July 10, 2009
Deductibility of LLC Tax Losses. Garnett v. Commissioner (Tax Ct. 2009)
posted by Gary Rosin
July 01, 2009
Buy or Sell Right in LLC Agreement Not Arbitrable. Gilbert Street Developers, LLC v. La Quinta Homes, LLC (Cal. App. 2009)
Gilbert Street Developers, LLC v. La Quinta Homes, LLC, 94 Cal. Rptr. 3d 918 (Cal. Ct. App. 2009) the Court was called upon to interpret two parts of an LLC's operating agreement. The agreement provided for arbitration of "[a]ny controversy or dispute arising out of or relating to this agreement or the breach thereof (exclusive of matters which are expressly within the discretion of the Members)...." 94 Cal. Rptr. at 919 n.1; Slip Op. at 2 n.1 (emphasis added). The agreement also provided that, under certain circumstances, one member could set a price, and demand that the other member buy or sell at that price. 94 Cal. Rptr. at 927-28; Slip Op. at 13-15. The question of arbitrability turned on whether the buy or sell provisions fell withing the exclusion for discretionary matters:
The Yee parties argue that there really isn‟t any discretion in the operation of the buy out agreement, other than, obviously the initial choice to invoke it. For them, it is essentially a machine that grinds to one of two inexorable results (you‟re bought out or you get bought out) once a lever is thrown.
* * *
* * * A simple binary choice as here (shall I buy or shall I sell?) qualifies under the ordinary person‟s definition of discretion as well. Discretion is simply the act of separating or distinguishing, and that includes binary choices as well as ranges.
94 Cal. Rptr. at 928; Slip Op. at 15-16.
Interestingly, the buy-or-sell provisions could only be invoked "[i]n the event of a dispute among the Members which cannot be resolved[.]" 94 Cal. Rptr. at 927; Slip Op. at 13 (emphasis added). To me, the real issue is whether arbitration would "resolve" the dispute. In any event, the agreement provided for two dispute-resolution mechanisms, and did not clearly address how they related to each other.
posted by Gary Rosin
June 24, 2009
Dissolution, Cancellation and LLC Survival Statutes. Chadwick Farm Owners Ass'n v. FHC LLC (Wash. 2009)
We all know how survival statutes work--or at least we think we do. The recent opinion in Chadwick Farm Owners Ass'n v. FHC LLC, 207 P.3d 1251 (Wash. 2009) (en banc) (majority and dissenting opinions) may change that.
Under the Washington Limited Liability Company Act, Wash. Rev. Code, Chapter 25.15, dissolution of an LLC starts winding up. § 25.15.270. Dissolution does not impair remedies against the LLC, its managers or members, unless an action or proceeding is started within three years of dissolution. § 25.15.303. Those winding up the affairs have the right to bring or defend lawsuits after dissolution, but only until the filing of certificate of cancellation. § 25.15.295(2). The filing of a certificate of cancellation cancels the certificate of formation, § 25.15.080, and terminates the existence of the LLC as a separate entity, § 52.15.070(c).
Chadwick Farm Owners Ass'ninvolved LLCs that had been administratively dissolved under Section 25.15.280. An administratively dissolved LLC has two years to seek reinstatement. § 25.15.290(1). What happens if the LLC is not reinstated within two years? Here the statutes conflict. Under Section 52.15.270(6), that triggers dissolution (again?) of the LLC. Under Section 25.15.290(4), the secretary of state "shall cancel the limited liability company's certificate of formation." Which controls? The majority in Chadwick Farm Owners Ass'n held that Section 25.15.290(4)controlled, and that pending suits against the LLC abated once a certificate of cancellation had been filed:
Under the statutory scheme applying to limited liability companies that are administratively dissolved, if the company does not seek reinstatement it must wind up the company’s affairs within that two year period, because once the two years pass, the company no longer exists and has no power to act. While the company still exists, and during the time it is winding up (the time following dissolution and before cancellation of the certificate of formation), it has the power to prosecute and defend suits. But once the company is canceled, it can no longer prosecute or defend suits; it no longer exists as a legal entity.
* * *
* * * The statutes do not permit an administratively dissolved limited liability company to continue winding up, including prosecuting and defending suits, on its own schedule after cancellation of the company’s certificate of formation. * * * There is no basis to treat a member canceled limited liability company differently than an administratively dissolved company.
207 P.3d at 1257-58 (citations and footnotes omitted).
What about three-year survival of actions under Section 25.15.303?
By its plain language, RCW 25.15.303 provides that (1) dissolution does not affect any claim against a limited liability company and (2) there is a three-year limitations period from the date of dissolution in which to commence suit against a limited liability company. The statute never mentions “cancellation.” Of utmost importance, the legislature did not alter any provision in chapter 25.15 RCW and thus it left intact the statutes discussed above which provide that a limited liability company maintains its existence as a separate legal entity during dissolution but only until cancellation. In particular, as noted, RCW 25.15.295(2) unambiguously states that after a limited liability company is dissolved and before cancellation, i.e., during the winding up period, a manager or other representative who winds up the company’s affairs may “prosecute and defend suits” only until cancellation.
The Condominium Association in Emily Lane contends, however, that all canceled limited liability companies are also first dissolved companies, and logically the statute applies to dissolved companies that later cancel themselves. Amicus Washington State Trial Lawyers Association Foundation makes a similar argument.
