Ward on Iowa Limited Liability Company Law

ABA Primer on the Tax Provisions of LLC Operating Agreements

Here is a link to an excellent overview of the tax provisions found in most LLC operating agreements presented at ABA CLE sponsored by the Business Section. http://www2.americanbar.org/calendar/business-law-section-2011-spring-meeting/Meeting%20Materials/2075.pdf - Marc Ward

Boiler Plate in LLC Operating Agreements is Risky Business

Risk Management Services, L.L.C. v. Moss, 40 So.3d 176 (La. App. 2010) provides an interesting lesson on the importance of covering all elements of an LLC’s existence within the operating agreement; including the expulsion or termination of a fellow member.  If the operating agreement doesn’t spell it out-there’s no telling how a court will rule!

The April 2010 case was an appeal from an action for declaratory judgment and damages against Moss, a member who was expelled from the LLC.  On November 23, 2004, a Petition for Declaratory Judgment and Damages for Breach was filed by Risk Management Services, L.L.C., (“RMS”), Jean L. Robert and Dominick A. Vaccaro, Jr. against Robert W. Moss, III, a former member and manager of RMS, alleging breach of an operating agreement signed by Moss. Specifically, plaintiffs alleged that Moss was acting outside his role and authority as manager of RMS by forming a competing corporation and soliciting RMS customers and staff, and that these acts amounted to a breach of fiduciary duty and duty of loyalty to RMS.  Additionally, the members Robert and Vaccaro sought to have the court ratify Moss’ expulsion.

Moss argued that as the operating agreement failed to provide an affirmative right to expel a member; it would require either the amendment of the operating agreement or dissolution based on a strict reading of the operating agreement. Moss contended that as it took unanimous consent by the Members to amend or dissolve the operating agreement, as found under the provisions regarding voting rights, the 2/3 vote to expel him was invalid.    

The sections of the operating agreement regarding dissolution were relied on, as the basis for Moss’ expulsion.  These provisions in Section 6.1, set forth causes of dissolution, including consent of all members and a list of various events including expulsion.

Section 1.8 as per Section 6.1(2) discusses the voting rights of the member for dissolution and amending the operating agreement, stating that “Notwithstanding anything else in this Article I, the consent of one hundred percent (100%) of all the members eligible to vote will be required to approve the following matters. . .”  The district court judge found, based on this provision, that unanimous consent was not required for expulsion, and that this provision only required notification of all members when there was going to be a vote on expulsion.  As Moss was properly notified, the expulsion was proper.

Then, on Appeal the Appellate Court simply concluded that via the amended dissolution provision, the agreement actually did provide for the act of expulsion.  Thus, Moss’ expulsion was valid, even though the operating agreement did not contain an explicit procedure for expulsion.  The Court also added that equity consideration would require that a provision for expulsion be included in “this type of agreement”.  Thus, the court found that the dissolution provision contemplated expulsion and that the same provision did not require unanimous consent of the members. The Court concluded that there was no error in the trial court’s determination that Moss’ expulsion was proper according to the operating agreement.

This is another example how boilerplate language can lead to unexpected consequences.  It is always better to expressly provide for those important terms of operation, including the expulsion or termination of a member. As it is unlikely that the members of this LLC intended the operating agreement to be interpreted in such a manner when they entered into it; it is evident that you’re entering into a world of unknown when a clause is left up to the courts for interpretation.

-Allison M. Lindner

Here is an interesting article about the mass production of paper businesses. Expect regulation soon. http://finance.yahoo.com/career-work/article/113032/little-house-secrets-great-plains-reuters

Ambiguous Provisions May Blur the Line Between Customary Capital Call and Personal Liability of LLC Members

In Racing Investment Fund 2000 v. Clay Ward Agency, Inc., 320 S.W.3d 654 (Ky. 2010), an LLC creditor attempted to force the LLC to call for capital from the members in order to satisfy the creditor’s judgment claim for unpaid insurance premiums.  The creditor’s attempt was based on a capital call provision in the LLC operating agreement that stated in pertinent part the following: 

            “The Investor Members . . . shall be obligated to contribute to the capital of the Company, on a prorata basis in accordance with their respective Percentage Interests, such amounts as may be reasonably deemed advisable by the Manager from time to time in order to pay operating, administrative, or other business expenses of the Company which have been incurred, or which the Manager reasonably anticipates will be incurred . . .”

