As Iowa lawyers know, we often lack Iowa corporate/LLC case law to support our legal positions. This is certainly true of the law of charging orders.
Here is a case from Connecticut that confirms the statutory application of an LLC charging order law very similar to Iowa' s law. Goldberg v. Winogradow, 2006 Conn. Super. LEXIS 3067 (2006).
-Marc Ward
Alleging an illegal plan and deceptive conduct on the part of InBev, Anheuser-Busch upped the ante in the struggle for its future by filing a lawsuit yesterday in the United States District Court for the Eastern Division of Missouri. You can read the complaint here.
The complaint seeks an injunction against InBev and its officers, agents, servants, employees and attorneys for violating Section 14(a) of the Securities and Exchange Act of 1934 and SEC Rule 14a-9.
-Marc Ward
Not many state LLC Acts are like the one Iowa has adopted effective January 1, 2009, but the Illinois statute is very similar. How Illinois courts interpret its LLC law will likely have a great deal of impact on Iowa courts and Iowa LLCs.
Federalpha Steel LLC Creditors' Trust v. Federal Pipe & Steel Corp. et al, 368 B.R. 679 (N.D. Ill. 2006) is worth your time to read. It illustrates how a third party (the court) may interpret provisions of an operating agreement differently than the drafters (the members) intended.
It is a lengthy opinion, but let me give you one example. The operating agreement between two members provided that a member may not "voluntarily withdrawal" and such withdrawal would be considered a wrongful dissociation under the Illinois LLC Act. Most lawyers, I think, would interpret that to mean a unilateral withdrawal.
Not so fast. The two members and the LLC subsequently entered into a Withdrawal Agreement in which one of the members withdrew from the LLC. The court concluded based on the terms of the operating agreement that such withdrawal might be wrongful and even a breach of its fiduciary duty.
-Marc Ward
The state of Vermont is getting some undeserved credit for adopting amendments to its corporate statute that permit so-called virtual corporations. It is much ado about nothing.
A visiting law professor at New York Law School who doesn't know much about corporate law, David Johnson, is touting the changes as unique in the country. They are not. He makes a big deal out of the fact that Vermont corporations will no longer be required to hold face-to-face annual meetings (I can't help but think of the Town Hall meeting episode from "Newhart"). Iowa has permitted telephonic and video conference meetings for years, and written actions without a meeting have been around even longer.
Iowa, and many other states I am sure, is also ahead of Vermont when it comes to filing annual reports online and permitting electronic signatures.
There are unique aspects to the Vermont law. Start with the name of the legislation, H.0888 Miscellaneous Tax Documents. Yep. That is the name of the act. In Iowa it would be unconstitutional.
But it gets better. Vermont goes off the deep end in a number of places. Notice to a shareholder can now be delivered by voice mail. (Is it delivered if not listened to?) And, get this, and I quote: "terms of shares may be made dependent upon facts objectively ascertainable outside the articles of incorporation." Say What? Are they serious or did the maple syrup ferment?
If anyone wants to read this zany bill you can get it here.
-Marc Ward
As reported in earlier blogs, it appears that it is becoming easier in some states to pierce the veil of limited liability. Take the case of Network Enterprises, Inc. v. APBA Offshore Productions, Inc., 264 Fed. Appx. 36,2008 U.S. App. LEXIS 2961 (2nd Cir. February 11, 2008).
In this case the Second Circuit Court of Appeals looked at the veil piercing requirements of the states of New York and Florida. In New York to pierce the veil it takes (1) a showing of complete domination over the corporation/LLC with respect to the transaction at issue and (2) such "domination was used to commit a fraud or wrong that injured the party seeking to pierce the veil." (underline added)
In Florida, it takes a showing that the corporation/LLC is the mere instrumentality or alter ego of the owner and the owner "engaged in improper conduct." (underline added)
The Second Circuit concluded that the defendant completely dominated the LLC and was its alter ego (meeting both standards) because (a) he formed the company, (b) he was the sole member, (c) he conducted all of its business, signed the checks, and signed the contract that was the center of the controversy, and (d) hold on to your hat, "operated the company from the same address where he maintained his law practice."
These characteristics describe the vast majority of single member LLCs in existence (modifying the last one to fit the circumstances). In other words, according to the Second Circuit all one has to do is prove that a "wrong" has been committed or the defendant engaged in "improper conduct" in order to pierce the veil of a single member LLC. Whatever happened to piercing being an extraordinary remedy that courts were reluctant to impose? Whatever happened to fraud being a necessary element to pierce the veil? Is a single member safe from personal liability only when they do right? What of the risk-taker, the gambler, the fool?
Fortunately, Iowa looks at piercing a little differently. Rather than focusing on domination or alter ego tests, the Iowa courts apply a six-factor test: (1) the corporation/LLC is undercapitalized, (2) it lacks separate books, (3) its finances are not kept separate from individual finances or individual obligations are paid by the corporation/LLC, (4) the corporation/LLC is used to promote fraud or illegality, (5) corporate formalities are not followed and (6) the corporation/LLC is a mere sham.
The six-factor test is certainly preferred. Let us hope Iowa continues to apply it.
-Marc Ward
This has nothing to do with LLCs, but then I don't limit my practice to just LLCs.