However, there is a clear distinction between dissolution and cancellation.A dissolved company still exists for the purpose of winding up, during which it can sue or be sued. But once a limited liability company’s certificate of formation is canceled, it no longer exists as a separate legal entity for any purpose. RCW 25.15.303 does not even mention cancellation, and the legislature did not alter any of the existing provisions in the Act. On its face, and read in the context of the entire Act, RCW 25.15.303 means that an action against a limited liability company, whether arising before or after dissolution, must be brought within three years of dissolution, but an action against a limited liability company will abate upon cancellation.
The plain language in RCW 25.15.303 and the other provisions in the Act resolve the statute’s meaning. * * *
207 P.3d at 1259 (emphasis added) (citations and footnotes omitted).
What happens after other dissolutions? Could the members (or managers) file a certificate of cancellation, and stiff plaintiffs in pending suits? Yes, but the Court warns:
* * * [That does] not take into account the whole statutory scheme, however. A dissolved limited liability company must, under the Act, properly complete the winding up process, which includes paying or making arrangements to pay known obligations and claims, even if unmatured or contingent. Members of a limited liability company who fraudulently attempt to use the provisions of the act to avoid liability and members who wind up a limited liability company improperly expose themselves to individual liability....
207 P.3d at 1261 (emphasis added); see also, id. at 1262-64 (discussing individual liability for improper winding up).
Finally, the Court rejected the argument that its interpretation was not the "bvest" result:
We recognize, however, that these arguments reflect the homeowners’ view that the statute is unfair when it is applied according to its express terms. However, if the result here is not what the legislature envisioned it is, nonetheless, what the statute plainly provides. We understand from the house and senate bill reports that a comprehensive review of the Act is underway. If the result here is not what the legislature wants, it will be positioned to make additional changes deemed necessary. It is not, however, the province of this court to rewrite RCW 25.15.303 or any other provision of the Act.
207 P.3d at1261. So, the Washington legislature has some work to do. I offer a couple of thoughts
- If the legislature intended for dissolution, rather than cancellation of the certificate of formation, to apply to LLCs not timely reinstated, the statutes should be amend to provide for an initial administrative suspension of the right to do business, followed by an administrative dissolution.
- Alternatively, it can change the survival statute to survival for three years after cancellation.
Also, the potential of personal liability, if widely known, may reduce the number of LLC "walk-aways," where the owners of an unsuccessful LLC abandon it to administrative dissolution, and make no attempt to wind up its affairs in an orderly fashion.
posted by Gary Rosin
May 06, 2009
LLCs and Fiduciary Duties: A Glimmer of Hope for Delaware
I have criticized many Delaware opinions for dicta saying that there are no fiduciary duties in Delaware LLCs unless they are expressly contracted for (what I have called the "mere contractual entity" approach). The recent opinion in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC,C.A. No. 3658-VCS (Del. Ch. Ct. April 20, 2009) (Mem. Op.) ("Bay Center"), gives me reason to hope that Delaware has not lost its way. In Bay Center,Vice Chancellor Strine denied a motion to dismiss, among other things, claims of breach of fiduciary duty. In discussing the fiduciary duty claim, Strine began by emphasizing the inherently fiduciary character of the relationship between an LLC's manager and the LLC and its members. Slip Op. at 17-18.
Another important aspect of the opinion is VC Strine's treatment of a purported waiver of fiduciary duties in section 6.2 of the LLC Agreement:
Section 6.2 Liability of Members. . . . Except for any duties imposed by this Agreement . . . each Member shall owe no duty of any kind towards the Company or the other Members in performing its duties and exercising its rights hereunder or otherwise.
Slip Op.at 19 (emphasis in original). Strine found that Section 6.2 conflicted with Section 6.1(b), which provided
Section 6.1 Relationship of Members. Each Member agrees that, to the fullest extent permitted by the Delaware Act and except as otherwise expressly provided in this Agreement or any other agreement to which the Member is a party: . . . (b) The Members shall have the same duties and obligations to each other that members of a limited liability company formed under the Delaware Act have to each other.
Slip Op. at 18-19 (emphasis in original). As a result, the LLC Agreement was ambiguous. Even though, to survive on a motion to dismiss, plaintiffs must offer only areasonable interpretation that supports their claim, VC Strine indicated that a reading of the LLC Agreement as allowing fiduciary duties under Section 6.1(b) was more reasonable than a reading that Section 6.2 controlled. Accord to VC Strine, the latter reading would make Section 6.1(b) meaningless. Slip Op.at 19-20. Last, VC Strine invoked traditional principles of interpretation of fiduciary waivers:
And, the interpretive scales also tip in favor of preserving fiduciary duties under the rule that the drafters of chartering documents must make their intent to eliminate fiduciary duties plain and unambiguous. As a result, the defendants’ interpretation of the fiduciary duty provisions of the LLC Agreement is not the most reasonable interpretation, let alone the only reasonable interpretation.
Slip Op. at 20 (footnote omitted) (emphasis added).
posted by Gary Rosin
Sole Member of LLC Is Not the "Owner" of LLC Property . 3519-3513 Realty, LLC v. Law (N.J. Superior App. 2009)
In 3519-3513 Realty, LLC v. Law, 967 A.2d 954 (N.J. Superior App. Div. 2009) (slip opinion), the Court rejected an attempt by the sole member of an LLC to evict a tenant of a unit in a building owned by the LLC. The statutory grounds for the attempted eviction was that the "owner" wanted to personally occupy the unit. The Court refused to treat the building as owned by the sole member:
Appellant argues that [the sole member]formed [the LLC] for the protection it afforded him individually in terms of potential liability. [He] had every right to decide to arrange his affairs in that manner. At the same time, he must accept the concomitant burdens that follow from the choice he made. Finally, appellant contends that adopting the trial court's construction unreasonably requires expenditure of money and time to transfer the property back to [the sole member's] name, individually, with the accompanying risk of incurring personal liability. While not unsympathetic to the dilemma posed, we are not free to relieve [him] of the consequences which flow from the considered choices he earlier made. posted by Gary Rosin
Appellant argues that [the sole member]formed [the LLC] for the protection it afforded him individually in terms of potential liability. [He] had every right to decide to arrange his affairs in that manner. At the same time, he must accept the concomitant burdens that follow from the choice he made.