 The court thoroughly analyzed the specific capital call provision in great detail (deeming the same as “ambiguous”) in determining the members’ liability to the LLC’s judgment creditor, but ultimately refused to order a capital call based on its interpretation of the limited liability provision contained in the Kentucky’s LLC Act.  The LLC Act was deemed to be categorical in its denial of personal liability for members, and the court emphasized limited liability as the integral component of an LLC.  The court required unequivocal evidence of the members agreement to assume personal liability, and ultimately determined that the specific language contained in the operating agreement did not rise to that level. 

The court ruled that a creditor could not force LLC members to contribute capital to the LLC to cover the creditor’s claim unless the operating agreement, through explicit terms and provisions therein, unequivocally evidences the parties’ intention that the members assume personal liability for the same.

The lesson to be learned from this case is that one court’s “ambiguous” may be another’s “unequivocal”, and thus there is great importance in the proper drafting of operating agreement provisions setting forth capital call terms and conditions.  It might be recommended that capital call provisions in operating agreements:  1) contain an express and unequivocal refusal to assume personal liability on behalf of managers and members; 2) limit the discretion of the mangers in demanding capital calls; 3) carefully define the purposes for which partial calls may be made and the type of expenses that such capital may be utilized for; 4) carefully set forth adjustments to be made to a member’s interest in the case of default of a capital call; and 5) consider adding a “no third-party beneficiary” clause, to make clear that no creditor or other third party has any right to rely on or to enforce any of the provisions of the operating agreement, including any obligation of members to contribute capital.

-Ben Bruner

Explicit Provisions in an Operating Agreement may create Implicit Provisions

In Related Westpac LLC v. JER Snowmass, LLC, 2010 WL 2929708 (De. Ch. July 23, 2010), one member of a land development company sought to force the other member to pay damages and meet future capital calls, arguing that his refusal to give such consents and to meet capital calls was “unreasonable”.  The members disagreed over whether to expand the company’s  development projects funded with additional capital from the members.

This case was dismissed, because although the operating agreement prohibited the defendant from unreasonably withholding consent to certain decisions, it did not constrain other decisions with the “unreasonably withheld” standard including capital calls.  In stating specific events requiring consent, the implication was that non-stated events would then be excluded from those same terms and conditions.

The court also rejected the request for an implied reasonableness condition as part of the operating agreement’s implied covenant of good faith and fair dealing based on the fact that the express bargain covered that and implying such an obligation would override the express agreement.  Also, there were no contractual obligations to pay damages as the operating agreement provided that a member who did not fund a capital call would not have personal liability.

The court concluded “when a fiduciary duty claim is plainly inconsistent with the contractual bargain struck by parties to an LLC or other alternative entity agreement, the fiduciary duty claim must fall…” and dismissed the case. 

While the court refused to imply provisions or duties into the operating agreement, by doing so a set of implied terms were created.  When drafting operating agreements the more explicit your terms are, you may be creating an implicit set of terms by exclusion.  It is important to keep this in mind, as it may create unintended consequences. 

- Allison M. Linder

Creditors of an LLC can Collect from Members in Certain Cases

In Colborne Corporation v. Weinstein, 2010 WL 185416 (Colo. App. 2010), the plaintiff creditor in this case brought suit against two members of the LLC debtor pursuant to the Colorado LLC Act, alleging that the members authorized and received a distribution that rendered the LLC insolvent, thereby frustrating the plaintiff’s efforts to collect.  

The Colorado LLC Act, like Iowa’s, barred LLCs from making distributions to members if the LLC is insolvent or if the distribution will make the LLC insolvent.  The Colorado Act set forth that a member who knowingly receives a distribution in violation of the Act is liable to the LLC to return the distribution, but does not explicitly state that there is any liability for the same to the creditor themselves. The court in noted that when the LLC members who authorize the distribution are the same members who receive the distribution, they have no interest in suing themselves to “recover”, and thus the creditors of the LLC are possessed with the right to sue the members directly for the return of the improper distribution.  The court further ruled that managers of LLCs owe a limited fiduciary duty to creditors of the LLC and accordingly are prohibited from favoring their own interests over those of the creditors.    