The Iowa Business Corporation Act, like most corporate statutes, permits the articles of incorporation, bylaws or an agreement among shareholders to "impose restrictions on the transfer" of shares. Iowa Code 490.627.
But Iowa Code 490.601 and 490.602 require certain stock rights and limitations to be exclusively in the articles of incorporation.
How do you know when a provision must be in the articles and not the bylaws? Kansas Heart Hospital, LLC v. Duick, et al, 184 P 3rd 866 (May 16, 2008) offers a helpful rule of thumb. In that case, which has little to do with an LLC despite the lead plaintiff, the Kansas Supreme Court concluded that a restriction that affects an entire class of stock instead of certain shareholders of the stock, must be in the articles. Put another way, if a restriction operates against the holder of the stock, but not the stock itself, it can appear in the bylaws.
In this case, the court upheld a bylaw restriction that permitted the corporation to redeem the stock of stockholders who invested in a competing health care facility.
The case is also worth reading (a) for an explanation of the difference (or lack of difference) between "purchase" and "redeem" (b) as an application of the business judgment rule to what appears to be a situation not requiring "judgment" and (c) as an example where shareholder-directors are independent for purposes of applying the business judgment rule.
-Marc Ward
As part of its battle to acquire Anheuser-Busch (AB), InBev filed a declaratory action in Delaware Chancery Court yesterday seeking the court's judgment that InBev could remove all AB directors from the board without cause by obtaining the written consent of a majority of the shareholders to do so. You might think they would wait for the annual meeting to wage a proxy battle, but the terms of 5 of the 13 directors are not up until 2009.
This issue arises from the fact that prior to 2007 AB's directors were divided into three classes so they could be elected to 3-year staggered terms. Such "classified" directors could not be removed except for cause under Delaware law. See 8 Del. C. 141(k). Unclassified directors can be removed without cause. Id.
In 2006 the AB shareholders approved an amendment to its certificate of incorporation that declassified the directors beginning in 2007. Directors elected to 3-year terms in 2006 still have a year to go in their terms.
The question for the court seems to be whether declassified directors serving out their classified terms can be removed without cause. You can access the complaint here.
Fascinating question, but it is curious that InBev isn't willing to assert a cause for removal since it implies in paragraph 4 of its complaint that the current directors have not complied with their fiduciary duties.
-Marc Ward
As I have appointed out in an earlier post, some states (Texas and Idaho, for two) have as an element for piercing the veil of limited liability the nonsensical notation of insolvency at the time of the event giving rise to the cause of action. South Carolina is another state in this column. See Ashley II of Charleston, LLC v. PCS Nitrogen, Inc., 2008 US Dist. LEXIS 47262 (June 13, 2008).
The problem, of course, is that this seems to imply that members have a continuing duty to maintain the capitalization of an LLC. This is contrary to the statutory concept of limited liability as well as the provisions of most LLC operating agreements.
Unfortunately, Iowa may be one of these states since the Supreme Court has been less than clear in articulating its position.
-Marc Ward
Occasionally reading one case sends me off in an unexpected direction to another case and then another. Such was the case, so to speak, recently.
While skimming a run-of-the-mill breach of fiduciary duty case I eventually ended up reading North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A 2d 92 (Del. 2007) and Trenwick America Litigation Trust v. Ernst & Young et al, 906 A 2d (Del. Ch. 2006).
North American Catholic reminds us that when a corporation is solvent the shareholders may enforce the directors' fiduciary duties owed to them and the corporation by derivative action. When a corporation is insolvent the creditors "take the place of the shareholders" and have standing to bring a derivative claim against the directors for breaches of fiduciary duty. North American Catholic, 930 A 2d at 101. This case stands for the additional proposition that creditors do not have a direct claim against directors for breaches of fiduciary duty. Id. at 94.
Trenwick nips in the bud another cause of action creditors have tried to advance lately; the claim of "deepening insolvency." Trenwick, 906 A 2d at 174. As Judge Strine put it in a delightful, if lengthy, 36 page opinion, "Put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent." Id.
I recommend both opinions to those interested in the impact of insolvency on the duties of directors.
-Marc Ward
"This case underscores the reality that it is not only greed that can inspire disloyal behavior by a business fiduciary. In fact, when a business fiduciary lives a plush and comfortable life, derived from substantial distributions from family trusts, he can afford to place other considerations -- such as the achievement of a personal dream, a desire to prove himself a CEO, or a stubborn refusal to admit failure -- ahead of the prudent pursuit of maximum profit, having a silk-sheeted safety net to fall back upon. In this case, that is just what happened." Venhill Limited Partnership v. Hillman, 200 Del. Ch. LEXIS 67 (June 3, 2008).
Well said!
-Marc Ward
Corporate doctrines continue to be applied to limited liability companies. A recent example is application of the no successor liability rule to an LLC in Milliken v. Duro Textiles, LLC, 887 NE 2d 244 (Mass. May 30, 2008).
The traditional corporate law principle followed by most courts, including Iowa, holds that the liabilities of a selling corporation (LLC) are not imposed upon the successor corporation (LLC) which purchased its assets.
There are four exceptions to this rule: (1) the successor entity agrees to assume the liabilities of the predecessor; (2) the transaction is a de facto merger (Iowa doesn't recognize this exception); (3) the successor is a "mere continuation" of the predecessor; or (4) the transaction is fraudulent.