Finally, appellant contends that adopting the trial court's construction unreasonably requires expenditure of money and time to transfer the property back to [the sole member's] name, individually, with the accompanying risk of incurring personal liability. While not unsympathetic to the dilemma posed, we are not free to relieve [him] of the consequences which flow from the considered choices he earlier made.
posted by Gary Rosin
February 20, 2009
Holdover LLCs. Spellman v. Katz (Del. Ch. 2009)
What happens when the practice of the members of an Unincorporated Business Entity (UBE) varies from the terms of the UBE's constitutive documents? In a recent opinion in Spellman v. Katz, C.A. No. 1838-VCN (Del. Ch. February 9, 2009), Vice Chancellor Noble invoked the Parole Evidence Rule to prohibit the consideration of evidence showing that the members of an LLC had disregarded a provision in the LLC Agreement.
In Spellman, Doctors Katz, Spellman and Alfieri formed Delaware Bay Surgical Services, P.A. as the vehicle for the joint practice of medicine. At the same time, the three also formed KSA, L.L.C. The LLC bought a piece of property, constructed a building, Bayview Medical Center, and leased it (or a portion of it) to the PA. At some point, Dr. Alfieri withdrew form the LLC (and, presumably, the PA), and bought one of what eventually became three "units" from the LLC. In February, 2002, after an unsuccessful attempt to force dissolution of the PA, Dr. Spellman withdrew from the practice. In 2002, presumably after Spellman's departure, another unit in the building was sold. Dr Katz continues to practice through the PA, and the PA continues to lease a unit in the building. Slip Op., at 1-2 & nn. 1-4.
In his recent opinion, Chancellor Noble granted Dr. Spellman's request for dissolution of the LLC and the appointment of a liquidating trustee. Section 5.1 of the LLC Agreement provided for dissolution and winding up of the LLC
as soon as possible after the construction of the building [Bayview Medical Center] has been completed, the condominium documents have been finalized and a certificate of occupancy has been issued with respect to each condominium unit . . .
Id. at 2 (bracketed portion in the opinion's quotation of Section 5.1).
Although Dr Katz did not cast his argument in terms of mistake, he did argue that the members had intended the LLC to be used as the vehicle to own the facilities used by the PA in order to obtain tax benefits. Id. at 5. He claimed that the members did not know of the language of Section 5.1. Id. at 6. Chancellor Noble rejected those arguments out-of-hand:
Dr. Katz would have the Court ignore the plain language of Section 5.1 in deference to his recollection of the parties’ intention that KSA would continue as an entity long after the completion of Bayview Medical Center....
Id. at 5.
The Chancellor also noted that Dr. Katz had not argued waiver, estoppel or acquiescence. Id. at 6 n.20. In retrospect, that was a mistake. Whatever else is true, the LLC did continue doing business for over two years after the completion of the facility. Dr. Alfieri left the practice, withdrew from the LLC, and then bought his unit (presumably, the space he had already been using). The practice PA continued to lease the remainder of the building until Dr. Spellman left the practice, at which point the LLC sold a second unit.
How should the law handle a variance between the agreements and the practice of the parties? Continuation of a business beyond an agreed term or undertaking, and without an express agreement to do so, was common enough that, almost a hundred years ago, the UPA addressed it (Section 23). RUPA continues to provide for it (Section 406). ULLCA Section 802(b) does permit the members to waive winding up, but the ULLCA does not address a continuation without a waiver. Section 18-806 of the Delaware LLC Act does allow "revocation of dissolution," but only by "the affirmative vote or written consent of all remaining members...."
All the LLC statutes need to address the problem of "holdover" LLCs. The R/UPA approach of falling back on the statutory default may not be the right solution. For example, under Section 18-801(a)(1) of the Delaware LLC Act, the statutory default is perpetual existence. One the other hand, the substance of the RUPA statutory default--an "at will" entity--may well be proper to handle holdovers.
In the absence of a legislative solution, UBE documents should address the problem.
Time to get to work.
Hat tip to the Delaware Business Litigation Report.
posted by Gary Rosin
February 19, 2009
Joint Ventures vs. Partnerships. Costa v. Borges (Idaho 2008)
I know that historically--before the Great Depression, perhaps even before the 20th Century--courts considered joint ventures and partnerships to be distinct business forms (for reasons that will become apparent, note my use of "forms" instead of "entities"). To be sure, the two were "similar" and courts usually applied partnership law to joint ventures. As the Idaho Supreme Court recently put it in its opinion in Costa v. Borges, 2008 Op. No. 23, at 4, 179 P.3d 316 (Idaho February 15, 2008) (citations omitted):
Because of the similarities between partnerships and joint ventures, partnership law generally governs joint ventures. A partnership is "an association of two (2) or more persons to carry on as co-owners a business for profit." "A joint adventure is generally a relationship analogous to but not identical with a partnership, and is often defined as an association of two or more persons to carry out a single business enterprise with the objective of realizing a profit."
