Tuesday, March 5, 2019

Quick Take on Polsky's Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups

Gregg D. Polsky, University of  Georgia Law, recently posted his paper, Explaining Choice-of-Entity Decisions by Silicon Valley Start-Ups. It is an interesting read and worth a look. H/T Tax Prof Blog.  Following the abstract, I have a few initial thoughts:

Perhaps the most fundamental role of a business lawyer is to recommend the optimal entity choice for nascent business enterprises. Nevertheless, even in 2018, the choice-of-entity analysis remains highly muddled. Most business lawyers across the United States consistently recommend flow-through entities, such as limited liability companies and S corporations, to their clients. In contrast, a discrete group of highly sophisticated business lawyers, those who advise start-ups in Silicon Valley and other hotbeds of start-up activity, prefer C corporations.

Prior commentary has described and tried to explain this paradox without finding an adequate explanation. These commentators have noted a host of superficially plausible explanations, all of which they ultimately conclude are not wholly persuasive. The puzzle therefore remains.

This Article attempts to finally solve the puzzle by examining two factors that have been either vastly underappreciated or completely ignored in the existing literature. First, while previous commentators have briefly noted that flow-through structures are more complex and administratively burdensome, they did not fully appreciate the source, nature, and extent of these problems. In the unique start-up context, the complications of flow-through structures are exponentially more problematic, to the point where widespread adoption of flow-through entities is completely impractical. Second, the literature has not appreciated the effect of perplexing, yet pervasive, tax asset valuation problems in the public company context. The conventional wisdom is that tax assets are ignored or severely undervalued in public company stock valuations. In theory, the most significant benefit of flow-through status for start-ups is that it can result in the creation of valuable tax assets upon exit. However, the conventional wisdom makes this moot when the exit is through an initial public offering or sale to a public company, which are the desired types of exits for start-ups. The result is that the most significant benefit of using a flow- through is eliminated because of the tax asset pricing problem. Accordingly, while the costs of flow-through structures are far higher than have been appreciated, the benefits of these structures are much smaller than they appear.

Before commenting, let me be clear: I am not an expert in tax or in start-up entities, so my take on this falls much more from the perspective of what Polsky calls "main street businesses." I am merely an interested reader, and this is my first take on his interesting paper. 

To start, Polsky distinguishes "tax partnerships" from "C Corporations."  I know this is the conventional wisdom, but I still dislike the entity dissonance this creates.  Polsky explains: 

Tax partnerships generally include all state law entities other than corporations. Thus, general and limited partnerships, LLCs, LLPs, and LLLPs are all partnerships for tax purposes. C corporations include state law corporations and other business entities that affirmatively elect corporate status. Typically, a new business will often need to choose between being a state-law LLC taxed as a partnership or a state-law corporation taxed as a C corporation. The state law consequences of each are nearly identical, but the tax distinctions are vast.

 As I have written previously, I'd much rather see the state-level entity decoupled from the tax code, such that we would 

have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax

As Dinky Bosetti once said, "It's good to want things." 

Anyway, as one who focuses on entity choice from (mostly) the non-tax side, I dispute the idea that "[t]he state law consequences of each [entity] are nearly identical, but the tax distinctions are vast."  From governance to fiduciary duties to creditor relationships to basic operations, I think there are significant differences (and potential consequences) to entity choice beyond tax implications. 

 I will also quibble with Polsky's statement that "public companies are taxed as C corporations."  He is right, of course, that the default rule is that "a publicly traded partnership shall be treated as a corporation." I.R.C. § 7704(a). But, in addition to Business Organizations, I teach Energy Law, where we encounter Master Limited Partnerships (MLPs), which are publicly traded pass-through entities. See id. § 7704(c)-(d).

Polsky notes that "while an initial choice of entity decision can in theory be changed, it is generally too costly from a tax perspective to convert from a corporation to a partnership after a start-up begins to show promise."  This is why those of us not advising VC start-ups generally would choose the LLC, if it's a close call. If the entity needs to be taxed a C corp, we can convert.  If it is better served as an LLC, and the entity has appreciated in value, converting from a C corp to an LLC is costly.  Nonetheless, Polsky explains for companies planning to go public or be sold to a public entity, the LLC will convert before sale so that the LLC and  C Corp end up in roughly the same place:  

The differences are (1) the LLC’s pre-IPO losses flowed through to its owners while the corporation’s losses were trapped, but as discussed above this benefit is much smaller than it appears due to the presence of tax-indifferent ownership and the passive activity rules, (2) the LLC resulted in additional administrative, transactional, and compliance complexity (including the utilization of a blocker corporation in the ownership structure), and (3) the LLC required a restructuring on the eve of the IPO. All things considered, it is not surprising that corporate classification was the preferred approach for start-ups.

This is an interesting insight. My understanding is that the ability pass-through pre-IPO losses were significant to at least a notable portion of investors. Polsky's paper suggests this is not as significant as it seems, as many of the benefits are eroded for a variety of reasons in these start ups.  In addition, he notes a variety of LLC complexities for the start-up world that are not as prevalent for main street businesses. As a general matter, for traditional businesses, the corporate form comes with more mandatory obligations and rules that make the LLC the less-intensive choice.  Not so, it appears, for VC start-ups.  

 I need to spend some more time with it, and maybe I'll have some more thoughts after I do.  If you're interested in this sort of thing, I recommend taking a look.

March 5, 2019 in Corporate Finance, Corporate Governance, Corporations, Joshua P. Fershee, LLCs, Partnership, Unincorporated Entities, Venture Capital | Permalink | Comments (0)

Tuesday, February 19, 2019

New Paper: Business Entities as Skeleton Keys

Christopher G. Bradley at University of Kentucky College of Law has posted his paper, Business Entities as Skeleton Keys.  The paper was also selected for the 2019 AALS Section on Agency, Partnership, LLCs and Unincorporated Associations program, Respecting the Entity: The LLC Grows Up.  

Chris notes the use of business entities to accomplish goals not attainable previously and the use of entities "to accomplish customized transactions and evade legal restrictions that would otherwise prevent them."  His observations and insights are good ones, and his paper is definitely worth the read.  I can't help but think that some of this is occurring more because of an increasing comfort with entities and a willingness to engage in creative transactions. We're seeing in beyond the use of entities, too, with the rise of derivatives over the last 20 or so years, not to mention cryptocurrencies.  Anyway,  it's a good paper and I recommend it. 

Here's the abstract:

This Article identifies the increasingly important phenomenon of what I term “skeleton key business entities” and discusses the ramifications of their rise. Modern business entities, such as LLCs, are increasingly created and deployed to accomplish customized transactions and evade legal restrictions that would otherwise prevent them. Rather than acting as traditional businesses, such entities are tools, or “skeleton keys,” used to open “locked doors” presented by existing bodies of law, including contract, property, bankruptcy, copyright, tax, national security, and even election law.

The Article centers on the example of the “Artist’s Contract,” a fascinating 1971 project, in which artists sought to retain rights in artworks they sold—to obtain a percentage of future appreciation in value, to exhibit the work upon request, and so on. As prior scholarship has noted, the transaction contemplated by the Artist’s Contract could not have been accomplished in regular contract form due to rules concerning privity, servitudes on chattels, and the first sale doctrine, among other things. But this no longer remains true. The emergence of modern business entity law provides the tools—i.e., skeleton key business entities—to “solve” all of these legal problems and allow for bespoke transactions such as those desired by the artists.

The rise of skeleton key business entities may unsettle numerous other bodies of law. They may bring efficiencies but may undermine important policies. After providing a range of examples, I suggest that scholars—including those outside the business and commercial law realm—should turn renewed attention to the remarkable capacities of these flexible, inexpensive, and surprisingly potent transactional tools. We should consider if it makes sense to force parties pursuing newly enabled forms of commerce to bear the costs of filtering transactions through business entities; or alternatively, which traditional doctrines should bind modern entities just as they bind parties outside of those forms.