The Milliken case dealt with the mere continuation exception. The court also noted that many courts consider the de facto merger and mere continuation exceptions interchangeably, which may be the reason Iowa doesn't bother with the de facto merger exception.
Under both exceptions the courts compare the owners, management, assets, operations and physical locations of the predecessor and the successor. No single factor is dispositive and the facts must be considered on a case-by-case basis. It is a classic substance over form test or as one court put it, is the buyer "merely a 'new hat' for the seller?"
In Milliken the court concluded that New Duro, as the successor was called, was merely a new hat for Old Duro. The secured lenders owned 51% of Old Duro and all of New Duro, which they created to acquire the assets of Old Duro (but not the unsecured liabilities). Management was the same between the old and new companies, operations were the same, and the physical location was the same. Old Duro ceased its old line of business and became the landlord to, you guessed it, New Duro. The court imposed Old Duro's unsecured obligations on New Duro.
The lesson here, particularly for lenders, is not to assume that form will prevail over substance and secured lenders are not impervious to the equitable power of the courts.
The most recent Iowa case on successor liability is Pancratz v. Monsanto, 547 NW 2d 198 (Iowa 1996). In that case the Iowa Supreme Court reaffirmed its commitment to the majority rule that "a corporation that purchases the assets of another corporation assumes no liability for the transferring corporation's debts and liabilities." The Iowa Supreme Court also recognized the exceptions noted in Milliken (other than de facto merger).
The Pancratz case is also significant for the fact that the Iowa Supreme Court refused to create another exception for no successor liability to product liability cases.
-Marc Ward
Dean David Walker and I made a joint presentation at the Iowa State Bar Association's 135th Annual Meeting on Wednesday regarding the new Iowa LLC Act. My presentation outline was posted here that afternoon.
David has graciously given me permission to also post his outline. You can find it here.
-Marc Ward
At yesterday's session on the new Iowa LLC Act, Dean Walker and I were asked what lawyers should do about existing LLCs and operating agreements. A great question. You need do nothing until January 1, 2011 when the current law expires. The current articles of organization will be deemed to be the certificate of organization under 489. Any management provision in the articles of organization will be deemed to be contained in the operating agreement. See generally, Iowa Code 489.1304 (2009).
If you want to get a jump on 2011 or consider opting-in to Chapter 489 before 2011, consider performing an operating agreement audit of the following subjects:
1. If the LLC is manager-managed, does it expressly provide that it is "manager-managed," "managed by managers," management is "vested in managers" or words "of similar import" as required by Iowa Code 489.407(1)?
2. Should the operating agreement restrict, eliminate or alter the duties of loyalty and care or any other fiduciary duties as permitted by Iowa Code 489.409(4)-(7)(2009)?
3. Are the manager-managed rules described in Iowa Code 489.407(3) regarding management rights and decision-making adequately addressed?
4. Because transferees of transferable interests have few rights under the default provisions of the new law, are they adequately protected in the operating agreement? See Article 5 of Chapter 489.
5. Dissociation is a new concept introduced in Chapter 489, although the Chapter 490A concepts of withdrawal, termination and cessation of membership (see in particular 490A.712) are similar. How is dissociation dealt with in the operating agreement? Are there any gaps that need to be addressed?
Of course, general rules may not cover the terms of a particular operating agreement, but these 5 points are a good start.
If you wish to adopt Iowa Code 489 before 2011, the new law permits it. Iowa Code 489.1304(1)(b) allows an LLC formed before January 1, 2009 to elect to be subject to 489 by amending its operating agreement to that effect.
-Marc Ward
This afternoon David Walker and I had the honor and the pleasure of presenting the new Iowa LLC Act at the 135th Annual Meeting of the Iowa State Bar Association.
As many of you know, David recently retired as Dean of the Drake Law School. He also chaired the NCCUSL Drafting Committee that created the Revised Uniform Limited Liability Company Act which forms the basis of the new Iowa statute.
In my half of the presentation I discussed (a) Formation (b) Shelf LLCs (c) Series LLCs (d) Dissociation (e) Transferees and (f) Piercing the Veil.
You can obtain a copy of my outline here.
-Marc Ward
Without careful drafting in the operating agreement, a transferee of a transferable interest in an Iowa LLC can be an uncomfortable and unsatisfactory status.
Understanding the terminology is important before getting to the specifics. Under the new Iowa LLC law (Iowa Code §489.102(24) and (25) (2009)):
A. “Transferable interest” means the right, as originally associated with a person’s capacity as a member, to receive distributions from a limited liability company in accordance with the operating agreement, whether or not the person remains a member or continues to own any part of the right.
B. “Transferee” means a person to which all or part of a transferable interest has been transferred, whether or not the transferor is a member.
Transfers of transferable interests are permissible and do not by themselves cause a member to dissociate or the LLC to dissolve. Iowa Code §489.502(1) (2009). And herein lies the problem. When a member transfers a transferable interest, the transferor retains the rights of a member other than the interest in distributions transferred and retains all duties and obligations of a member. Iowa Code §489.502(7) (2009).
The member can only lose this right if (a) she transfers her entire transferable interest and (b) the other members expel her by unanimous vote.