The opinion in Costa v. Borges then took an unexpected turn. Because RUPA Section 201 declares a partnership to be an entity separate from its partners, the Idaho Supreme Court concluded that partnership and joint venture law have parted company:
Although a partnership is now an entity distinct from its partners, "a joint venture is not an entity separate and apart from the parties composing it." There is no statute providing that a joint venture is an entity distinct from its members. There is no statutory provision allowing for the dissociation of a member from a joint venture and the continuation of the joint venture in business as a separate entity. That portion of RUPA providing for the continuation of a partnership as a separate legal entity after dissociation of a partner has no application to a joint venture.
Slip. Op. at 5 (citations omitted) (emphasis added). Later, the Court indicated that, even in a three-member joint venture,
However, even if the joint venture had three members it could not continue doing business after the withdrawal of one member. Because "a joint venture is not an entity separate and apart from the parties composing it," a joint venture cannot continue in business as a separate legal entity after one joint venturer withdraws.
Id. at 4-5 (citation omitted).
The same could have been said of mid-(20th) century partnerships. Not only does the Costas v. Borges freeze joint-venture law, it also ignores Rights of partners under UP)A Section 38(2). A joint venture is only a partnership for a particular purpose. Under UPA Section 38(2), after the early withdrawal of a partner in a partnership for a particular purpose, the remaining partner(s) may
continue the business of the partnership, either by themselves or jointly with others ....
That is, the question is not whether a partnership may continue after the withdrawal of one of two partners, but whether the remaining partners may continue the business without dissolution. That said, with its emphasis on continuation of the entity, the RUPA does not adequately address continuation of the business of two-partner partnerships after the premature withdrawal of one of the partners.
Hat tip to Marc Ward.
posted by Gary Rosin
February 18, 2009
Reverse Piercing: A Single Member LLC Paradox
Carter G. Bishop (Suffolk) has posted on SSRN "Reverse Piercing: A Single Member LLC Paradox," an article forthcoming in the South Dakota Law Review. Bishop's focus is on the rise of single member LLCs (SMLLCs) as an asset-protection vehicle, and the resulting difficulties of creditors of the single member under existing LLC law. He suggests that, in lieu of "ad hoc equitable judicial remedies," id. at 6, the states should take the SMLLC off the table as an asset-protection vehicle:
every state would amend its SMLLC legislation to provide that upon the voluntary or involuntary transfer of the only economic interest in the SMLLC, the transferee will be admitted as a substituted member, with or without the consent of the only member.
Id. at 70.
On the Florida Asset Protection blog, Jonathan Alper notes that, in FTC v. Olmstead, the remedies of creditors of the sole member of an SMLLC are now before the Florida Supreme Court via a certified question. He has a recent post on the oral arguments in FTC v. Olmstead.
There also has been an interesting discussion of this on LNET-LLC.
Hat tip to Paul Caron.
posted by Gary Rosin
February 17, 2009
Allocations vs. Distributions. More on Casavecchia v. Mizrahi
As mentioned in my earlier post on the Casavecchia v. Mizrahi series of cases, the essence of the Casavecchia's claims was that
- the LLC had been formed to develop a single real estate development, Hills of the Heartland,
- the development had been completed, and all units sold, and
- instead of distributing profits, the Mizrahi had instead loaned the LLC's funds to another LLC in which the Casavecchias were not participating.
I have already noted the disconnect between the Casavecchia's understanding of the parties' prior practice--one development at a time, and the formation of a new vehicle for new projects--and the breadth of the purpose provision of the LLC's Operating Agreement.
But here are other puzzling aspects of the trial court's original order, Cassavecchia v. Mizrahi, No. 008635/2005 (N.Y. Sup. Ct. August 23, 2006) (Warshawsky, J.). At first, it seemed as though Justice Warshawsky had ordered a defacto dissolution of the LLC. In this connection, note that Section 701 only allows voluntary dissolution without a vote of the members only when the organizational documents provide for a time for dissolution, or dissolution on the happening of a specified event. Section 702 of the New York Limited Liability Company Law allows for judicial dissolution at the request of a member "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement." To the extent Warshawsky found a limited purpose, he could have found a voluntary dissolution under Section 701 or, perhaps that it was "not longer reasonably practicable" a purpose that had been completed. But that's not what the order said.
On closer reading, Warshawsky casts the issue as
The issue that emerges for determination is whether a reading of ¶ 8,together with ¶¶ 4, 6 and 9 leads to the conclusion that profits of the Hills of Heartland venture should be allocated and distributed to the shareholders so that they have the right to control their use. See e.g. LLCL § 507, Interim Distributions.
Slip Op., at 3 (emphasis added). Section 4 of the Operating Agreement set forth a broad, rather than a narrow, purpose of the LLC. Id. at 2. Section 6 provides for management by action of a majority in interest, which itself is consistent with the early statement that Mizrahi managed the day-to-day affairs of the LLC. Id. Section 9 provides for distributions "at the times and in the amounts determined by a majority in interest". Id. Section 507 of the New York LLC Law provides for interim distributions to members
to the extent and at the times or upon the happening of events specified in the operating agreement....
Section 8 of the operating agreement provides for the allocation of profits and losses to the members. Slip Op., at 3. Warshawsky then noted the dispute as to the purpose of the LLC, and concluded
While it is conceivable that [LLC] could build homes and lend money out of profits so generated, that plan of operating would have to be approved by all the investors in the venture as they are the lawful beneficiaries of the success of any LLC.
Slip Op., at 4. (emphasis added).