February 19, 2019 in Contracts, Corporations, Joshua P. Fershee, LLCs, Partnership, Unincorporated Entities, Writing | Permalink | Comments (0)

Tuesday, January 8, 2019

I Don't Care What the IRS Says, There Are No Federal Entities

Not for my purposes, anyway. Back in 2016, I made the argument that the IRS should "stop using state-law designations": 

My proposal is not abolishing corporate tax – that’s a much longer post and one I am not sure I’d agree with.  Instead, the proposal is to have entities choose from options that are linked the Internal Revenue Code, and not to a particular entity. Thus, we would have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax

This post deals with the tax code, which means I am in over my head, and because this is tax related, it means the solution is a lot more complicated than this proposal.  But now that the code provisions are not really linked to the state law entity, I think we should try refer to state entities as state entities, and federal tax status with regard to federal tax status.  Under such a code, it would be a little easier for people to understand the concept behind state entity status, and it would make more sense to people that a “C Corp” does mean “publicly traded corporation” (a far-too common misunderstanding).  Thus, we could have C Tax corporations, S Tax LLCs, K Tax LLCs, for example.  We'd know tax status and state-entity status quite simply and we'd separate the concepts. 

We discussed this issue on Saturday at the 2019 AALS Section on Agency, Partnership, LLCs & Unincorporated Associations Program on LLCs. As I taught my first Business Organizations class of the semester, I talked about this and it occurred to me that maybe the better way to think about this is to simply acknowledge that there are no federal entities.  

State law is the origin of all entity types (barring, perhaps, a few minor exceptions), and references to "C Corps" and "S Corps" are not really on target. I concede that the IRS does so, which is a challenge, but it's really unnecessary under today's tax code. That is, with check-the-box options, most entity types can choose whatever tax treatment they wish.  An LLC can choose to be taxed under subchapter S, for example, though it has to meet certain requirements (e.g., can only have one class of "stock"), but the LLC can file Form 2553 an make an S election.  

As such, as I have argued before, I think we should work to keep entity type and tax treatment separate.  Thus, for example, we can have an S-taxed LLC (an LLC that made the S election)  and a K-taxed LLC (an LLC that made a K election for pass-through taxation).  The tax treatment does not "convert" the LLC to a corporation -- or S corp. It simply provides for certain tax treatment.  I really think we'd see some doctrinal improvements if we could get more people to use language that makes clear tax treatment and entity type are separate issues, at least in today's word.   

Entities are creatures of state law. How the federal or state government tax such entities does not change that reality.  It's time we start using more precise language to make that clear.  

January 8, 2019 in Corporate Personality, Joshua P. Fershee, LLCs, Partnership, Unincorporated Entities | Permalink | Comments (1)

Tuesday, August 21, 2018

Everyone Wants to Make Non-Corporate Things Corporate: It's Sen. Warren's Turn

Senator Elizabeth Warren last week released her Accountable Capitalism Act. My co-blogger Haskell Murray wrote about that here, as have a number of others, including Professor Bainbridge, who has written at least seven posts on his blogCountless others have weighed in, as well.

There are fans of the idea, others who are agnostic, and still other who thinks it’s a terrible idea. I am not taking a position on any of that, because I am too busy working through all the flaws with regard to entity law itself to even think about the overall Act.

As a critic of how most people view entities, my expectations were low. On the plus side, the bill does not say “limited liability corporation” one time.  So that’s a win. Still, there are a number of entity law flaws that make the bill problematic before you even get to what it’s supposed to do.  The problem: the bill uses “corporation” too often where it means “entity” or “business.”

Let’s start with the Section 2. DEFINITIONS.  This section provides:

 (2) LARGE ENTITY.—

(A) IN GENERAL.—The term ‘‘large entity’’ means an entity that—

(i) is organized under the laws of a State as a corporation, body corporate, body politic, joint stock company, or limited liability company;

(ii) engages in interstate commerce; and

(iii) in a taxable year, according to in- formation provided by the entity to the Internal Revenue Service, has more than $1,000,000,000 in gross receipts.

Okay, so it does list LLCs, correctly, but it does not list partnerships.  This would seem to exclude Master Limited Partnerships (MLPs). The Alerian MLP Indexlist about 40 MLPs with at least a $1 billion market cap.  It also leaves our publicly traded partnerships(PTPs). So, that’s a miss, to say the least. 

Section 2 goes on to define a  

(6) UNITED STATES CORPORATION.—The term “United States corporation’’ means a large entity with respect to which the Office has granted a charter under section 3.

The bill also creates an “Office of United States Corporations,” in Section 3, even though the definitions section clear says a “large entity” includes more than just corporations. 

Next is Section 4, which provides the “Requirement for Large Entities to Obtain Charters.”

LARGE ENTITIES.—

(1) IN GENERAL.— An entity that is organized as a corporation, body corporate, body politic, joint stock company, or limited liability company in a State shall obtain a charter from the Office . . . .”

So, again, the definition does not include MLPs (or any other partnership forms, or coops for that matter) as large entities.  I am not at all clear why the Act would refer to and define “Large Entities,” then go back to using “corporations.”  Odd. 

Later in section 4, we get the repercussions for the failure to obtain a charter: 

An entity to which paragraph (1) applies and that fails to obtain a charter from the Office as required under that paragraph shall not be treated as a corporation, body corporate, body politic, joint-stock company, or limited liability company, as applicable, for the purposes of Federal law during the period beginning on the date on which the entity is required to obtain a charter under that paragraph and ending on the date on which the entity obtains the charter.

Here, the section chooses not to use the large entity definition or the corporation definition and instead repeats the entity list from the definitions section. As a side note, does this section mean that, for “purposes of Federal law,” any statutory “large entity” without a charter is a general partnership or sole proprietorship? I would hope not for the LLC, which isn’t a corporation, anyway.

Finally, in Section 5, the Act provides:

(e) APPLICATION.—

(1) RULE OF CONSTRUCTION REGARDING GENERAL CORPORATE LAW.—Nothing in this section may be construed to affect any provision of law that is applicable to a corporation, body corporate, body politic, joint stock company, or limited liability company, as applicable, that is not a United States corporation.

Again, I will note that “general corporate law” should not apply to anything but corporations, anyway. LLCs, in particular. 

The Act further contemplates a standard of conduct for directors and officers.  LLCs do not have to have either, at least not in the way corporations do, nor do MLPs/PTPs, which admittedly do not appear covered, anyway. The Act also contemplates shareholders and shareholder suits, which are not a thing for LLCs/MLPs/PTPs because they don’t have shareholders.

This is not an exhaustive list, but I think it’s a pretty good start. I will concede that some of my critiques could be argued another way.  Obviously, I'd disagree, but maybe some of this is not as egregious as I see it. Still, there are flaws, and if this thing is going to move beyond even the release, I sure hope they take the time to get the entity issues figured out. I’d be happy to help.

August 21, 2018 in Corporate Governance, Corporate Personality, Corporations, CSR, Joshua P. Fershee, Legislation, LLCs, Management, Partnership, Shareholders, Unincorporated Entities | Permalink | Comments (0)

Tuesday, July 24, 2018

Avengers Take Note: Hydra Is an LLC, But Not a Corporation

An Illinois appellate court decision that was just made available on Westlaw provides some revealing insight into Hydra, the longtime source of evil that many recognize from Captain America: The First Avenger

Hydra stated that Hydra's manager is Ahuva Horowitz, defendant's wife, and that she owns 100% of the membership interests of Hydra a limited liability corporation.

Xcel Supply LLC v. Horowitz, 2018 IL App (1st) 162986, ¶ 14, 100 N.E.3d 557, 561, reh'g denied (Mar. 9, 2018) (emphasis added). 

First, let's correct the record: Hydra is listed as an LLC, a limited liability company. It is not a corporation.  

Second, I should also note, after further review, it's not really THAT Hydra. It is apparently not this one:

In a prehuman time, a cabal of cold-blooded alien reptiles arrived on Earth, planning to start a legacy of evil. They planted the seed that would later gave birth to future evil empires. 