Transferees of a transferable interest who do not become members have few rights other than to receive distributions:
1. They have no role in the management of the LLC;
2. They have no right to information under 489.410; and
3. They have no right to bring a derivative action.
One right granted to transferees in the Iowa Act not found in the RULLCA is the right of a transferee to seek judicial dissolution if the managers or those members in control of the LLC have acted illegally, fraudulently or oppressively. See Iowa Code 489.701(1). Throw the dog a bone.
Because there are a lot of ways a member or his successors in interest can become transferees and many are inadvertent (e.g. death), it is imperative that the issue be addressed in the operating agreement. Some sort of buy-back clause or other buy-sell provision should be considered by the members and included in the operating agreement.
If a buy-back or buy-sell provision was overlooked, to avoid mere transferee status, it might behoove a transferee who does not expect to become a member to have the transferring member keep a fraction of the transferable interest and agree to exercise its governance rights in a manner that protects the transferee.
-Marc Ward
Iowa is typical in claiming to pierce the corporate or LLC veil only "where the corporation is a mere shell, serving no legitimate business purpose, and used primarily as an intermediary to perpetuate a fraud or promote injustice. See e.g. Briggs Transp. Co. v. Starr Sales Co., 262 NW2d 805, 810 (Iowa 1978).
A recent Connecticut case throws doubt on the need to show fraud or injustice to pierce the veil. In Double G.G. Leasing, LLC v. Underwriters at Lloyds, 2008 Conn. Super. LEXIS 1305 (May 16, 2008), the Connecticut Superior Court concluded that the "Identity Theory" does not require a showing of fraud or violation of a legal duty (as opposed to the "Instrumentality Theory" which does require such a showing.) It is vague and contradictory on the matter of proving an injustice.
In Double GG the plaintiff brought an action against Lloyd's of London to recover on an insurance policy. The plaintiff was an LLC whose sole member and manager was Carl Glatzel, Jr. The LLC's only asset was a duplex purchased on February 25, 2005. The LLC obtained an insurance policy against loss or damage to the property by fire on March 19, 2005. Less than 5 weeks later, on April 24, 2005, the duplex was destroyed by fires "of incendiary origin that were ignited at two separate locations at the rear of the building with the use of flammable liquid accelerant."
How does this case become a piercing the LLC veil case? Because Lloyd's sought Glatzel's personal tax returns and denied the claim when he refused. His refusal was based on the theory that the policy only requires the LLC to turn over financial records including tax returns. The Court agreed that the policy only applies to the LLC, but then pierced the LLC veil under the Identity Theory and held that duties under the insurance policy are imposed on Glatzel as well as the LLC.
The sole fact that caused the court to reach this conclusion was the fact that when his wife was threatening divorce Glatzel had, on the advice of counsel but without his father's knowledge, transferred his interest in the LLC to Glatzel, Sr., but continued to manage its affairs, and had his father reconvey the LLC interests to him once marital harmony was restored.
The court concluded that such facts revealed "a unity of interest and ownership between Glatzel and the company and a complete lack of independence of the latter" sufficient to pierce the veil. The court also made some noise to the effect that recognizing a separate identity for the LLC would "defeat justice" but that can be said in just about every case; why else is there a dispute?
To guard against such outcomes members of single member LLCs need to be sure that separate books are kept, commingling of funds prohibited, and other distinctions between the LLC and the sole member are observed.
-Marc Ward
Modern corporate and LLC statutes (including the New Iowa LLC law) permit corporations and LLCs to limit or exclude the personal liability of directors and managers for money damages for breach of a fiduciary duty. There are exceptions, of course. In the case of the New Iowa LLC law the exceptions are (i) any breach of the duty of loyalty, (ii) deriving a personal benefit for which the manager was not entitled, (iii) an improper distribution, (iv) an intentional infliction of harm on the LLC or member or (v) an intentional violation of criminal law.
You might think that such a clause in an operating agreement (or the corporate articles) would exculpate a director from liability for a breach of the duty of care. You would be wrong.
Returning to In re Bridgeport Holdings, Inc., 2008 Bankr. LEXIS 1586 (May 30, 2008), the court refused to dismiss a claim of breach of the duty of care even though the the corporation's certificate of incorporation contained the appropriate exculpatory clause. The court cited a number of Delaware cases in support of its decision. The rationale in this and the other cases was the presence of other claims by the plaintiff, notably a claim of breach of the duty of loyalty.
Since a breach of the duty of loyalty claim can be constructed to look and smell like a breach of care claim, as opposed to what one would naturally think would be a breach of the duty of loyalty (improper personal benefit, conflict of interest, competing with the LLC...See Iowa Code 489.409(2)(2009)), there does not appear to be much left of this supposed exculpatory provision. And you thought legislation was supposed to mean something.
-Marc Ward
On May 30, 2008, the United States of Bankruptcy Court for the District of Delaware handed down a significant decision involving the duty of loyalty that directors owe a corporation. This has important ramifications to LLCs organized under the new Iowa LLC Act. See In re Bridgeport Holdings, Inc., 2008 Bankr. LEXIS 1586 (Del. May 30, 2008).