The court found a statutory remedy for LLC creditors, even though the language of the statute only obligates the members to return unlawful distributions to the LLC.  The Colorado Supreme Court granted certiorari for further review of this ruling so stay tuned.    

-Ben Bruner, Dickinson associate

An Eye for an Eye, Is Only Fair: LLC Expulsions can be Tricky

Drs. Dietze and Graham had an established ophthalmology practice. Graham and Dietze each held a 50-percent interest in the professional practice as well as an equipment and real estate partnership.

On November 17, 2003, Graham received a notice of expulsion, the intent of which was to expel his professional corporation from the ophthalmology practice. Graham did not receive any formal notices for the termination of his 50-percent interests in the practice or the related equipment and real estate company, nor has there been dissolution of either entity. After Graham received the notice of expulsion from the ophthalmology practice, he no longer received financial information for either entity based upon Dietze's instruction to the entities' accountant and bookkeeper. Also at Dietze's direction, savings accounts were opened for the companies in which the entities appeared to retain net profits throughout the year until distribution.

After January 2004, Graham received no income distribution from either entity. Graham performed no surgeries after the early part of January 2004, as he received a letter dated January 19, 2004, stating he would not be allowed to perform surgeries. Graham discontinued payments to Geiger on his purchase of Geiger's interest in D & G in February 2004 as he was not receiving any payments from any of the entities.           

The Appellate court found that the trial court had erred in applying equitable principals contrary to the plain language of the articles of organization and operating agreement.    The agreement did not provide for expulsion or involuntary termination or transfer of a member’s interest and neither of the parties sought judicial dissolution or expulsion.  Also, Graham did not have to perform surgeries in order to share in the distributions, and was not expected to devote his full time and attention to the affairs of the LLC.  Because he was prevented from performing surgeries and not given financial information, he was unable to devote any time or attention to the LLC.

Therefore Graham remained a member. Rather than an accounting of Graham’s interest as of the time he was excluded, the court found that he was still entitled to share in the profits, even after excluded, because he still retained an interest.

 Attempts to exclude or remove members must be done according to the operating agreement.  It’s risky to operate with an operating agreement that does not provide for both involuntary and voluntary expulsion. As in this case, without the expulsion or termination provision the LLC’s only recourse would be to have this settled by the court, which is time consuming and costly.    

 Graham v. Dietze, 2010 WL 1600562 (Neb. App. April 20, 2010)

 - Allison M. Lindner

Associate, Business Law Section of the Dickinson Law Firm

Courts Continue to Ignore Independent Status of LLCs

Look out!  Another SMLLC is effectively disregarded by the court, seemingly for no other reason other than the composition of the members.  In Rossignol v. Rossignol, 2011 WL 723041 (N.Y.3d Dept., Mar. 3, 2011) the Supreme Court, Appellate Division in New York, affirmed a decision that found when spouses are the sole members of an LLC, the divorce action could provide complete relief.  The court found that since the spouses were the sole members of the LLC and both spouses were parties to the divorce action, the consolidation of the divorce action and the action to dissolve the LLC was proper as there would be no issues left for resolution after the distribution of the marital property.  Not only does the court disregard the entity itself, the court implies that through the divorce action the court has the power to dissolve the LLC due to the court’s empowerment to provide complete relief under the local Domestic Relations law and through the equitable distribution of marital property.  

There has also been an interesting comparison to the Olmstead v. FTC case, where the Florida Supreme Court expanded the rights of personal creditors of the single-member of an LLC. (See Professor Rosins blog posting on Unincorporated Business Entities Law).  We will just have to wait to see how far Rossignol actually opens the door to Olmstead’s expansive view.

-Allison M. Lindner/Dickinson Business Law Associate

 

White House Proposing to Eliminate Pass-Through Taxation?