So, instead, the instant Hydra is Hydra Properties, LLC, which came into existence in 2009. That makes more sense, but it's a lot less interesting.  

Still, either way, and for either Hydra, if it's Hydra LLC, it's not a corporation.  

July 24, 2018 in Corporations, Film, Joshua P. Fershee, LLCs, Unincorporated Entities | Permalink | Comments (0)

Monday, February 26, 2018

Professional Responsibility in an Age of Alternative Entities, Alternative Finance, and Alternative Facts

Like my fellow editors here at the BLPB, I enjoyed the first Business Law Prof Blog conference hosted by The University of Tennessee College of Law back in the fall.  They have begun to post their recently published work presented at that event over the past few weeks.  See, e.g., here and here (one of several newly posted Padfield pieces) and here. I am adding mine to the pile: Professional Responsibility in an Age of Alternative Entities, Alternative Finance, and Alternative Facts.  The SSRN abstract reads as follows:

Business lawyers in the United States find little in the way of robust, tailored guidance in most applicable bodies of rules governing their professional conduct. The relative lack of professional responsibility and ethics guidance for these lawyers is particularly troubling in light of two formidable challenges in business law: legal change and complexity. Change and complexity arise from exciting developments in the industry that invite—even entice—the participation of business lawyers.

This essay offers current examples from three different areas of business law practice that involve change and complexity. They are labeled: “Alternative Entities,” “Alternative Finance,” and “Alternative Facts.” Each area is described, together with significant attendant professional responsibility and ethics challenges. The essay concludes by offering general prescriptions for addressing these and other professional responsibility and ethics challenges faced by business lawyers in an age of legal change and complexity.

I do not often write on professional responsibility issues.  However, I do feel an obligation every once in a while to add to the literature in that area addressing issues arising in transactional business law.  In essence, it's service through scholarship.  

I hope you read the essay and, if you do, I hope you enjoy it.  I also can recommend the commentary on it published by my UT Law faculty colleague George Kuney and my student Claire Tuley.  Both comments will be available electronically in the coming months.  I will try to remember to post links . . . .

February 26, 2018 in Business Associations, Corporate Finance, Crowdfunding, Ethics, Joan Heminway, Lawyering, Securities Regulation, Unincorporated Entities | Permalink | Comments (2)

Tuesday, February 13, 2018

These Reasons Social Benefit Entities Hurt Business and Philanthropy Will Blow Your Mind

I suspect click-bait headline tactics don't work for business law topics, but I guess now we will see. This post is really just to announce that I have a new paper out in Transactions: The Tennessee Journal of Business Law related to our First Annual (I hope) Business Law Prof Blog Conference co-blogger Joan Heminway discussed here. The paper, The End of Responsible Growth and Governance?: The Risks Posed by Social Enterprise Enabling Statutes and the Demise of Director Primacy, is now available here.

To be clear, my argument is not that I don't like social enterprise. My argument is that as well-intentioned as social enterprise entity types are, they are not likely to facilitate social enterprise, and they may actually get in the way of social-enterprise goals.  I have been blogging about this specifically since at least 2014 (and more generally before that), and last year I made this very argument on a much smaller scale.  Anyway, I hope you'll forgive the self-promotion and give the paper a look.  Here's the abstract: 

Social benefit entities, such as benefit corporations and low-profit limited liability companies (or L3Cs) were designed to support and encourage socially responsible business. Unfortunately, instead of helping, the emergence of social enterprise enabling statutes and the demise of director primacy run the risk of derailing large-scale socially responsible business decisions. This could have the parallel impacts of limiting business leader creativity and risk taking. In addition to reducing socially responsible business activities, this could also serve to limit economic growth. Now that many states have alternative social enterprise entity structures, there is an increased risk that traditional entities will be viewed (by both courts and directors) as pure profit vehicles, eliminating directors’ ability to make choices with the public benefit in mind, even where the public benefit is also good for business (at least in the long term). Narrowing directors’ decision making in this way limits the options for innovation, building goodwill, and maintaining an engaged workforce, all to the detriment of employees, society, and, yes, shareholders.

The potential harm from social benefit entities and eroding director primacy is not inevitable, and the challenges are not insurmountable. This essay is designed to highlight and explain these risks with the hope that identifying and explaining the risks will help courts avoid them. This essay first discusses the role and purpose of limited liability entities and explains the foundational concept of director primacy and the risks associated with eroding that norm. Next, the essay describes the emergence of social benefit entities and describes how the mere existence of such entities can serve to further erode director primacy and limit business leader discretion, leading to lost social benefit and reduced profit making. Finally, the essay makes a recommendation about how courts can help avoid these harms.

February 13, 2018 in Business Associations, Corporate Governance, Corporate Personality, Corporations, CSR, Current Affairs, Delaware, Joshua P. Fershee, Law and Economics, Lawyering, Legislation, LLCs, Management, Research/Scholarhip, Shareholders, Social Enterprise, Unincorporated Entities | Permalink | Comments (0)

Tuesday, December 19, 2017

Washington Marijuana Law Has Entity Type Quirks (And LLCs Are Still Not Corporations)

A recent case in Washington state introduced me to some interesting facets of Washington's recreational marijuana law.  The case came to my attention because it is part of my daily search for cases (incorrectly) referring to limited liability companies (LLCs) as "limited liability corporations."  The case opens: 

In 2012, Washington voters approved Initiative Measure 502. LAWS OF 2013, ch. 3, codified as part of chapter 69.50 RCW. Initiative 502 legalizes the possession and sale of marijuana and creates a system for the distribution and sale of recreational marijuana. Under RCW 69.50.325(3)(a), a retail marijuana license shall be issued only in the name of the applicant. No retail marijuana license shall be issued to a limited liability corporation unless all members are qualified to obtain a license. RCW 69.50.331(1)(b)(iii). The true party of interest of a limited liability company is “[a]ll members and their spouses.”1 Under RCW 69.50.331(1)(a), the Washington State Liquor and Cannabis Board (WSLCB) considers prior criminal conduct of the applicant.2

LIBBY HAINES-MARCHEL & ROCK ISLAND CHRONICS, LLC, Dba CHRONICS, Appellants, v. WASHINGTON STATE LIQUOR & CANNABIS BOARD, an Agency of the State of Washington, Respondent., No. 75669-9-I, 2017 WL 6427358, at *1 (Wash. Ct. App. Dec. 18, 2017) (emphasis added).  
 
The reference to a limited liability corporation appears simply to be a misstatement, as the statute properly references limited liability companies as distinct from corporations. The legal regime does, though, have some interesting requirements from an entity law perspective. First, the law provides:
 
(b) No license of any kind may be issued to:
 
. . . .
 
(iii) A partnership, employee cooperative, association, nonprofit corporation, or corporation unless formed under the laws of this state, and unless all of the members thereof are qualified to obtain a license as provided in this section;
Wash. Rev. Code § 69.50.331 (b)(iii) (West). It makes some sense to restrict the business to in-state entities given the licensing restrictions that state has, although it is not clear to me that the state could not engage in the same level of oversight if an entity were, say, a California corporation or a West Virginia LLC. 
 
The state's licensing requirements, as stated in Washington Administrative Code 314-55-035 ("What persons or entities have to qualify for a marijuana license?") provide: "A marijuana license must be issued in the name(s) of the true party(ies) of interest." The code then lists what it means to be a  “true party of interest” for a variety of entities. 
True party of interest: Persons to be qualified
 
Sole proprietorship: Sole proprietor and spouse.
 
General partnership: All partners and spouses.
 
Limited partnership, limited liability partnership, or limited liability limited partnership: All general partners and their spouses and all limited partners and spouses.
 
Limited liability company: All members and their spouses and all managers and their spouses.
 
Privately held corporation: All corporate officers (or persons with equivalent title) and their spouses and all stockholders and their spouses.
 
