuit. Apparently the plaintiff’s only recourse would then be to attempt to show that the members or managers involved in the winding up did so improperly, such as by failing to satisfy or make adequate provisions for paying the LLC’s liabilities, or perhaps to try to establish that illegal distributions had been made to the members.
The opinion involved two consolidated cases, both decided on summary judgment. In each case the LLC’s certificate of formation was canceled, once in the middle of a lawsuit against the LLC and once prior to the filing of a lawsuit against the LLC. One LLC’s certificate of formation was canceled by the Secretary of State for failure to pay license fees and file reports. RCW 25.15.290. The other LLC’s certificate of formation was canceled voluntarily by the LLC after a dissolution vote by its members. RCW 25.15.270.
Most of the opinion deals with two questions: (1) does cancellation of an LLC’s certificate of formation bar the LLC from filing or continuing a lawsuit, and (2) does cancellation of the certificate of formation bar a plaintiff from filing or continuing a lawsuit against the LLC? The court answered both questions in the affirmative; cancellation of the LLC’s certificate of formation ends all suits by or against the LLC and bars any further lawsuits by or against the LLC.
To reach that seemingly draconian result, the court reviewed the LLC Act’s dissolution and winding-up provisions. Dissolution is a change in the status of the LLC that can occur (a) on the date of specific events set forth in the certificate of formation, (b) on the written consent of all members, (c) 90 days after dissociation of the last remaining member unless within the 90 days the assignees vote to admit one or more new members, (d) by judicial decree, or (e) by action by the Secretary of State for nonpayment of fees. RCW 25.15.270. Once dissolved, the LLC’s affairs “shall be wound up.” Upon the completion of winding up, the certificate of formation must be canceled. RCW 25.15.080.
Note that the LLC Act’s dissolution procedures are quite different from those of Washington’s Business Corporation Act (BCA). Under the BCA, a corporation may dissolve (after board and shareholder approval) by filing articles of dissolution with the Secretary of State. RCW 23B.14.030. A dissolved corporation continues its corporate existence but may not carry on any business except that appropriate to wind up and liquidate its business and affairs. RCW 23B.14.050. The contrast is stark: a corporation commences dissolution with a public filing and continues its existence indefinitely while winding up; but an LLC commences dissolution by a vote of its members (i.e., no public filing) and after winding up terminates its existence by filing a cancellation of its certificate of formation.
The court in Chadwick relied on the language of the Act to conclude that cancellation of the certificate of formation terminates the existence of the LLC:
A limited liability company formed under this chapter shall be a separate legal entity, the existence of which as a separate legal entity shall continue until cancellation of the limited liability company’s certificate of formation.
RCW 25.15.070. And, said the court, if the LLC does not exist it cannot sue or be sued. The Act’s survival statute did not alter the court’s conclusion. RCW 25.15.303 provides that “[t]he dissolution of a limited liability company does not take away or impair any remedy available against that limited liability company, its managers, or its members for any right or claim existing” so long as an action is commenced “within three years after the effective date of dissolution.” The dissent read this section as applying whether or not the certificate of formation was canceled within three years after dissolution; the majority instead read Section 303’s survival period to be truncated by an intervening cancellation of the certificate of formation.
Under this ruling, an LLC involved in unwelcome litigation could vote to dissolve and then end the lawsuit by canceling its certificate of formation. However, the statute requires that the LLC’s affairs “shall be wound up” upon dissolution, and that the LLC “pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional, or unmatured claims and obligations, known to the limited liability company,” including known claims for which the identity of the claimant is unknown. Assets may be distributed to members only upon completion of winding up, i.e., after paying or making provision for all claims.
In both Chadwick cases, claims of personal liability were raised against those involved in winding up the LLCs, for failure to pay or make provision for claims. The statute implies that there can be personal liability: “Any person winding up a limited liability company’s affairs who has complied with this section is not personally liable to the claimants of the dissolved limited liability company by reason of such person’s actions in winding up the limited liability company.” RCW 25.15.300. The court easily drew the inference and found that personal liability to claimants may result if the persons winding up the LLC do not comply with RCW 25.15.300.
The Chadwick case will have significant impacts on how litigation with LLCs is conducted, and raises many questions. The temptations on defendant LLCs to dissolve (no public filing is required), wind up, make some arguable provisions for any claims, and then threaten to cancel or actually cancel their certificate will in some cases be irresistible. That scenario raises the question: just exactly how can an LLC make provision for a claim against it in a pending lawsuit when the LLC is about to end the lawsuit and terminate its very existence? Perhaps the manager that carries out the winding up could hold any funds set aside for claimants. If the lawsuit against the LLC is abated, the claimant will likely sue the manager anyway on an “improper winding up” theory. If the case turns in that direction, will the litigation then have to fully determine the merits of the original claim against the LLC, when the LLC is not participating in the lawsuit because its existence has been terminated?
Chadwick only involved claims of personal liability against the manager or members that carried out the winding up. But RCW 25.15.235, not discussed by the Chadwick court, can in some cases create personal liability for members who receive liquidating distributions from a dissolved LLC. Section 235 requires LLCs to refrain from making distributions to members if the LLC is insolvent under either test: it is unable to pay its debts as they become due in the ordinary course, or its liabilities exceed the fair value of its assets. A member who receives a distribution in violation of Section 235 and who knew of the violation at the time of the distribution is liable to the LLC for the amount of the distribution. The Chadwick court relied on RCW 25.15.300, which refers to liability to claimants on the part of those winding up the dissolved LLC. RCW 25.15.235, on the other hand, could be invoked by claimants against a dissolved and canceled LLC in order to reach members who knowingly received an illegal distribution, even if they were not involved in the winding up. But Section 235 only refers to the member’s liability to the LLC, not to third-party claimants. If the LLC’s certificate of formation has been canceled, could a claimant reach the member that received the illegal distribution?