The Delaware courts have recently expanded the duty of loyalty to include a duty to act in good faith. See Stone v. Ritter, 911 A.2d 362 (Del. 2006). Failure to act in good faith has been interpreted to mean a failure to act in the best interests of the corporation or abdicating directorial duties or demonstrating "faithlessness or lack of true devotion to the interests of the corporation and its shareholders." See Ryan v. Gifford, 918 A. 2d 341 (Del. Ch. 2007). It has also been described as "consciously and intentionally" disregarding the responsibilities of a director "by knowingly failing to make decisions critical to the company on an informed basis." See Boles v. Filipowski, 345 B.R. 426 (Bankr. D. Mass. 2006).
This sounds a lot like a breach of the duty of care to me, which is not surprising. Many corporate statutes, and the new Iowa LLC Act, permit a corporation or LLC to eliminate or limit a director/manager's liability to the corporation/LLC for monetary damages except for "a breach of the duty of loyalty." See e.g. Iowa Code 489.110(7)(2009). By using the concept of good faith to construe the duty of loyalty to be just another way of saying a breach of the duty of care the courts avoid this limitation on liability. Another example of ignoring the plain language of a statute.
-Marc Ward
A merger of an LLC requires the unanimous consent of the members of an LLC under the new Iowa LLC Act, but the operating agreement may provide otherwise. It will not be unusual for operating agreements to provide for less than unanimous approval of mergers, but what will the minority members expect in return for giving up their right to approve a merger?
If the history of corporations is any indication, appraisal rights will be the protection sought by minority members. As many of you know, corporate law use to require unanimous shareholder approval of mergers. The modern trend, adopted by Iowa and most other states, allows mergers to be approved by a majority of the shareholders but also allows shareholders who dissent to the proposal to assert appraisal rights as the "exclusive remedy" if they believe they are not receiving fair value for their shares.
That sounds reasonable enough, but be careful when drafting such a provision for your operating agreements. It will be important to make it clear that appraisal is truly the exclusive remedy for dissenting members. Several courts have interpreted the "exclusive remedy" or similar language in the corporate statutes not to be exclusive when the majority shareholders are using the merger process to eliminate minority shareholders. See McMinn v. MBF Operating Acquisition Corporation, 164 P. 3d 41 (New Mexico 2007). These courts have allowed claims for breach of fiduciary duty to survive in such circumstances.
-Marc Ward
As explained in an earlier post, the operating agreement (if there is one, be it oral, written or implied) dictates the relationship among members and the rights and duties of the managers. The new Iowa LLC Act only matters when the operating agreement is silent (or non-existent). But of course, there are exceptions.
An operating agreement may not:
1. Vary an LLC's capacity to sue;
2. Vary the applicability of Iowa law regarding (a) internal affairs of the LLC and (b) the liability of members and managers for the debts, obligations and other liabilities of the LLC;
3. Vary the power of a court to require a person to sign a record, deliver a record to the Secretary of State or order the Secretary of State to file a record;
4. Unreasonably restrict the duties and rights with regard to providing information about the LLC to the members, managers and dissociated members;
5. Vary the power of a court to dissolve an LLC unlawful, fraudulent or other extraordinary misconduct;
6. Vary the ability to wind up the affairs of a dissolved LLC;
7. Unreasonably restrict the right of a member to maintain a derivative action;
8. Restrict the right to approve a merger, etc. by a member who will have personal liability as a result of such fundamental change; and
9. Restrict the rights of a person other than a member or manager with one minor exception.
The duty of loyalty may be restricted or eliminated, the duty of care can be altered (except authorization of intentional misconduct and knowing violations of the law), as can all other fiduciary duties so long as such restrictions or eliminations are not manifestly unreasonable.
The operating agreement can also prescribe standards to measure the contractual obligation of good faith and fair dealing.
The operating agreement may also establish a process by which an act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified by one or more disinterested and independent persons after full disclosure.
Finally, the operating agreement (not the certificate of organization) may eliminate or limit a member or manager's liability to the LLC for money damages except for (a) breach of the duty of loyalty, (b) a financial benefit to a member or manager to which the member or manager is not entitled, (c) receipt of an improper distribution, (d) intentional infliction of harm to the LLC or a member,and (e) an intentional violation of law.
See Iowa Code 489.110 (2009).
-Marc Ward
In a trio of private letter rulings released on April 18, 2008, the IRS concluded that S corporation stock can be owned by a single-member LLC (SMLLC) so long as (1) the SMLLC did not elect to be treated as a corporation and (2) the single member of the LLC could own the stock directly without causing the S corporation to lose its S status.
The fact pattern in these rulings involved existing single shareholder S corporations. The shareholder proposed to transfer his/her shares in the S corporation to a SMLLC. In essence the LLCs were treated as disregarded entities and the shareholder continued to be considered the shareholder of the S corporations. See PLRs 200816002, 200816003, and 200816004 (January 14, 2008; released April 18, 2008).
-Marc Ward
The charging order is an arcane legal construct that will be getting a lot more attention as the increasing popularity of LLCs meets the new economic realities. Many judgment creditors will be surprised and disappointed to learn that their judgment entitles them to nothing more than the distributions (if any) from an LLC. That is why you see challenges to the charging order like the one I wrote about yesterday.
One of the first cases to deal with charging orders and the single-member LLC was In re Albright, 2003 Bankr. LEXIS 291 (April 4, 2003). Ashby Albright was the sole member of a Colorado LLC. She was also its manager. The LLC owned Colorado real estate. Ashby, not the LLC, was the debtor in bankruptcy.