It is clear that, while Warshawsky contemplates interim distributions, the basis for his order of "an inquest ... to determine the profits available for distribution" is not entirely clear. Does he deem that the Cassavecchias' own a majority of interest, so can decide to make distributions? Does he instead believe (wrongly) that allocations under Section 8 give the members the right to distributions? Why else would he suggest that the diversion of profits into a loan would require the approval of all investors?
posted by Gary Rosin
February 11, 2009
Transactional Perspectives on Casavecchia v. Mizrahi
The still on-going litigation arising out of Hills of Heartland LLC can help illuminate the role of a transactional lawyer. The latest installments are two opinions out of the NY Appellate Court, 2nd department, Casavecchia v. Mizrahi, 2008 NY Slip Op 00938 & 2008 NY Slip Op. 00939 (NY AD [2nd] December 16, 2008). The appellate opinions grow out of orders by Judge Warshawsky (N.Y. Sup. Ct., Nassau County) on August 23, 2006 and on September 11, 2007. The point here is not to parse the opinion, but to note the inconsistency between the LLC's operating agreement and the practice of the parties.
Casavecchia and Mizrahi were serial real estate developers who
were in business together for many years constructing and marketing residential housing of which Hills of Heartland is just one. Allegedly, as a development was completed , the profits were used to finance the building of a new development. There came a time when plaintiff was no longer associated with the business.
Order, September 11, 2007, at 2. One of the key disputes between Casavecchia and Mizrahi related to the role (and purpose) of Hills of Heartland LLC. In the Order of August 26, 2006, Judge Warshawsky found that the purpose of Hills of Heartland LLC was solely to develop Hills of Heartland:
Defendant bootstraps section 202(f) & (c) of the LLC on to the Hills of Heartland Operating Agreement to support the claim that the purpose of the Company was to build and to lend money. He unfolds a rather convoluted claim that plaintiff was interested in the Company lending money rather than distributing it when the Company acquired a parcel of land on which it has now completed development.... * * * His profound ending is that the process of lending retained money rather making a distribution to investors is a sage and efficacious way of doing new business with old money.
* * * The only dispute in the arguments of the parties ... is whether the Company was formed to lend money.
Despite thoroughly and carefully searching the record the court can find no evidence that it was. Defendant's assertion is unsupported by evidentiary proof in admissable form .... He testified that the Company had not made any loan. He admitted in the answer that it was formed to build homes.
Id. at 4.
Mizrahi's attorney appears to have focused on Section 202(f) of the New York Limited Liability Company Law, which includes in the laundry list of general powers of an LLC the power to "lend money for any lawful purpose, invest or reinvest its funds...." Earlier in the opinion, Judge Warshawsky had quoted paragraph 4 of the LLC's Operating Agreement, which included an omnibus purpose clause:
4. PURPOSE. The Company is formed for the purpose of acquiring, owning, operating, developing, constructing buildings of all kinds or nature and selling real estate and engaging in any lawful act or activity for which limited liability companies may be formed under the LLCL and engaging in any and all activities necessary or incidental to the foregoing.
Order of August 26, 2006, at 2 (emphasis added).
The point here is not to assess Judge Warshawsky's conclusion, could well have been influenced by the fact that he loaned the LLC's funds to a company in which the Casavecchia's had no ownership interest:
that defendant Mizrahi is the only investor in the Company who is actively involved in Casa Mason, the proposal of being an unsecured, unguaranteed, interest free lender to a Mizrahi entity appears to be a bountiful bonanza to only defendant.
Id. at 5.
Instead, assuming that the parties' prior practice had been to invest in particular development projects via project-related unincorporated business entities (UBEs), why did the purpose clause not only refer to investment in real estate generally, but also include an omnibus purpose clause? Surely, some transactional dropped the ball here, probably by trying to save drafting time by pulling out a form.
There is more that I could say, but I'll stop here.
posted by Gary Rosin
February 05, 2009
Civil Contempt and LLEs. 1319Third Ave. Realty Corp. v. Chateaubriant Restaurant Dev. Co, LLC
Most people--even many lawyers and judges--think that "limited liability" means immunity, even for "officers" of a limited liability entity (LLE). But those acting--or deciding not to act--on behalf of an LLE remain personally responsible for their actions. They can avoid liability on contracts entered into on behalf of the LLE by fully disclosing that they are acting as agents for, and identifying by proper name, the LLE as principal. But they remains fully responsible for whatever civil or criminal wrongful acts in which they participate.
This was brought home to me by the opinion in 1319 Third Ave. Realty Corp. v Chateaubriant Rest. Dev. Co., LLC, 2008 NY Slip Op 09910 (NY AD [1st] December 18, 2008). That opinion affirmed a civil contempt order against "the sole owner and principal" of an LLC even though only the LLC was a party to the law suit in which the civil order was issued. Id. at 1. The court found that "It defies credulity that [the LLC's only member & presumably its manager] was unaware of the [trial court's] orders." Id.
The only problem that I have with the opinion is that it does not discuss the wording of the orders defied by the LLC and its member and "principal". Most injunctions and orders against an LLE apply by their terms to the LLE and to its officers, agents and employees. A knowing failure by an officer, agent or employee to obey the order is routinely grounds for civil contempt.
Words to the wise.
posted by Gary Rosin
February 04, 2009
Choice of Law and Hotel 71 Mezz Lender LLC v. Falor
Hotel 71 Mezz Lender LLC v. Falor, 2008 NY Slip Op 09848 (NY AD [1st], December 16, 2008), involved a couple of interesting questions about a judgment creditor of a member of an LLC in that member's rights and interests in an LLC:
- For purposes of determining jurisdiction in an in rem proceeding, what is the situs of an interest in an LLC?
- Internal affairs doctrine. Does local law or the law of the jurisdiction under which the LLC was organized determine the rights of creditors in interests in an LLC?