The Chadwick opinion raises a host of such questions, but the law of the case may be short-lived. The court seemed to recognize that its ruling could in some cases yield unsatisfactory results, and noted that according to the house and senate bill reports, a comprehensive review of the LLC Act is underway (presumably by a Washington State Bar Association committee). In an apparent invitation to the state legislature, the court said “[i]f the result here is not what the legislature wants, it will be positioned to make additional changes deemed necessary.” I think it’s a safe prediction that some revisions to the dissolution and winding-up provisions of Washington’s LLC Act will be coming soon.
Courts Continue to Find an Accounting Remedy
A recent decision of the New York Appellate Division, Gottlieb v. Northriver Trading Co. LLC (Jan. 27, 2009), garnered some controversy when it recognized that members of an LLC may seek an equitable accounting under common law. The New York LLC Law does not explicitly authorize an accounting remedy, and the court’s decision has been characterized by Professor Larry Ribstein as an example of the unpredictability of New York’s LLC law and as a contribution to the “impenetrable murk” of New York’s LLC Law.
The Gottlieb opinion relied on the reasoning of New York’s highest court in Tzolis v. Wolff. The court in Tzolis had to decide whether members of an LLC may bring a derivative suit on the LLC’s behalf, even though there were no provisions authorizing or governing derivative suites in New York’s LLC Law. The Tzolis court reasoned by analogy to both corporations and limited partnerships. The New York courts had in the past found an equitable right to a derivative suit for shareholders of a corporation and for limited partners in a limited partnership. In neither of those prior cases, at the times of their holdings, was there a statutory authorization of derivative suits for shareholders or limited partners.
Two recent cases from other states have dealt with this issue, both handed down just a month after publication of the New York court’s opinion in Gottlieb. One state had statutory language explicitly authorizing an accounting, one did not. Both upheld the availability of an accounting.
In February the Indiana Court of Appeals concluded in Perkins v. Brown that the trial court erred when it failed to order an accounting of an LLC’s finances in connection with the dissolution of the two-member LLC. Without discussing or analyzing whether Indiana’s LLC Act authorizes an accounting, the court simply concluded that an accounting was necessary to determine the LLC’s creditors and expenses and whether any improper distributions had been made. Indiana’s LLC Act does not expressly authorize an accounting, but it does provide that “[a] court may enforce an operating agreement by injunction or by granting other relief that the court in its discretion determines to be fair and appropriate in the circumstances.” Section 23-18-4-7(a). That section was also not discussed by the court.
In another February decision, the South Carolina Supreme Court recognized that its courts have “broad judicial discretion in fashioning remedies in actions by a member of an LLC against the LLC and/or other members,” including the remedy of an accounting. Historic Charleston Holdings, LLC v. Mallon. The court proceeded to reverse the trial court’s order for an accounting, but only because “a full financial accounting would unnecessarily prolong this otherwise simple matter.” The court’s conclusion about the authority for an accounting was based on South Carolina’s LLC Act. South Carolina has enacted the ULLCA, and Section 33-44-410(a)of South Carolina’s Act states that “[a] member or manager may maintain an action against a limited liability company or another member or manager for legal or equitable relief, with or without an accounting as to the company’s business . . . .”
In contrast to the explicit ULLCA language, the Revised Uniform Limited Liability Company Act (RULLCA), currently recommended by the National Conference of Commissioners on Uniform State Laws, states that “[u]nless displaced by particular provisions of this Act, the principles of law and equity supplement this Act.” Section 107. Many courts would likely see that as an implicit statutory approval of the accounting remedy for LLCs. RULLCA has been adopted by Idaho and Iowa.
The right to seek an accounting has long been recognized by U.S. courts as an equitable remedy with origins in England’s Chancery Courts. 1 Dan B. Dobbs, Law of Remedies 609-14 (2d ed. 1993). An accounting is generally available when there is a claim of breach of fiduciary duty or other wrongdoing, and is often used in partnership dissolution cases.
Washington, the state where I practice, danced around the issue of an LLC accounting in 2007, but concluded that it need not reach that issue on the facts of the case. Noble v. A&R Envtl. Services, LLC, 140 Wn. App. 29, 164 P.3d 519 (2007). One party appealed the trial Court’s refusal to order an accounting. The Court of Appeals decided that the trial court had not made sufficient findings of fact, remanded the case for adequate findings, and concluded that it need not reach the accounting argument.
The three opinions handed down this year (in New York, Indiana and South Carolina) all recognized that on request of a member of an LLC, an accounting may be ordered in appropriate situations. In none of the three was an accounting to be automatically granted – the analysis is fact-specific and will likely depend on whether there was fraud, breach of fiduciary duty or other wrongdoing, and whether the facts are complex enough to warrant the accounting process. The courts find the authority either in their LLC statute (explicitly or implicitly), by analogy to partnership and corporate law, or under general principles of equity.
These three opinions seem to reflect an unspoken reluctance to rule out the accounting remedy unless the applicable LLC Act expressly bars it, and I’m not aware of any LLC Act that does so. It seems likely that in the absence of such a statutory prohibition, most courts, when first presented with the issue and on request of a member of an LLC, will order an accounting in appropriate situations.