Publicly held corporation: All corporate officers (or persons with equivalent title) and their spouses and all stockholders and their spouses.
Multilevel ownership structures: All persons and entities that make up the ownership structure (and their spouses).
Wash. Admin. Code 314-55-035. 

This is a pretty comprehensive list, but I note that the corporation requirements are missing some noticeable parties: directors. The code states, for both privately and publicly held corporations, that all "corporate officers (or persons with equivalent title)" and their spouses and all stockholders and their spouses must be qualified. Directors are not "equivalent" in title to officers. Officers, under Washington law, are described as follows:
 
(1) A corporation has the officers described in its bylaws or appointed by the board of directors in accordance with the bylaws.
(2) A duly appointed officer may appoint one or more officers or assistant officers if authorized by the bylaws or the board of directors.
(3) The bylaws or the board of directors shall delegate to one of the officers responsibility for preparing minutes of the directors' and shareholders' meetings and for authenticating records of the corporation.
(4) The same individual may simultaneously hold more than one office in a corporation.
Wash. Rev. Code § 23B.08.400. Directors have a different role. The statute provides:

Requirement for and duties of board of directors.

(1) Each corporation must have a board of directors, except that a corporation may dispense with or limit the authority of its board of directors by describing in its articles of incorporation, or in a shareholders' agreement authorized by RCW 23B.07.320, who will perform some or all of the duties of the board of directors.
(2) Subject to any limitation set forth in this title, the articles of incorporation, or a shareholders' agreement authorized by RCW 23B.07.320:
(a) All corporate powers shall be exercised by or under the authority of the corporation's board of directors; and
(b) The business and affairs of the corporation shall be managed under the direction of its board of directors, which shall have exclusive authority as to substantive decisions concerning management of the corporation's business.
Wash. Rev. Code § RCW 23B.08.010.
 
The Code, then, seems to provide that directors are, as a group, exempt from the spousal connection. The code separately provides:
 
(4) Persons who exercise control of business - The WSLCB will conduct an investigation of any person or entity who exercises any control over the applicant's business operations. This may include both a financial investigation and/or a criminal history background. 
Wash. Admin. Code 314-55-035.  This provision would clearly include directors, but also clearly excludes spouses. That distinction is fine, I suppose, but it is not at all clear to me why one would want to treat directors differently than LLC managers (and their spouses).  To the extent there is concern about spousal influence--to the level that the state would want to require qualification of spouses of shareholders in a publicly held entity--leaving this gap open for all corporate directors seems to be a rather big miss (or a deliberate exception).  Either way, it's an interesting quirk of an interesting new statute.   
 
 
 
 
 
 

December 19, 2017 in Corporations, Current Affairs, Entrepreneurship, Family Business, Joshua P. Fershee, Legislation, Licensing, LLCs, Management, Nonprofits, Partnership, Shareholders, Unincorporated Entities | Permalink | Comments (0)

Tuesday, August 15, 2017

Poor LLC Language Leads to Poor LLC Doctrine (And Unnecessary Veil Piercing)

Earlier this week, Professor Bainbridge posted California court completely bollixes up business law nomenclature, discussing Keith Paul Bishop's post on Curci Investments, LLC v. Baldwin, Cal. Ct. App. Case No. G052764 (Aug. 10, 2017).  The good professor, noting (with approval) what he calls my possibly "Ahabian" obsession with courts and their LLC references, says that "misusing terminology leads to misapplied doctrine."  Darn right.

To illustrate his point, let's discuss a 2016 Colorado case that manages to highlight how both Colorado and Utah have it wrong. As is so often the case, the decision turns on incorrectly merging doctrine from one entity type (the corporation) into another (the LLC) without acknowledging or explaining why that makes sense.  To the court's credit, they got the choice of law right, applying the internal affairs doctrine to use Utah law for veil piercing a Utah LLC, even though the case was in a Colorado court. 

After correctly deciding to use Utah law, the court then went down a doctrinally weak path.  Here we go:

Marquis is a Utah LLC. (ECF No. 1 ¶ 7.) Utah courts apply traditional corporate veil-piercing principles to LLCs. See, e.g., Lodges at Bear Hollow Condo. Homeowners Ass'n, Inc. v. Bear Hollow Restoration, LLC, 344 P.3d 145, 150 (Utah Ct. App. 2015). The basic veil-piercing analysis requires two steps:
The first part of the test, often called the formalities requirement, requires the movant to show such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist. The second part of the test, often called the fairness requirement, requires the movant to show that observance of the corporate form would sanction a fraud, promote injustice, or condone an inequitable result.
Jones v. Marquis Properties, LLC, 212 F. Supp. 3d 1010, 1021 (D. Colo. 2016). 
 
First, say it with me: You Can’t Pierce the Corporate Veil of an LLC Because It Doesn't Have One.  Second, the so-called "the formalities requirement" is a problem for Utah LLCs if one looks at the Utah LLC Act. The Colorado court does not do that, and neither does the Utah court that decided Bear Hollow Restoration, upon which Colorado relied.  They should have. You see, Utah has adopted the Revised Uniform Limited Liability Act, and the Utah version states expressly: 
The failure of a limited liability company to observe formalities relating to the exercise of its powers or management of its activities and affairs is not a ground for imposing liability on a member or manager of the limited liability company for a debt, obligation, or other liability of the limited liability company.
Utah Code Ann. § 48-3a-304(b). So, that is at least potentially a problem, because the Utah test for the formalities requirement is supposed to be determined by looking at seven factors:
(1) undercapitalization of a one-[person] corporation; (2) failure to observe corporate formalities; (3) nonpayment of dividends; (4) siphoning of corporate funds by the dominant stockholder; (5) nonfunctioning of other officers or directors; (6) absence of corporate records; [and] (7) the use of the corporation as a facade for operations of the dominant stockholder or stockholders....
Lodges at Bear Hollow Condo. Homeowners Ass'n, Inc. v. Bear Hollow Restoration, LLC, 344 P.3d 145, 150 (Utah App. 2015).
 
I know some will argue I am being overly formalistic in highlighting how corporate focused these factors are, but this is problematic.  Virtually all of these factors must, at a minimum, be contorted to apply to LLCs.  If the test is going to be applied, the least a court should do is to rewrite the test so it refers LLCs specifically.  Why? Well, primarily because in doing so, it would make clear just how silly these factors are when trying to do so.  (For example, LLCs don't have stockholders, corporate funds, dividends, and generally don't have an obligation to have officers or directors.) 

 The Marquis Properties court skips actually applying the test saying simply that an SEC investigation report was sufficient to allow veil piercing. The court determined that an SEC report establishes that sole member of the LLC used the entity "to create the illusion of profitable investments and thereby to enrich himself, with no ability or intent to honor" the LLC's obligations. "Given this, strictly respecting [the LLC's] corporate form [ed. note: UGH] would sanction [the member's] fraud."  The Court then found that veil-piercing was appropriate to hold the member "jointly and severally liable for the amounts owed by" the LLC to the plaintiffs.

But veil piercing is both neither appropriate nor necessary in this case.  In discussing the SEC report earlier in the case, the court found that "all elements of mail and wire fraud are present." I see nothing that would absolve either the LLC as an entity of liability for the fraud and I see no reason why the member of the LLC would not be personally liable for the fraud he committed purportedly on behalf of the LLC and for his own benefit.  

This case illustrates another problem with veil piercing: both courts and lawyers are too willing to jump to veil piercing when simple fraud will do. This case illustrates clearly that fraud was evident, and fraud should be sufficient grounds for the plaintiffs to recover from the individual committing fraud. That means the entire veil piercing discussion should be treated as dicta. The entity form did not create this problem, and the entity form does not need to be disregarded, at least as far as I can tell, to allow plaintiffs to recover fully.  Before even considering veil piercing, a court should be able to state clearly why veil piercing is necessary to make the plaintiff whole. Otherwise, you end up with bad case law that can lead to bad doctrine, which leads to inefficient courts and markets.  

Oh, and while I'm at it, Westlaw needs to get their act together, too.  The Westlaw summary and headnotes say "limited liability corporation (LLC)" five times in connection with this case.  Come on, y'all.  