- Forum non conveniens. Even if a court has jurisdiction over an interest in an LLC organized under the law of another state, if the internal affairs doctrine will determine the rights of the parties, should the court decline to determine the rights of the parties and direct them to the courts of the other state?
Situs. The Court noted that, under New York law, the situs of shares of a corporation of interests in a limited partnership is where the business is formed and operates. Given that LLCs are a "hybrid" of both, the same rule should apply. Id. at 3. Given that there was no evidence that any of the out-of-state LLCs had any business operations in New York, the court held that the ex parte order of attachment should not have been confirmed by the trial court. Id. at 4.
Internal Affairs and Forum Non Conveniens. Invoking the internal affairs doctrine, the Court reasoned that it should decline jurisdiction in favor of the situs of the LLCs. I specifically noted that whether the judgment creditor of the member could get at real property owned by an LLC should be determined by the the courts of the state in which the property was located. Id. at 4. Here, the opinion suffers from a lack of clarity. Perhaps as a result of the failure of the parties to use the statutory remedy--the charging order, the court is conflating situs of the property of an LLC and the internal affairs doctrine.
A strong argument can be made that the nature of an interest in an LLC, and of the rights of a member, should be governed by the internal affairs doctrine, and determined by the laws of the state under which the LLC was organized. To have the courts of each state in which the LLC might own property determine the right of the creditor of a member to proceed against the property of the LLC in that state could result in chaos.
posted by Gary Rosin
Creditors and Interests in LLEs: A Rant on Reading Hotel 71 Mezz Lender LLC v. Falor
In Hotel 71 Mezz Lender LLC v. Falor, 2008 NY Slip Op 09848 (NY AD [1st], December 16, 2008), the Court correctly vacated a trial court
pre-judgment order confirming the ex parte attachment of their membership interests in 23 entities, including Delaware, Georgia and Florida limited liability companies and a solely owned Florida corporation, and the subsequent orders conditionally appointing a receiver of those out-of-state interests.
Slip Op at 2.
The odd thing about the trial court order, and in the appellate opinion, is the absence of recognition of the concept of charging orders. In most states, including New York, a charging order is the exclusive manner by which a creditor can get at an interest in a limited liability entity (LLE). One would hope that somewhere among the trial court judge, the four appellate justices, and the eleven (!) lawyers listed in the opinion--and their associates or clerks), someone might have brought that concept to the attention of the court. Perhaps someone did, but that person's advice was ignored.
Certainly, that must say something about the state of legal education system and its products (lawyers). But only about a third of law schools offer a separate course in Agency, Partnerships and LLEs. Even in those schools, most students do not take both Corporations and A&P. The usual Business Associations course virtually ignores agency, and only gestures in the direction of partnerships and LLEs; then it's off to talk about public corporations and control transactions.
posted by Gary Rosin
January 28, 2009
Judicial Dissolution of LLCs. Fisk Ventures, LLC v. Segal (Del. Ch. 2009)
Id. at 13.Chancellor Chandler has handed down another Memorandum Opinion in Fisk Ventures, LLC v. Segal, C.A. No. 3017-CC (Del Ch. Ct. January 13, 2009). In the latest opinion, Chancellor granted a request to judicially dissolve a Delaware LLC under Section 18-802 of the Delaware Limited Liability Company Act, which allows the Court of Chancery to dissolve an LLC
[o]n application by or for a member or manager ... whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
The basis for the dissolution was deadlock, and the distressed financial and operating condition of the LLC:
When such a company has no office, no employees, no operating revenue, no prospects of equity or debt infusion, and when the company’s Board has a long history of deadlock as a result of its governance structure, more than ample reason and sufficient evidence exists to order dissolution.
Fisk Ventures, LLC, slip op. at 1. Apparently, the LLC's Operating Agreement provided for management by a four-person Board, with each member appointing half of the Board. Action by the Board required approval by 75% of the Board. Id. at 10-13.
Apart from the general discussion of the "not reasonably practicable to carry on" standard, the opinion deals with an interesting wrinkle: the party asking for judicial dissolution had a contractual "put" that would let them sell their interest to the LLC at an adjusted book value, based on "an independent valuation ... by a nationally recognized, reputable investment banker." Id. at 3-4. If the put price was more than half of the LLC's tangible assets, the price would be paid in three equal installments over two years. The court rejected the argument that the existence of this unexercised put made judicial dissolution unnecessary:
... it would be inequitable for this Court to force a party to exercise its option when that party deems it in its best interests not to do so.
Id. at 13.
Prof. Larry Ribstein has a good discussion of the opinion. He focuses on judicial dissolution as a remedy for oppression. But Section 18-802 only allows dissolution when it is "not reasonably practicable to carry on business in conformity with the [LLC] agreement." Where the agreement provides for majority control, I'm not sure that abuse of control would make it not reasonably practicable to continue to carry on business under the agreed management structure. Of course, there might be a breach of fiduciary duty claim, but only if the agreement didn't waive all fiduciary duties. That would leave only the breach of the good faith and fair dealing contractual obligation.
posted by Gary Rosin
January 26, 2009
When is a Subsidiary Not a Subsidiary? American Electric Service Power Co. Inc. v. Affiliated FM Ins. Co. (5th Cir.)