The bankruptcy trustee wanted to take control of the LLC and sell the real estate to satisfy Ashby's debts. Albright contended that the trustee was acting on behalf of her creditors and was entitled to nothing more than a charging order under Colorado law (the Colorado charging order provision at the time was almost identical to the current Iowa provision). Of course, this was a case about the bankruptcy trustee's authority, not that of a judgment creditor.
The bankruptcy court rejected Albright's argument. The court concluded that (1) the LLC membership interest was personal property transferred to the bankruptcy estate when she filed for bankruptcy (including both the governance rights as well as economic rights even though Colorado law made it clear that a membership interest meant only economic rights), (2) because she was a sole member of the LLC, a transferee/assignee of an LLC membership interest could become a member without the consent of the members (as required by Colorado law), and (3) the charging order serves no useful purpose with respect to single-member LLCs. The court granted control of the LLC to the bankruptcy trustee.
Albright is an example of a reverse piercing case. Piercing the corporate/LLC veil is achieved by going through an entity to get to the assets of the owners to satisfy the entity's debts. In a reverse piercing the creditor goes through an individual to get to the entity's assets to satisfy the individual's debts.
Albright also raises a lot of issues regarding the treatment of single-member LLCs in the context of charging orders and bankruptcy of the single member. To be continued...
-Marc Ward
Anyone who spends much time with LLCs soon realizes that some of the statutory provisions have some awkward concepts. Take the definition for example. Under current Iowa law an LLC is defined as "an unincorporated association having one or more members." Never mind how one person associates alone ("to join or collect in a relationship" American Heritage Dictionary). The new definition (actually two definitions) is not much better. Section 489.102(9)(2009) describes an LLC as "an entity formed under this Act." (not very helpful). Section 489.104(1)(2009) describes an LLC as "an entity distinct from its members." This also describes corporations and the New York Mets.
Which brings me to charging orders. The concept makes a lot of sense in the context of partnerships with multiple members. It also makes sense with multi-member LLCs. Things start to break down when the concept is applied to single member LLCs. Consider the following example from Florida.
Defendants, Shaun and Julie, defrauded over 200,000 individuals in a credit card scam. A receiver was appointed over their assets including several single-member Florida LLCs in which one or the other was the member. The defendants objected to the order requiring them to surrender "all of their right, title and interest" in their membership interests in the single-member LLCs.
Florida's charging order provision is almost identical to Iowa's current law. However, the new Iowa LLC law is much different (see prior post).
Defendants claimed that the "plain language" of the Florida law makes no distinction between single and multiple-member LLCs. Therefore, all the receiver was entitled to were distributions from the LLCs (fat chance).
The FTC (for whom the receiver was appointed) countered that a charging order makes no sense in the context of a single-member LLC and is not the exclusive remedy under Florida law. As I explained in a prior post, the FTC argued that the point of a charging order is to protect the other partners from the uninvited guest, a purpose rendered meaningless in the single-member context.
Strict interpretation of the statute, the FTC argued, leads to absurd results. For example, the Florida LLC Act provides that an assignee only becomes a member with the consent of the other members. Unless single-member LLCs are treated differently than multiple-member LLCs the FTC, no assignee could ever become a member.
The FTC also made the point that under Florida law an LLC member ceases to be a member upon assignment of the member's interest. Under the charging order provision this would leave a single-member LLC without a member to dissolve and wind up the LLC.
Thus, according to the FTC the law must be harmonized to resolve these inconsistencies and allow a judgment creditor to step in and liquidate the assets of the LLC. I think on this final point the FTC may be stretching the statute a bit; having the rights of an assignee is not the same thing as being an assignee.
The 11th Circuit Court of Appeals certified this issue to the Florida Supreme Court in FTC v. Olmstead, et al, 2008 US App LEXIS 11393 (May 29, 2008). The Florida Supreme Court's decision could have a huge impact on creditors of current Iowa LLCs through 2010, but limited applicability, if any, under the new Iowa LLC law.
I'll analyze this fact pattern in light of the new Iowa LLC Act in a future post.
-Marc Ward
Dissociation is the withdrawal of a member from an LLC. It can be either voluntary or involuntary. The operating agreement can vary or eliminate the manner in which a member can dissociate. See generally, Iowa Code 489.110 (2009). What the operating agreement cannot do is eliminate the power of a member to dissociate, rightfully or wrongfully. Iowa Code 489.601(1)(2009).
The Act lists 14 events that trigger dissociation of a person as a member of the LLC. See 489.602(2009). Rather than repeat the law, in summary, a person is dissociated from the LLC (1) by express will to withdraw, (2) an event stated in the operating agreement occurs, (3) the person is expelled pursuant to the terms of the operating agreement, (4) the person is expelled by the unanimous consent of the other members because (a) the LLC cannot lawfully carry on its business with the person as a member or (b) the person transferred all of the person's transferable interest (other than for security purposes or due to a charging order), or (c) the person is a dissolved corporation, LLC or partnership, (5) the status of the person materially changes or its transferable interest is distributed. Please see 489.602 for the complete, complex list.
A member's dissociation is wrongful if (1) it is in breach of an express provision of the operating agreement or (2) it occurs prior to termination of the LLC and is due to withdrawal by express will, expulsion by judicial order, the member in a member-manager LLC becomes a debtor in bankruptcy or willful dissolution or termination of the member other than a trust or estate.