Treausary Secretary Timothy Geithner proposed yesterday that the ability of some businesses to choose between being taxed as a corporation or pass-through taxation needs to be revisited.  It is impossible to predict how this discussion will turn out. I doubt Congress would eliminate S corporations.  And if they won't do that, then it seems unlikely LLCs would be singled out for special treatment.  But in this political environment, who knows?

See the complete story here: http://www.bloomberg.com/news/2011-02-25/geithner-says-tax-overhaul-must-address-businesses-filing-as-individuals.html.

-Marc Ward 

Delaware Chancery Court Issues an Important Ruling on Poison Pills and Hostile Takeovers

In a comprehensive, 153-page ruling, Chancellor Chandler (say that 5 times real fast) provides a detailed overview of the responsibilities of a target board when faced with a structurally non-coercive, all-cash, fully financed hostile takeover.  In his opinion in Air Products and Chemicals, Inc. v. Airgas, Inc. (Civil Action No. 5349-CC and Civil Action No. 5256-CC, February 15, 2011), Chandler almost begs the Delaware Supreme Court to overrule him.  He feels compelled, however, to rule in light of Delaware precedent that so long as the target board meets the 2-prong test of Unocal(legally cognizable threat to the corporation and a reasonable response proportionate to the threat) it has the power to defeat what it perceives to be an inadequate offer without giving the shareholders an opportunity to decide for themselves.  On several occasions he implies that he is not happy with that conclusion, but feels obligated to follow precedent in reaching it.

While the length of the opinion is daunting, it is well worth the read.  The events of leading up to the decision, including the shareholders tossing out 3 incumbent directors and replacing them with Air Products nominees who then side with the rest of the board in rejecting Air Products' offer and the attempt by Air Products to shorten the time between annual meetings so it could replace the directors serving staggered terms quicker, are unique.  And the Chancellor's opinion thoughtfully and carefully outlines the case law on hostile takeovers, particularly poison pills and their proper place in corporate governance.

- Marc Ward

ISBA Business Law Council Opposes HSB 42

HSB 42 would amend the Iowa Business Corporation Act to mandate that publicly-held Iowa corporations have staggered terms for board of directors and only permit directors of such boards to be removed for cause.  Casey's, Inc. is advocating passage of the bill in order to add another roadblock to a hostile takeover bid like the one it avoided last year.  In a memo to the president of the Iowa Bar Association the ISBA Business Law Council opposes the bill because it is contrary to one of the principles of corporate law that shareholders should have a say in all fundamental corporate governance issues.  Because the Casey's shareholders won't approve staggered terms for the board of directors, management is asking the Legislature to do for them what the shareholders won't do.  Another reason the Business Law Council opposes the legislation is due to the belief, supported by research, that staggered terms suppress stock values.  You can read the Council's memo here.

- Marc Ward

SEC Issues Proposed Rule on Accredited Investor Definition

The SEC issued a proposed new rule last week that would conform the definition of an accredited investor as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Comments on the new rule must be received by March 11, 2011.  The new rule would change the $1,000,000 net worth test for individuals as follows:

 “Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.”

 - Marc Ward

Form over Substance, Shell Companies Don't Work

In an attempt to avoid some income from his psychiatric practice from being subject to federal self-employment tax, a Denver psychiatrist with the help of his CPA/attorney set up two corporations to perform certain management services.  Trouble was neither corporation did anything.  Neither had employees or assets and in the case of one, it didn’t even have a bank account.  Nevertheless the psychiatrist operated his practice as if the companies were for real and thereby deflected some income away from his W-2.

The Tax Court, in Robucci v. Commissioner, T.C. Memo. 2011-19 (filed January 24, 2011) saw through this canard.  The court first noted that “a corporation will be recognized as a separate taxable entity if (1) the purpose for its formation is the equivalent of business activity or (2) the incorporation is followed by the carrying on of a business by the corporation.” (citing Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943) and Achiro v. Commissioner, 77 T.C. 881 (1981).  The court also quoted Judge Learned Hand (I love that name) who wrote in Nat’l Investors Corp. v. Hoey, 144 F. 2d 466 (2d Cir. 1944) that “to be a separate jural person for purposes of taxation, a corporation must engage in some industrial, commercial, or other activity besides avoiding taxation….”

