De Facto Dissolution of California LLC

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De Facto Dissolution of California LLC

De Facto Dissolution of California LLC Allows LLC’s Creditor to Reach Assets Distributed to Members

An LLC sells its assets and distributes the proceeds to its members. It then goes out of business and leaves creditors holding the bag, unpaid. A creditor has a valid claim against the LLC, but can it assert its claim against the members who received the sale proceeds? That was the question before the court in a decision handed down by the California Court of Appeal last month, in CB Richard Ellis, Inc. v. Terra Nostra Consultants, 178 Cal.Rptr.3d 640 (Cal. Ct. App. Oct. 7, 2014). The court allowed the creditor to assert its claim against the members that received distributions, but only after finding that a de facto dissolution of the LLC had occurred.

The facts of the case were straightforward. CB Richard Ellis, Inc., a real estate broker (CBRE), signed a listing agreement with Jefferson 38, LLC to sell the LLC’s 38-acre real estate parcel. A dispute between CBRE and the LLC over the duration of the listing agreement and CBRE’s performance developed, and the LLC sold the real estate for $11.8 million without help from CBRE. One day after its receipt of the net sale proceeds, the LLC transferred essentially all of the proceeds to its members, without paying any commission to CBRE. Seven months later the LLC filed a certificate of cancellation with the California Secretary of State, indicating that it had been dissolved by a vote of its members.

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CBRE arbitrated the dispute in accordance with the listing agreement and obtained a $960,000 judgment against the LLC for its commission, interest, and attorneys’ fees. The LLC had essentially no assets and could not pay, so CBRE later sued the LLC’s members.

CBRE alleged that the LLC had been dissolved, that the members had received distributions of the sale proceeds upon dissolution, and that in accordance with the LLC Act each member was therefore liable to CBRE for the LLC’s commission obligation, up to the amount of the distribution received by each member. A jury trial resulted in a verdict and judgment in favor of CBRE, against each member up to the amount of the member’s distribution. The members appealed on grounds that the jury had been improperly instructed on the law regarding the LLC’s dissolution.

Court of Appeal.  The Court of Appeal first had to determine which version of the California LLC Act to apply. (California adopted the Revised Uniform Limited Liability Company Act, effective January 1, 2014.) The court determined that it would apply the earlier version of the LLC Act, because it was in force at the time the dispute arose. Id. at 644.

CBRE based its claim on Section 17355 of the prior LLC Act, which provides that a cause of action against a dissolved LLC may be enforced, “[i]f any of the assets of the dissolved limited liability company have been distributed to members, against members of the dissolved limited liability company to the extent of the limited liability company assets distributed to them upon dissolution of the limited liability company.” Cal. Corp. Code § 17355(a)(1)(B) (repealed 2014). (Section 17707.07(a)(1) of the new LLC Act is nearly identical.)

The defendants objected to the jury instructions, which in relevant part stated:

Dissolution of a limited liability company occurs when it ceases operating in the ordinary course of its business, with the intention, on the part of its members, not to resume the ordinary course of its business….A limited liability company may continue to do business after it has dissolved for the purpose of winding up its affairs, paying its creditors and distributing its remaining assets. In determining whether a dissolution of Jefferson… occurred, you may consider all evidence bearing on that issue, including; for example, the ordinary business of the limited liability company, the assets of the limited liability company both before and after a distribution, the continuation of the ordinary business and the cessation of its ordinary business activities.

CB Richard Ellis, 178 Cal.Rptr.3d at 645. The Court of Appeal noted that the instruction uses the concept of a “de facto” dissolution, based on all the facts and circumstances rather than the formal dissolution steps taken under the statute.

The defendants contended that the jury instruction was incorrect because dissolution could occur only upon compliance with former Section 17350, which says that an LLC is dissolved upon the first to occur of (a) events specified in the articles of organization or operating agreement; (b) a majority vote of the members; or (c) a judicial decree of dissolution. Cal. Corp. Code § 17350 (repealed 2014). The defendants argued that because the LLC had not been formally dissolved when they received their distributions, former Section 17355 did not apply to the members and CBRE could not assert its claim against them.

The court, however, did not read Section 17350 to say that there are no other potential causes of dissolution, or that the three listed causes of dissolution are the exclusive grounds for dissolution. Finding no relevant legislative history, the court looked to the policy of the statute, which it saw as preventing unjust enrichment of LLC members when the members have received assets the dissolved LLC needs to pay its creditors. The court noted that if the members’ interpretation of the statute were correct, LLCs and their members could avoid the Section 17355 clawback “by the simple expedient of transferring assets out of the company the day before voting to dissolve.” CB Richard Ellis, 178 Cal.Rptr.3d at 647.

The court accordingly held that the jury was correctly instructed. “‘De facto’ dissolution is an acceptable predicate to a claim under former section 17355, subdivision (a)(1)(B).” Id.

Comment.  CB Richard Ellis stands out – most states do not recognize de facto dissolutions of LLCs. The issue doesn’t come up frequently because most states have a prohibition in their LLC laws on distributions to a member at a time when the LLC is insolvent or would be rendered insolvent by the distributions, regardless of whether the LLC has been dissolved. E.g., Cal. Corp. Code § 17704.05; Wash. Rev. Code § 25.15.235; Del. Code Ann. tit. 6, § 18-607. And many, including California, Washington, and Delaware, also require that a member who receives a distribution with knowledge that the LLC was insolvent must return the distribution to the LLC, without reference to whether the LLC is dissolved.

The LLC in CB Richard Ellis was presumably rendered insolvent by the distributions, given that CBRE had asserted a large claim against it. A creditor considering using that provision would have to establish the members’ knowledge of the LLC’s insolvency, of course, and that may be why CBRE did not pursue that avenue.

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