When a person is dissociated as a member the person no longer has the right to participate in management of the LLC, if the LLC is member-manager the person's fiduciary duties as a member end going forward, and, with a couple of exceptions, the person becomes a transferee.
As will be seen in a future post, transferees who do not become members have few rights other than to receive distributions. They have no role in the management of the LLC, no right to information under 489.410, and no right to bring a derivative action. One right granted to transferees in the Iowa Act not found in the RULLCA is the right of a transferee to seek judicial dissolution if the managers or those members in control of the LLC have acted illegally, fraudulently or oppressively. See Iowa Code 489.701(1).
To avoid being a mere transferee, it might behoove a transferee who does not expect to become a member to have the transferring member keep 1% of the transferable interest and then exercise its governance rights in a manner that protects the transferee.
The Iowa Act diverges from the RULLCA by adding 489.604. This section permits dissociation by a member (if the operating agreement does not cover the topic or waive applicability of 489.604) if an amendment to the certificate of organization or operating agreement adversely affects the member's transferable interest any of six ways described in 489.604 (e.g. alters or abolishes right to distributions, right to vote, etc.)
-Marc Ward
The charging order originates from the English Partnership Act of 1890 and the Uniform Partnership Act of 1914. It exists in the current Iowa LLC Act (490A.904), but the new Iowa LLC Act provides more clarity and understanding to the concept. The most important thing to know about charging orders is that they are "the exclusive remedy by which a person seeking to enforce a judgment against a member or transferee may, in the capacity of judgment creditor, satisfy the judgment from the judgment debtor’s transferable interest." Iowa Code Section 489.503 (2009). (There are cases to the contrary on this point.)
The point of the charging order is to allow creditors a means to satisfy judgments (through distributions from the LLC) while protecting the LLC and the other members from having an unwanted third-party participate in the management of the LLC.
Under the new Iowa LLC law, a charging order is entered by a judge and represents a lien on a judgment debtor’s transferable interest (better, if inaccurately, known as the LLC membership interest). It requires the LLC to pay over to the judgment creditor any distribution that would otherwise be paid to the judgment debtor.
If necessary a court can appoint a receiver to collect the distributions. If the distributions will not satisfy the judgment within "a reasonable time" a court can foreclose the lien and order the sale of the transferable interest. A purchaser only obtains the transferable interest and does not become a member (i.e. has not voting or other management rights). The court also has the authority to issue orders to the extent necessary to collect the distributions.
Satisfaction of the judgment by the debtor prior to foreclosure extinguishes the charging order. The other members and the LLC also have the right to satisfy the judgment and step into the shoes of the judgment creditor and receive the distributions; the charging order is not extinguished in this case.
-Marc Ward
Many of you are aware of the Martin Ice Cream tax court decision (Martin Ice Cream Company v. Commissioner, 110 TC 189 (1998)). In that case the Tax Court recognized that a shareholder's personal relationships and contacts with customers can be personal assets. In the event of a sale of a business these assets can be sold by the individual, not the company. This treatment can have tax advantages for the owners. It is important to recognize that the Martin holding arose because of the exceptional personal services provided by the taxpayer (according to the court he "changed the way ice cream was marketed to customers in supermarkets") and he never entered into a non-compete or employment agreement with his company.
The Tax Court had a chance to revisit its Martin Ice Cream decision recently in Solomon v. Commissioner, TC Memo 2008-102 (April 16, 2008). The taxpayers did not fare so well in this case. Martin Ice Cream was distinguished on the basis that the Martin taxpayer was the controlling shareholder and the success of the ice cream distribution company depended entirely on the taxpayer and the quality of his personal services and customer relationships. The Court also highlighted three other differences between the two cases: (1) the types of businesses were different (personal services in the Martin case versus processing, manufacturing and selling in the Solomon case); (2) the Martin taxpayers signed the acquisition agreements in their personal capacities, the Solomon shareholders did not; and (3) the buyer in Solomon required noncompetes from the taxpayers, but not employment agreements. On this last point, the court interpreted this to mean that the buyer was not acquiring their personal goodwill.
It would appear from the Solomon case that the Tax Court narrowed or at least clarified its ruling in Martin. It is also clear from a reading of the facts in Solomon that careful planning in advance might have led to a different result.
-Marc Ward
A Federal district court recently reaffirmed a long-standing rule with respect to the determination of diversity jurisdiction in cases involving artificial entities other than corporations. In Provini v. Paradigm Global Advisors, LLC, 2008 U.S. Dist LEXIS 40500 (N.J. May 19, 2008) a rather exasperated court declared that a petition alleging for purposes of diversity jurisdiction the fact that the defendant was a New York LLC with its principal office in New York was "meaningless." Unlike corporations, where such an allegation would be meaningful, LLCs are unincorporated associations deemed citizens of each state in which their members are citizens.
In fact, it may be necessary to go deeper than the first layer of ownership to determine diversity if the LLC has members who are LLCs (Belleville Catering Co. v. Champaign Mkt. Place, 350 F. 3d 691 (7th Cir. 2003) or limited partnerships (Hart v. Terminex Int'l, 336 F. 3d 541 (7th Cir 2003).