 

August 15, 2017 in Business Associations, Corporations, Joshua P. Fershee, Lawyering, LLCs, Shareholders, Unincorporated Entities | Permalink | Comments (0)

Tuesday, April 11, 2017

Why Do So Many People Assume States Can Disregard Series LLCs?

The Uniform Law Commission is in the process of considering the Limited Liability Company Protected Series Act (f/k/a Series of Unincorporated Business Entities Act), and the final reading is schedule to take place in July 2017.  (Draft is here.) I have been discussing the challenges of Series LLCs with a variety of folks, and it strikes me that a consistent theme about the Series LLC is a concern about asset protection between each LLC in there Series. That is, there is concern that some courts may disregard the separateness of each LLC in the Series and treat the entire Series as a single entity.  I share this concern, but it strikes me that it is a rather outlandish concern that a court would do so without some significant level of fraud or other injustice to warrant whatever the state version of veil piercing would mandate. 

One source goes so far as to state: 

Case law has not been developed on Series LLCs yet, and there is much fear in the professional world that the assets may not be as protected as when the entity is formed. What is clear is that the “corporate formalities” must be carefully followed, such that:

  1. Separate books and records should be maintained for each series;

  2. Creditors need to be made specifically aware of the separate existence of each series; and

  3. The assets of each must be unambiguously identified as belonging to that series.

I don't consider these corporate formalities as at all, given that we're talking about an LLC, but it's true that any Series LLC would be well served to follow the entity formalities we'd expect of any entity seeking to protect limited liability.  Perhaps because the Series LLC as an entity is new, there is a need for heightened vigilance, but I am of the mind these kinds of measures are proper for all entities, if one wants to reduce the likelihood of veil piercing, enterprise liability, or other agency/guarantor concerns.  

Another source warns of the risks of the Series LLC:

The biggest problem with series LLCs is that many states (including California) don’t have series legislation and may choose to ignore the laws of the state where the series was created. That’s because you’re subject to their rules when doing business in their state. The example of the attitude of the California Franchise Tax Board applies to fees, but liability protection is also an issue. Since series LLCs are so new they’ve never been tested by courts, even in the states that permit them. That means there’s no guarantee that limited liability protection will be extended to each series until every state rules on the subject. It’s hard to see how a court would choose to grant this kind of protection inside one entity, and only time will tell if courts will do this. But do you want this type of uncertainty when you are trying to protect your assets?

Again, perhaps valid, but the idea that a state would simply ignore a properly created entity formed in another state is an outrageous proposition, in my mind.  If a state sees fit to define an entity, and such an entity is properly formed, that should be sufficient to follow the entity rules.  That might be different if a state were to write a law that specifically disallows certain kinds of entity structures. (I'd likely have a problem with that, too, but on the merits of such a law.)  And some laws clearly change the analysis, like bankruptcy. But to simply disregard another state's entity structure if the business is properly operating? That's not right.  

Anyway, I agree with those who are cautious about the relative limited liability protections of the Series LLC, especially outside of the eight(?) states that have such laws (Delaware, Nevada, Illinois, Iowa, Oklahoma, Tennessee, Texas and Utah). But I do find it disturbing that so many people are comfortable with the idea that courts would (and perhaps should) be so inherently skeptical of a structure chosen by a state legislature that the court would disregard the concept completely.  I am all for requiring entities to be clear which entity is to bound (and I think those doing business with those entities should seek guarantees, co-signers, or other assurances where they want them).  Courts allowing plaintiffs to expand limited liability beyond a Series entity to include other entities, based only on the use of the Series structure, is different. Like haphazard veil piercing, such decisions run the risk of incentivizing careless or ambiguous drafting and give creditors a chance to pursue a windfall in the form of an un-negotiated guarantee. 

As I often remind my students, to argue against the concept of limited liability is a very different thing than arguing that the current law allows one to disregard an entity in a particular circumstance. One asks, "What should be?,"  while the other asks, "What is?"  And to dislike the idea of a Series LLC is very different than suggesting a Series LLC law is invalid.  There, the former says what the law should be,"  while the latter says that what is, is not.  

 

April 11, 2017 in Corporations, Delaware, Joshua P. Fershee, LLCs, Unincorporated Entities | Permalink | Comments (1)

Tuesday, February 14, 2017

Business Law on Valentine's Day

I hope this Valentine's Day is a good one for you, dear readers.  Mine started with a random (minor) dog bite on my morning run, followed by some time with some very nice health care professionals and quite a few less pleasant needles. 

A friend alerted me to the law-related Twitter hashtag #AppellateValentines. Some of them are quite funny.  See, e.g.,

There is also a #BusinessValentines hashtag, which is less creative, but has its moments.  Of course, there was no #BusinessLawValentines, but there should be and there is now. I went first. Join in, if you're so inclined.  

And, of course, I could not resist:

February 14, 2017 in Corporations, Current Affairs, Joshua P. Fershee, Partnership, Unincorporated Entities, Web/Tech | Permalink | Comments (0)

Tuesday, January 17, 2017

Oops: Oregon District Court Rule For LLCs that are Defined as Corporations

Here we go again. The Oregon Federal District Court has a rule with an incorrect reference to LLCs on the books: 

In diversity actions, any party that is a limited liability corporation (L.L.C.), a limited liability partnership (L.L.P.), or a partnership must, in the disclosure statement required by Fed. R. Civ. P. 7.1, list those states from which the owners/members/partners of the L.L.C., L.L.P., or partnership are citizens. If any owner/member/partner of the L.L.C., L.L.P., or partnership is another L.L.C., L.L.P., or partnership, then the disclosure statement must also list those states from which the owners/members/partners of the L.L.C., L.L.P., or partnership are citizens.
U.S. Dist. Ct. Rules D. Or., Civ LR 7.1-1 (emphasis added). This rules is designed to assist with earlier disclosure to assist in determining diversity jurisdiction and other related issues. As the Practice Tip explains, 
The certification requirements of LR 7.1-1 are broader than those established in Fed. R. Civ. P. 7.1. The Ninth Circuit has held that, “[L]ike a partnership, an LLC is a citizen of every state of which its owners/members/partners are citizens.” Johnson v. Columbia Properties Anchorage, LP, 437 F.3d 894, 899 (9th Cir. 2006). Early state citizenship disclosure will help address jurisdictional issues. Therefore, the disclosure must identify each and every state for which any owner/member/partner is a citizen. The disclosure does not need to include names of any owner/member/partner, nor does it need to indicate the number of owners/members/partners from any particular state.
The problem is that the rule defines an LLC as a limited liability corporation, while the Ninth Circuit case cited in the Practice Tip was referring to limited liability companies, which are different entities than corporations. The language from Johnson v. Columbia Properties is correct, but the Oregon District Court rule does not include traditional LLCs. It includes corporations, as per the rule's definition of LLC.  Corporations, of course, have shareholders, not members or partners, and for diversity jurisdiction purposes, "a corporation shall be deemed to be a citizen of every State and foreign state by which it has been incorporated and of the State or foreign state where it has its principal place of business." 28 U.S.C. § 1332 (2016).  Shareholders are not part of the equation. Cf. Hertz Corp. v. Friend, 559 U.S. 77, 88 (2010). 

For federal law purposes, it appears that the rule has excluded LLCs, despite the intent (and likely specific purpose) of the rule. Interestingly, Oregon law, has extended "unless context requires otherwise" the concept of LLCs to apply to partnership and corporate law. Oregon law provides: 
Unless the context otherwise requires, throughout Oregon Revised Statutes:
(1) Wherever the term “person” is defined to include both a corporation and a partnership, the term “person” shall also include a limited liability company. 
(2) Wherever a section of Oregon Revised Statutes applies to both “partners” and “directors,” the section shall also apply:
(a) In a limited liability company with one or more managers, to the managers of the limited liability company.
(b) In a limited liability company without managers, to the members of the limited liability company.
 (3) Wherever a section of Oregon Revised Statutes applies to both “partners” and “shareholders,” the section shall also apply to members of a limited liability company.
 