In American Electric Service Power Co. Inc. v. Affiliated FM Insurance Co., No. 07-31061 (5th Cir. (La.) Jan. 21, 2009), the Fifth Circuit Court of Appeals concluded that an insurance policy covering a utilities conglomerate and "any subsidiary corporation" was unambiguous and did not cover the conglomerate's subsidiary LLCs. The court found the term "corporation" to be "clear and explicit" and stated that interpreting the term to exclude unincorporated entities does not lead to "absurd consequences."
posted for Elizabeth Miller
January 02, 2009
Derivative Fiduciary Duties and Fiduciary Waivers (Faulkner)
The recent opinion in Faulkner v. Kornman (In re The Heritage Organization, L.L.C.), Adv. Proc. No. 06-3377-BJH (Banker. N.D. Tex. Dec. 12, 2008), raises an interesting question. The underlying Operating Agreement provided that Heritage's Manager owed no fiduciary duties of any sort to it or to its members. Slip Op., at 29. The trustee of the bankruptcy estate of Heritage asserted breach of fiduciary duties against the officers of Heritage's Manager (also an LLC). Although those officers may also have been officers of Heritage, this post will focus only the duties that they might have owed when acting as officers of the Manager.
Begin with two central principles. First, an organization is separate from the persons that act on its behalf ("agents"). Although owners of the organization may not be liable for its obligations (assuming a limited liability form was used), the same is not true for its agents. Agents can avoid liability on contracts entered into by them of behalf of the organization, but only if they fully disclose the the other party the identity of the organization, and that they are acting for it. Agents remain fully responsible for any torts or crimes in which they participate. The Nuremberg defense--I was just following orders (or acting for my organization)--does not wash.
The second principle is that organizations act only through human agents. Those agents owe fiduciary duties to the organization, but generally owe only the usual duties to other persons--the duty to operate a car carefully, the duty not to defraud, or the duty not to murder (although Hollywood seems to think that duty is customary in large corporations!).
As I argued in Car gill & Statutory Preemption, the fiduciary obligations of persons that control a fiduciary derive from the fiduciary obligations of the controlled fiduciary. To the extent that the controlled fiduciary (the manager of The Heritage Organization, L.L.C.) has procured a waiver of its fiduciary obligations (as in Section 6.03(A) of Heritage's Operating Agreement), it should follow that the controlling fiduciary's (the defendant's in Faulkner) duties should follow that of the controlled fiduciary. Thus, in Faulkner, a waiver of fiduciary duties of Heritage's Manager should also extend to the managers and officers of that Manager.
Of course, it would be better to address that question in the Operating Agreement itself. But then litigators would have less to do!
posted by Gary Rosin
Breathtaking Fiduciary Waiver: Faulkner v. Kornman (In re The Heritage Organization, LLC) (Bankr. N.D. Tex. 2008)
Faulkner v. Kornman (In re The Heritage Organization, L.L.C.), Adv. Proc. No. 06-3377-BJH (Bankr. N.D. Tex. Dec. 12, 2008) involved a breathtakingly broad fiduciary waiver and exculpatory clause. Section 6.03(A) of the LLC's Operating Agreement provided:
The Manager shall not be required to exercise any particular standard of care, nor shall he owe any fiduciary duties to the Company or the other Members. Such excluded duties include, by way of example, not limitation, any duty of care, duty of loyalty, duty of reasonableness, duty to exercise proper business judgment, duty to make business opportunities available to the company, and any other duty which is typically imposed upon corporate officers and directors, general partners or trustees. The Manager shall not be held personally liable for any harm to the Company or the other Members resulting from any acts or omissions attributed to him. Such acts or omissions may include, by way of example but not limitation, any act of negligence, gross negligence, recklessness, or intentional misconduct.
Slip Op., at 29.
In Mere Contractual Entities? UBEs and Fiduciary Waivers, I argued that waivers of fiduciary duties should be interpreted strictly. Section 6.03(A) leaves no doubt as to the scope of the fiduciary duties being waived. Given that the LLC was organized under Delaware law, id. at 27-28, such a broad waiver is clearly permitted under Section 18-1101(e) of the Delaware Limited Liability Company Act.
The problem is that the trustee in bankruptcy sued the officers of the Manager (also an LLC), claiming that they owed fiduciary duties, either as officers of the Manager, or of the LLC. But that's another story.
Hat tip to Marc Ward.
posted by Gary Rosin
December 16, 2008
Tangled Webs: Estate Taxes and Family UBEs (Stuart v. Oklahoma Tax Comm'n, 2008)
Stuart v. Oklahoma Tax Commission, 2008 Ok. Civ. App 85, 195 P.3rd 1280 (OK Civ. App. 2008) (cert. denied), involved the application of the Oklahoma estate tax to interests in a family LLC (organized in Oklahoma) which was itself owned by a family limited partnership.
In the beginning, a retired rancher,then living in Texas, owned ranch land in Oklahoma, and used it to conduct a ranching business. After that, the facts are not entirely clear, but it appears that
- He formed an Oklahoma LLC (Ranch LLC), and transferred at least the ranching business to it, thereby becoming its sole member.
- He organized a revocable trust (Trust), and transferred to it his interest in the Ranch LLC, and his other property, which may have included the Oklahoma ranch land & buildings used in the ranching business.
- The Trust then formed a corporation and became its sole shareholder.
- The corporation became the general partner of a Texas limited partnership (Texas Family Partnership). The Trust transferred the entire ownership interest in the Ranch LLC to the Texas Family Partnership, became its sole limited partner.
- Apparently the Trust retained ownership of the ranch land & buildings.
Id. at ¶¶ 2-6. Oklahoma imposed its estate tax on the Trust's limited partnership interest in the Texas Family Partnership. Id. at ¶ 2. On appeal, the court affirmed the imposition of the tax.