Provini is an excellent case for learning what will not suffice as sufficient allegations of diversity of citizenship. For a terrific review of the history of diveristy jurisdiction and artificial entities, see C.T. Carden v. Arkoma Associates, 494 U.S. 185, 110 S. Ct. 1015, 108 L. Ed. 157 (1990).
-Marc Ward
The Eleventh Circuit Court of Appeals put its foot down on using the Business Judgment Rule as a scapegoat in this case. TSG sued its former CFO (Bencini) and accounting firm (D&D) for breach of fiduciary duty, fraud, securities fraud, and breach of contract. Bencini prepared financial statements for TSG in 2000 showing that the company was earning a profit for the first time. D&D reviewed the statements and came up with an even bigger profit for the company. Management and the Board of Directors took a look and believed the company had “turned a corner.” In May of 2001, Bencini noticed that the cash flow was flowing the wrong way, and a closer look revealed that the 2000 financial statements were just plain wrong—the company was still in the red. The President of TSG was informed of the cash flow issue, but not the 2000 accounting errors, so he proceeded to the annual meeting, and told investors the good news about making a profit. Bencini didn’t jump in to correct the misunderstanding.
A month later, the directors had to act quickly to avoid a lien on one of TSG’s projects. Investors and Directors opened their own pockets to support TSG, thinking this was an unfortunate blip on the upward trip to continued profitability. But that profit had never existed—it was the product of numerous accounting errors. The District Court granted Bencini summary judgment on the basis that the Business Judgment Rule applied because Bencini relied on outside experts (D&D). The Appeals Court didn’t buy it. Reliance on outside experts is not determinative, but simply weighs in favor of a finding that there was no abuse of discretion. The totality of the facts must be considered. In addition, the Appeals Court disagreed with the District Court’s assessment that there was no fact issue as to whether Bencini acted fraudulently, in bad faith, or in an abuse of his discretion. There were indications of collusion between Bencini and D&D, and evidence that Bencini stood to gain from an inaccurate picture of TSG’s finances. He sat on his hands at the board meeting instead of correcting the President when the news of profit was announced, and his spreadsheets induced investors to prop up the company with their own cash. The Appeals Court put it all together and decided Bencini did not deserve summary judgment in his favor.
So now we know that invoking the Business Judgment Rule and relying on experts will not blindfold Lady Justice, at least not in the Eleventh Circuit.
The new Iowa LLC Act implements new provisions regarding operating agreements, including modified rules for defining, limiting, and sometimes eliminating elements of fiduciary duties. The Act parallels the Revised Uniform Limited Liability Company Act (“RULLCA”) to establish a “not manifestly unreasonable” standard for the modification of fiduciary duties. Unlike other statutes using the term, however, the LLC Act purports to provide direction to courts applying the standard via section 489.110(8), which – in determining whether a modification is manifestly unreasonable – requires the court to make its determination as of the time the challenged term became part of the operating agreement and to consider only circumstances existing at that time. It further provides that a term may be invalidated only if, in light of the purposes and activities of the LLC, it is readily apparent the objective of the term is unreasonable, or the term is an unreasonable means to achieve the provision’s objective.
Despite the attempted clarification of the standard, the new Act's approach leaves open for debate the extent to which courts will actually allow operating agreements to redefine the scope of fiduciary duties because the "not manifestly unreasonable" standard has yet to be clearly defined.
The "not manifestly unreasonable standard" first appeared in business statutes when the Revised Uniform Partnership Act (RUPA) borrowed the concept from the UCC. The phrase appears in various code provisions and is mentioned in various cases, but as one author has noted, although "numerous cases apply the concept, they rarely explain why a provision is found manifestly unreasonable." (Mark J. Loewenstein, Fiduciary Duties and Unincorporated Business Entities: In Defense of the "Manifestly Unreasonable" Standard, 41 Tulsa Law Review 411, 431 n. 112 (Spring 2006)).
Official Comments to the UCC suggest that a "manifestly unreasonable" provision might be equated to an "obviously unfair" provision. Other commentators say it is falls somewhere between "unreasonable and unconscionable" or "passing beyond the outer limits of permissiveness." (See Timothy R. Zinnecker, The Default Provisions of Revised Article 9 of the Uniform Commercial Code: Part I, 54 Business Law 1113, 1124 (May 1999)).
Ultimately, however, existing statutes with a not manifestly unreasonable standard, like the new Iowa LLC Act, fail to clearly define the term, and case law does little to clarify. Definitions or suggested interpretations are limited, and those that exist very by court and context. Forecasting a court's treatment of the not manifestly unreasonable standard is difficult. One thing is certain: someone is going to be the guinea pig for the Iowa Supreme Court as it tries to draw the line between unreasonable and unconscionable.
Ms. Erickson is an associate with the Dickinson Law Firm and a contributor to this blog.
Being an employer is a very complex undertaking. My law firm has for a number of years published a Basic Guide for Employers including forms to help with such things as regulatory reporting requirements, immigration law, employee benefits, wage/hour notices, and the like. Today I posted the guide with the forms on this blog.
Please remember that the guide is designed for general informational purposes only and is not intended as legal advice. Although every effort has been made to ensure the accuracy and completeness of the information, my firm cannot be responsible for any errors or omissions or changes to the regulations described in the guide.
You can find the guide here.
-Marc Ward