Beyond potentially leaving limited liability companies out of the disclosure requirement, the rule could have another effect. The way the rule reads, although it does not change the underlying jurisdictional law, it could be read to change disclosure requirements. Though not the only possible reading, one could certainly read "owner" to include shareholders, which would require a corporation to disclose the states of citizenship of all shareholders.  
 
This is pretty obviously an error in drafting, as the court almost certainly intended to define LLCs as "limited liability companies." See Or. Rev. Stat. § 63.002 (2015).  And the court almost certainly did not intend to compel disclosure of all shareholders' states of citizenship.  Nonetheless, courts generally read statutes for what they say, not for what they meant to say.  This might just get a little interesting, if anyone (besides me) is paying attention.   

January 17, 2017 in Corporations, Joshua P. Fershee, Lawyering, Legislation, Litigation, LLCs, Partnership, Unincorporated Entities | Permalink | Comments (0)

Wednesday, September 14, 2016

Americold & Diversity Jurisdiction

Last spring, in the wake of Justice Scalia's passing, I blogged about Justice Scalia's final business law case: Americold Realty Trust v. ConAgra Ltd. The oral argument signaled that the Court's preference for a formalistic, bright line test that asked whether the entity involved was an unincorporated entity, in which case the citizenship of its members controlled the question of diversity, or whether it was formed as an corporation, in which a different test would apply.  The Supreme Court issued its unanimous (8-0) opinion in March, 2016 holding that the citizenship of an unincorporated entity depends on the citizenship of all of its members. Because Americold was organized as a real estate investment trust under Maryland law, its shareholders are its members and determine (in this case, preclude) diversity jurisdiction.   

S.I. Strong, the Manley O. Hudson Professor of Law at the University of Missouri, has a forthcoming article, Congress and Commercial Trusts: Dealing with Diversity Jurisdiction Post-Americold, forthcoming in Florida Law Review.  The article addresses the corporate constitutional jurisprudential questions of how can and should the Supreme Court treat business entities.  What is the appropriate role of substance and form in business law?  Her article offers a decisive reply:

Commercial trusts are one of the United States’ most important types of business organizations, holding trillions of dollars of assets and operating nationally and internationally as a “mirror image” of the corporation. However, commercial trusts remain underappreciated and undertheorized in comparison to corporations, often as a result of the mistaken perception that commercial trusts are analogous to traditional intergenerational trusts or that corporations reflect the primary or paradigmatic form of business association.

The treatment of commercial trusts reached its nadir in early 2016, when the U.S. Supreme Court held in Americold Realty Trust v. ConAgra Foods, Inc. that the citizenship of a commercial trust should be equated with that of its shareholder-beneficiaries for purposes of diversity jurisdiction. Unfortunately, the sheer number of shareholder-beneficiaries in most commercial trusts (often amounting to hundreds if not thousands of individuals) typically precludes the parties’ ability to establish complete diversity and thus eliminates the possibility of federal jurisdiction over most commercial trust disputes. As a result, virtually all commercial trust disputes will now be heard in state court, despite their complexity, their impact on matters of national public policy and their effect on the domestic and global economies.

Americold will also result in differential treatment of commercial trusts and corporations for purposes of federal jurisdiction, even though courts and commentators have long recognized the functional equivalence of the two types of business associations. Furthermore, as this research shows, there is no theoretical justification for this type of unequal treatment.

This Article therefore suggests, as a normative proposition, that Congress override Americold and provide commercial trusts with access to federal courts in a manner similar to that enjoyed by corporations. This recommendation is the result of a rigorous interdisciplinary analysis of both the jurisprudential and practical problems created by Americold as a matter of trust law, procedural law and the law of incorporated and unincorporated business associations. The Article identifies two possible Congressional responses to Americold, one involving reliance on minimal diversity, as in cases falling under 28 U.S.C. §§1332(d) and 1369, and the other involving a statutory definition of the citizenship of commercial trusts similar to that used for corporations under 28 U.S.C. §1332(c). In so doing, this Article hopes to place commercial trusts and corporations on an equal footing and avoid the numerous negative externalities generated by the Supreme Court’s decision in Americold.

A special thanks to Professor Strong who read the blog's coverage of Americold and shared her scholarship with me.

-Anne Tucker

September 14, 2016 in Anne Tucker, Constitutional Law, Corporate Governance, Corporate Personality, Corporations, Litigation, Shareholders, Unincorporated Entities | Permalink | Comments (2)

Tuesday, September 6, 2016

Private Ordering in the Uncorporation: Modified and Eliminated Fiduciary Duties Are Often the Same Thing

What does it mean to opt out of fiduciary duties?  In follow-up to my co-blogger Joan Heminway's post, Limited Partnership Law: Should Tennessee Follow Delaware's Lead On Fiduciary Duty Private Ordering?, I will go a step further and say all states should follow Delaware's lead on private ordering for non-publicly traded unincorporated business associations. 

Here's why:  At formation, I think all duties between promoters of an unincorporated business association (i.e., not a corporation) are always, to some degree, defined at formation. This is different than the majority of other agency relationships where the expectations of the relationship are more ingrained and less negotiated (think employee-employer relationship).  

As such, I'd make fiduciary duties a fundamental right by statute that can be dropped (expressly) by those forming the entity.  I'd put an additional limit on the ability to drop fiduciary duties: the duties can only be dropped after formation if expressly stated in formation documents (or agreed unanimously later). That is, if you didn't opt out at formation, tell all those who could potentially join the entity how you can change fiduciary duties later. This helps limit some (though not all) freeze-out options, and I think it would encourage investors to check the entity documents closely (as they should).

At formation, the concerns we might have of, for example, an employee without fiduciary duties, are not the same as they are for co-venturers. Those starting an entity have long negotiated what is a breach of the duty of loyalty, for example.  In contrast, I think fiduciary duties in most employer-employee (and similar) relationships reflect the majoritarian default and they facilitate the relationship existing at all. For LLCs and partnership entities, I think that's less clear. Entity formation is relatively rare compared to how often we enter other agency relationships, and they almost always involve significant negotiation (if not planning).  And if they don't, the rules we expect traditionally should be the default. But where the parties talk about it, and they usually do, allowing a more robust sense of freedom of contract has value.  

Even in Delaware, where one can negotiate out of fiduciary duties, there remains the duty of good faith and fair dealing. I think of that as meaning that the parties still have a right to the essence of the contract.  That is, the contract has to mean something.  It has to have had a purpose and potential value at formation, and no party can eliminate that.  But, the parties only have a right to what was bargained for.  As such, what we might traditionally consider a breach of the duty of loyalty could also breach the duty of good faith and fair dealing, but a traditional breach of the duty of loyalty might not be sufficient to find liability where there is expressly no duty of loyalty. Instead, the act must so contradict the purpose of the contract that it rises to the level of a breach the duty of good faith and fair dealing. 

Part of the reason I support this option is that I think case law has already validated it, but in such an inartful manner that it confuses existing doctrine. See, e.g.McConnell v. Hunt Sports Enterprises132 Ohio App. 3d 657, 725 N.E.2d 1193 (Ct. App. 1999) (“An LLC, like a partnership, involves a fiduciary relationship. Normally, the presence of such a relationship would preclude direct competition between members of the company. However, here we have an operating agreement that by its very terms allows members to compete with the business of the company.”).

In closing, I will note that I am all for express provisions that require investors to pay attention at the outset. I don't believe in helping cheaters hide the ball. I just think law that encourages investors and others joining new ventures to pay attention is useful and will provide long-term value to entities.  I don't think that eliminated fiduciary duties at formation raise any more of a risk than we already have with limited or modified fiduciary duties at formation. With the more limited protections described above, freedom of contract should reign. 