On seeing the West summary of the opinion, 195 P.3rd at 1280, I was expecting that the basis of the Court's ruling was that the limited partner owned the ranch land. That was not case. The Court recognized that an interest in a partnership is personal property (an intangible). 2008 Ok. Civ.. App. 85, at ¶ 10. Instead, the Court relied on Section 807(A)(7), which includes in the taxable estate of a nonresident decedent
the interest of such nonresident in a partnership the business of which is conducted in the state or the majority of assets of which are located in this state.
68 O.S. § 807(A)(7). The Court reasoned that the Texas Family Partnership was conducting ranching business in Oklahoma.
The Court rejected the argument that the Texas Family Partnership was not conducting business in Oklahoma, but only owned an interest in Ranch LLC, which was conducting business in Oklahoma through a manager designated in the Operating Agreement. 2008 OK 85 at ¶ 12. The Court reasoned that, as sole member of Ranch LLC, the Texas Family Partnership had the right to manage Ranch LLC's business directly:
Consequently, but for the appointment of Ms. Forst as the Ranch LLC's manager, the business of the LLC would be conducted by the Texas Family Partnership, and Oklahoma's authority to levy estate tax could not be questioned. Albeit through an Oklahoma LLC, the Texas Family partnership would, nonetheless, be conducting the business of Stuart Ranch in Oklahoma, and the terms of 68 O.S.2001 § 807(A)(7) would clearly apply.
Id. at ¶ 15. So far as the Court was concerned, it was no Ranch LLC, but Texas Family Ranch, that appointed the LLC's manager: "no other legal entity put pen to paper". Id. at ¶ 18. The Court further reasoned that:
Presumably, the Ranch LLC pays Oklahoma sales, property and income taxes no matter how far the Texas Family Partnership can distance itself from the Oklahoma operation. Nonetheless, one need not disregard the legal existence of that partnership [sic] to conclude that those taxes "come out of the pocket" of the Texas Family Partnership ....
Id. at ¶ 19.
The reasoning in both Paragraphs 18 and 19 clearly does disregard the status of Ranch LLC as an entity separate from its member. The "no other legal entity put pen to paper" ignores the status of an Operating Agreement as a foundational document of the LLC itself. See Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286 (Del. 1999).
The argument in Paragraph 15 that a managing member of an LLC with an Oklahoma-based business is conducting business in Oklahoma is more interesting. As i recall the general rule, partners are considered to be doing business wherever the partnership is, which would also apply to general partners of limited partnerships. But that reasoning is based on an aggregate view of partnerships. Under an entity approach would a partner or a member be deemed to be doing business wherever the entity is doing business? In my view, that might depend on whether the employees acting on behalf of the entity were different from other employees of the entity. To the extent that an employee of the member is actively conducting LLC business in Oklahoma, it certainly can be argued that the member is also present. Food for thought.
posted by Gary Rosin
December 12, 2008
And/Or Check Your Drafting (Portnoy)
In the Memorandum Opinion in Kahn v. Portnoy, C.A. No. 3515-CC (Del. Ch. December 11, 2008), one of the grounds of defendants' 12b-6 motion to dismiss a breach of fiduciary duties is that the LLC Agreement modified defendants' fiduciary duties. Slip Op., at 9-15.
The key provision was Section 7.5(a) of the LLC Agreement. Section 7.5(a) differed from DGCL Section 144, in that it allowed for some validation of certain transactions involving a conflict of interest. Slip Op., at 10 n.17. The problem was the scope of Section 7.5(a), which applied
whenever a potential conflict of interest exists or arises between any Shareholder or an Affiliate thereof, and/or one or more Directors or their respective Affiliates and/or the Company
In the view of Chancellor Chandler, in the context of a 12b--6 motion, the scope of Section 7.5(a) was ambiguous. In his view, the scope clause arguably did not include conflicts between a director and the LLC (Company). Id. at 11-13.
Although Chancellor Chandler did not elaborate, in my view the problem was the serial use of "and/or" without any guide as to grouping (the referents of each and/or). For example, the language supports three groupings:
- Shareholders and/or (vs.)
Directors and/or the Company, or
- Shareholders and/or Directors and/or (vs.)
- Shareholders vs. Directors,
Shareholders vs. Company, or
Directors vs. Company.
The use of "and/or" must be a Strunk and White no-no. Moreover, neither the punctuation nor the layout suggests any organization.
Even if we end up with an "authoritative" interpretation of ambiguity in Kahn v. Portnoy, that won't eliminate the need for "mindful" drafting. Time to take a hard look at all those form documents lurking about the office.
posted by Gary Rosin
Portnoy's Defense Rejected at Pleading Stage. Kahn v. Portnoy (Del Ch. 2008)
Sorry, but how often do you get refer to Philip Roth, even if to a book published almost 40 years ago? Too bad Portnoy wasn't the plaintiff.
In a recent Memorandum Opinion in Kahn v. Portnoy, C.A. No. 3515-CC (Del. Ch. December 11, 2008), Chancellor Chandler denied a 12b-6 motion to dismiss a complaint by a member of a publicly traded Delaware LLC (Slip Op,. at 2) that alleged breach of fiduciary duties by Its directors. The motion argued that dismissal was required either because
- the LLC Agreement either modified defendants' fiduciary duties or exculpated them from liability, Slip Op. at 9-24, or
- demand on its board of directors was not excused, Slip Op. at 24-34.
The LLC Agreement provided not only for management by a board of directors, but also for fiduciary duties identical to those of directors of a Delaware corporation (except to the extent modified by the LLC Agreement). For our purposes, the most interesting grounds for dismissal is the first ground. That said, to the extent that the second ground does not duplicate the first ground, its discussion of demand excusal is illuminating.
Hat tip to the Delaware Business Litigation Report blog.