September 6, 2016 in Corporations, Delaware, Joan Heminway, Joshua P. Fershee, Legislation, LLCs, Negotiation, Partnership, Unincorporated Entities | Permalink | Comments (1)

Wednesday, July 27, 2016

Fiduciary Duty Waiver in Delaware Alternative Entities

Just in case you haven't gotten the message yet:  Delaware law means fiduciary duty freedom of contract for alternative entities.  In May 2016, the Delaware Chancery Court upheld a waiver of fiduciary duties in a master limited partnership.  In Employees Retirement System of the City of St. Louis v. TC Pipelines GP, Inc., Vice Chancellor Glasscock upheld challenges to an interested transaction (sale of a pipeline asset to an affiliated entity) that was reviewed, according to the partnership agreement, by a special committee and found to be fair and reasonable.  The waiver has been described as "ironclad" to give you a sense of how straight forward this decision was. No close call here.  

Vice Chancellor Glasscock's letter opinion starts:

Delaware alternative entity law is explicitly contractual;1 it allows parties to eschew a corporate-style suite of fiduciary duties and rights, and instead to provide for modified versions of such duties and rights—or none at all—by contract. This custom approach can be value enhancing, but only if the parties are held to their bargain. Where equity holders in such entities have provided for such a custom menu of rights and duties by unambiguous contract language, that language must control judicial review of entity transactions, subject only to the cautious application of the implied covenant of good faith and fair dealing. Such is the case in the instant matter, which involves a master limited partnership (“MLP”) created with interested transactions involving the general partner as part of its business model.....

The Defendants point out that the [transaction] was approved by a special committee (the “Conflicts Committee”), which approval, in accordance with the partnership agreement, creates a conclusive presumption that the transaction is fair and reasonable to the Partnership. I find that the Conflicts Committee’s approval, in these circumstances, precludes judicial scrutiny of the substance of the transaction and grant the Defendants’ Motion.

Importantly, the contractual safe harbor for interested transactions established a process which, if followed, created a fair and reasonable transaction outside of judicial scrutiny and without recourse by the other partners.  The court found that the partnership agreement precluded a good faith analysis of the Conflicts Committee's review and limited the court's review purely to matters of process.

The relevant portions of the Special Approval provision, importantly, are silent as to good faith.....According to the contractual language, the Special Approval of a duly constituted and fully informed Conflicts Committee is conclusive evidence that such transaction is fair and reasonable, and such approval is, therefore, preclusive of further judicial review. The Plaintiff does not allege that the Conflicts Committee was not duly constituted—that is, directors who are neither security holders nor employees or officers of the General Partner or its affiliates. Nor does the Plaintiff allege that the Conflicts Committee was not fully informed. Thus, the approval here is conclusive that the [transaction] is “fair and reasonable” to TCP. According to the explicit language of the LPA, when a conflicted transaction is deemed “fair and reasonable” by the terms of the agreement, such conflicted transaction is incapable of breaching the LPA.

Get the message? LOUD and CLEAR!

The opinion contains more analysis and excerpts of the relevant portions of partnership agreement.  Look for an excerpt on this case in my ChartaCourse (electronic platform) Business Organizations casebook

-Anne Tucker

July 27, 2016 in Anne Tucker, Business Associations, Delaware, Litigation, LLCs, Partnership, Unincorporated Entities | Permalink | Comments (0)

Wednesday, July 13, 2016

Let Corps Be Corps: Follow-Up on Entity Tax Status

This is just me musing a bit, but in following up my post on how LLCs can choose to “be corporations” for federal tax purposes, meaning they get C corp tax treatment, I was thinking that maybe the IRS could just stop using state-law designations at all.  That is, stop having “corporate” tax treatment at all. 

My proposal is not abolishing corporate tax – that’s a much longer post and one I am not sure I’d agree with.  Instead, the proposal is to have entities choose from options that are linked the Internal Revenue Code, and not to a particular entity. Thus, we would have (1) entity taxation, called C Tax, where an entity chooses to pay tax at the entity level, which would be typical C Corp taxation; (2) pass-through taxation, called K Tax, which is what we usually think of as partnership tax; and (3) we get rid of S corps, which can now be LLCs, anyway, which would allow an entity to choose S Tax

This post deals with the tax code, which means I am in over my head, and because this is tax related, it means the solution is a lot more complicated than this proposal.  But now that the code provisions are not really linked to the state law entity, I think we should try refer to state entities as state entities, and federal tax status with regard to federal tax status.  Under such a code, it would be a little easier for people to understand the concept behind state entity status, and it would make more sense to people that a “C Corp” does mean “publicly traded corporation” (a far-too common misunderstanding).  Thus, we could have C Tax corporations, S Tax LLCs, K Tax LLCs, for example.  We'd know tax status and state-entity status quite simply and we'd separate the concepts. 

A guy can dream, right?

July 13, 2016 in Corporations, Joshua P. Fershee, Legislation, LLCs, Unincorporated Entities | Permalink | Comments (0)

Tuesday, June 21, 2016

LLC Member Crimes Not Crimes of the LLC (and LLCs Are Not Corporate Entities)

Last week, a federal court determined that an insurance disclosure that asked about an "applicant's" criminal history did not apply to an LLC member's individual criminal past.  In Jeb Stuart Auction Servs., LLC v. W. Am. Ins. Co., No. 4:14-CV-00047, 2016 WL 3365495, at *1 (W.D. Va. June 16, 2016), the court explained: 

“Question Eight” on the [insurance] application asked, “DURING THE LAST FIVE YEARS (TEN IN RI), HAS ANY APPLICANT BEEN INDICTED FOR OR CONVICTED OF ANY DEGREE OF THE CRIME OF FRAUD, BRIBERY, ARSON OR ANY OTHER ARSON-RELATED CRIME IN CONNECTION WITH THIS OR ANY OTHER PROPERTY?” Hiatt, on behalf of Jeb Stuart (who [sic] was the sole [LLC] applicant for the insurance policy), answered, “No.” Hiatt signed the application and left.

As you might imagine, Hiatt had been convicted of "hiring individuals to wreck cars so that he could receive the proceeds from the applicable insurance policies," and, yep, about a month later, the building burned down.  Id. at *2.

The insurance company cancelled the policy because it claimed Hiatt had lied on the application, and Hiatt sued for the improper cancellation of the policy because he did not lie (he prevailed) and for attorneys fees claiming “the insurer, not acting in good faith, has either denied coverage or failed or refused to make payment to the insured under the policy.” Id. at *3.  Judge Kiser determined that not attorneys' fees were warranted: 

Neither party was able to rely on a case on point regarding the issue of whether questions on an LLC's insurance application asking about criminal history applied to the members of the LLC, to the corporate entity, or to both. Although I believe the answer to that question is clear, I am not aware of any other court being called upon to answer it. Therefore, although it was unsuccessful in asserting its defense to Jeb Stuart's claim, West American's position did present a novel legal question. As such, the final Norman factor weighs in favor of a finding of good faith.
Id. at *5.  I'll buy that, though I think it's a stretch. Would the court have thought this was a close call if an employee signed Amazon or IBM instead of Jeb Stuart? I doubt it.  Maybe the court meant that a small business or single-member LLC makes it a closer call?  Should it?  I don't think so. Suppose Jeb Stuart was the claimant, but the property was under water, so all of the recovery was supposed to go to a bank.  Would this tactic be appropriate then?  I would think not, and it would seem "less close," I suspect. Hopefully, this case answering the question will put this to rest, but I don't love it.  Still, I concede it is a plausible interpretation, but wrong, when put in context. 
 
The Judge explains his thinking, stating that "[p]rimarily, as West American argued, the question of whether an LLC has a prior criminal history is, admittedly, confusing." Id. at *4.  As I just noted, I don't think that's remotely true if it's a large entity.  We care about who gets the payment, not who signs, I think. That is, the question is designed to track incentives, not applicants.  Maybe -- maybe -- this is a harder case if the question were about the "beneficiary" or "real party in interest" and not the "applicant." 
 
The Judge notes, "Criminal laws typically target and punish individuals, and the types of crimes addressed by Question Eight overwhelmingly ensnare individuals, not corporate entities." Id.  I'll buy that.  He continues: "Therefore, although the question, by its terms, applied to the applicant (the LLC), a reasonable person reading Question Eight might interpret it to apply to the individuals that make up the LLC." Id.  Perhaps, but not always. Again, now I worry about the size of the entity.  And who the applicant is.  
 
Judge Kiser finished: "Undoubtedly, that is what West American envisioned when it drafted the application, and Question Eight in particular. This factor weighs in favor of West American."  But we construe ambiguity against the drafter for a reason, right?  Is it clear that's what they meant?  I don't know that it is, especially because this appears to be their standard form, not something applying to just this application. 
 
What's clearly wrong is the discussion of Jeb Stuart as "a single-member limited liability corporation ('LLC')." Id. at *1.  (It's a limited liability company.) As are the statements above (did you think I missed them?) calling LLCs "corporate" entities  at Id. **4-5.  
 
On the facts here, this seems like a reasonable outcome, but I don't like the path this is headed down.  That is, this case suggests that it might be reasonable for a sophisticated entity to argue that because "some people" think something.   Even if they knew (or should have known) better.  Even worse, by conflating LLCs and corporations, this case helps reinforce inaccuracies in what "some people" think.

June 21, 2016 in Corporations, Joshua P. Fershee, LLCs, Unincorporated Entities | Permalink | Comments (1)

Monday, June 13, 2016

From The Big Peach to Music City

This past week, I completed the second leg of my June Scholarship and Teaching Tour.  My time at "Method in the Madness: The Art and Science of Teaching Transactional Law and Skills" at Emory University School of Law last week was two days well spent.  I had a great time talking to attendees about my bylaw drafting module for our transaction simulation course, Representing Enterprises, and listening to others talk about their transactional law and skills teaching.  Great stuff.

This week's portion of my academic tour begins with a teaching whistle-stop at the Nashville School of Law on Friday, continues with attendance (with my husband) at a former student's wedding in Nashville on Saturday evening, and ends (my husband and I hope) with Sunday brunch out with our son (and his girlfriend if she is available).  Specifically, on Friday, I teach BARBRI for four hours in a live lecture.  The topics?  Well, I drew a short straw on that.  I teach agency, unincorporated business associations (including a bit about both extant limited liability statutes in Tennessee), and personal property--all in four hours.  Ugh.  Although I am paid for the lecture and my expenses are covered, I would not have taken (and would not continue to take) this gig if I didn't believe that I could be of some help to students.  These topics--especially agency and partnership law, but also personal property--often are tested on the bar exam.  So, on I press.

I also am completing work this week on the draft article that I will present in Chicago and Seattle on the last two stops of my tour.  I will say more about that article in next week's post.  In the mean time, let me know if you have any suggestions (or good jokes) on the law of agency, partnerships, LLCs, or personal property (e.g., tenancies, gifts, bailments, adverse possession, replevin) for my lecture on Friday . . . .  It's so hard to make these speed-lectures somewhat engaging for the students.  [sigh]

June 13, 2016 in Agency, Conferences, Corporations, Joan Heminway, LLCs, Partnership, Personal Property, Teaching, Unincorporated Entities | Permalink | Comments (0)

Wednesday, May 18, 2016

Dear California: LLCs are Not Corporations. Or Are They?

California is the back on my short list for the state's inability to successfully differentiate between corporations and limited liability companies (LLCs).  Last week, an "unpublished/noncitable" decision that was published on Westlaw provided a good example.

The opinion states: 

A corporation—including a limited liability corporation—may be served by effecting service on its agent for service of process. (Code Civ. Proc., § 416.10, subd. (a); see also Corp.Code, § 17701.16, subd. (a) [allowing service on limited liability corporations under Code Civ. Proc., § 413.10 et seq.].)7
*12 One of the ways a limited liability corporation can be served is by substituted service. (1 Weil & Brown, Cal. Practice Guide: Civil Procedure Before Trial (The Rutter Group 2015) ¶ 4:172, p. 4–26.) This requires that a copy of the summons and complaint be left at the office of the person to be served (or, in some cases, at the mailing address of the person to be served), in the presence of a person who is apparently in charge, “and by thereafter mailing a copy of the summons and complaint by first-class mail, postage prepaid to the person to be served at the place where a copy of the summons and complaint were left.” (Code Civ. Proc., § 415.20, subd. (a).)
City of Fontana v. Bani, LLC, No. E062018, 2016 WL 2864971, at *11-12 (Cal. Ct. App. May 12, 2016).

No, no, no.  First, even in California, an LLC is a "limited liability company." It says so right in the act. Cal. Corp. Code § 17701.01 (West) ("This title may be cited as the California Revised Uniform Limited Liability Company Act.").

And, yet, I have to admit, if you note the cite to the LLC act, California lawmakers have made this less clear than in other states. Yes, that's right. In California, the LLC Act is part of the California Corporations Code.  Cal. Corp. Code §§ 17701.16 - 17713.13 (West).  For that matter, so are partnerships, under Title 2.  Sigh.   

Would it be so terrible if the Corporations Code were called what it is: the Business Entities Code? As currently structured, LLCs and partnerships are arguably types of corporations under California law, as the above cases suggests. One could argue the headings don't change the meaning or intent of the laws. See Cal. Corp. Code § 6 (West) ("Title, division, part, chapter, article, and section headings contained herein do not in any manner affect the scope, meaning, or intent of the provisions of this code.").  The problem with that is that the code text says otherwise: "This act shall be known as the Corporations Code." Cal. Corp. Code § 1 (West).  

To reinforce that notion, the Code Commission notes from the 2014 main volume explain: 

This code was listed in the appendices of Code Commission reports showing code classification as the “Corporations, Partnerships, and Associations Code.” The 14 syllables of that title appear to make it impractical, but no shorter phrase indicative of the full subject-scope has been found. Therefore, resort has been had to the rhetorical device of synecdoche, and the entire code designated by the name of longest part.

I admit I had to look up synecdoche to be sure I was on the right track, but the term supports, I think, my point that California is treating LLCs and partnerships as corporations (or some subset thereof).  See, for example, this explanation

Synecdoche is a literary device in which a part of something represents the whole or it may use a whole to represent a part.

Synecdoche may also use larger groups to refer to smaller groups or vice versa. It may also call a thing by the name of the material it is made of or it may refer to a thing in a container or packing by the name of that container or packing.

Still, even if it were accurate to says LLCs and partnerships are "types" of corporations under the California code, one thing is still clear: an LLC is a limited liability company, which is, at a minimum, a specific type of "limited liability corporation." 

I suppose I can see how "14 syllables" might be deemed "impractical," but not at the cost of imprecision.  The "Business Entities" -- or even just "Entities" or "Associations" -- Code would seem like a better, more accurate, option.  

Oh well.  At least the court cited the part of the California code for service of an LLC.  That much, they got right.  

May 18, 2016 in Corporate Personality, Corporations, Joshua P. Fershee, LLCs, Partnership, Unincorporated Entities | Permalink | Comments (0)

Tuesday, May 10, 2016

Save the Date - Washington & Lee Symposium Honoring Two of Business Law's Greatest Scholars

This is just to give everyone a "heads up" on a symposium being held this fall (Friday, October 21 and Saturday, October 22) to honor Lyman Johnson and David Millon.  The symposium is being sponsored by the Washington & Lee Law Review (which will publish the papers presented), and I am thrilled to be among the invited speakers.  I will have more news on the symposium and my paper for it as the date draws nearer.  But I wanted everyone to know about this event so that folks could plan accordingly if they want to attend.  I understand Lexington, Virginia is lovely in late October . . . .  Actually, it's always been lovely when I have been up there! And the honorees and contributors are a stellar group (present company notwithstanding).  I hope to see some of you there.

May 10, 2016 in Business Associations, Conferences, Corporate Governance, Corporations, Joan Heminway, Unincorporated Entities | Permalink | Comments (0)