As mentioned, the two corporations set up by Robucci didn’t do anything. They looked quite impressive on paper, but in fact, they couldn’t do anything.  They didn’t have assets or employees in order to perform any “industrial, commercial, or other activity besides avoiding taxation.”  Both were disregarded by the court for tax purposes and their income was allocated to the psychiatrist as a sole proprietor.

 - Marc Ward

What is a Reasonable Wage for Shareholder/Employee of an S Corporation?

One of the opportunities that S corporations afford its shareholders/employees is the ability to divide its net income between wages and dividends.  The advantage of course is that dividend payments are not subject to FICA or other employment related taxes.  Thus, there is a desire on the part of shareholder/employee to have as much of the corporation’s net income paid as dividends as possible.  The trick is knowing the right proportion that will not raise the interest of the IRS.  A recent case gives us guidance on the test to use to determine the right proportion.

 In Watson v. US, 2010 WL 5369530 ( S.D. Iowa, December 23, 2010) the court considered the case of an S corporation that together with other S corporations was the owner of an accounting firm.  The S corporation’s sole shareholder, director, and employee was an accountant that performed accounting services for the accounting firm through his S corporation.  The Service had recharacterized dividend and loan payments from the S corporation to the accountant as wages.  The accountant paid the assessment and then challenged the recharacterization in court.

 The IRS retained an expert who used compensation data from Robert Half International and the Management of an Accounting Practice survey conducted by the American Institute of Certified Public Accountants to conclude that the accountant’s wages from his S corporation were about one-fourth of what they should have been.

 The court concluded that regardless of the form of the payment, distributions to a shareholder/employee that represent remuneration for services would be treated as wages.  In making this determination the court looked at “(1) the employee’s qualifications; (2) the nature, extent, and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the gross income and the net income; (5) the prevailing economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer as to all employees; and (9) in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years.”

 Applying these factors the court concluded that the S corporation structured the salary and dividend payments to avoid paying the federal employment taxes.  The court also adopted the IRS expert’s determination of what constitutes a reasonable salary for the accountant.

 - Marc Ward

SIngle Member LLCs Cannot Escape the Authority of a Bankruptcy Trustee

In re First Protection, Inc., 2010 WL 5059589 (9^Th Cir. BAP (Ariz.) November 22, 2010) is another case involving the attempt by a single member of an LLC to prevent a bankruptcy trustee from exercising management rights over the LLC.  Debtors, David and Laura Fursman, transferred a 50% interest in Redux Development LLC to his mother after filing an individual Chapter 11 petition but before converting that petition a Chapter 7 case.  Their contention was that the trustee could not avoid the transfer under Section 549 of the Bankruptcy Code because the management rights of the LLC were not property of the estate.  In their view, only their membership interest, the right to profits and distributions, were transferred to the estate when they filed bankruptcy.  The trustee was a mere assignee and had no right to participate in management or control it.

 Joining the other courts that have considered this issue (Albright, Ehmann, Modanlo and Olmstead), the 9^th Circuit concluded that in the case of a single member LLC a bankruptcy trustee is not a mere assignee but steps into the shoes of the debtor succeeding to all of the debtor’s rights.  In this case that included the right to manage the LLC.

The point of these cases is that the bankruptcy courts will not permit a single member LLC to use the nuances and idiosyncrasies of a state’s LLC statute to override the powers of a trustee may assert over the assets of a debtor.

 -Marc Ward

A Sale by Any Other Name is not a Sale

Paloian v. LaSalle Bank, N.A., 2010 WL 3363596 (7^th Cir. 2010) considers whether the parties succeeded in turning a special purpose entity into a true bankruptcy-remote vehicle, and whether  there really was a “true sale” of assets or just a scheme to avoid the reach of bankruptcy.

 A bankruptcy-remote vehicle functions in a way that if a debtor sells certain assets to another corporation, the lender can rely on those assets without worrying about bankruptcy complications (i.e. preference-recovery actions).  To work, the entity must be separate and distinct from the other parties to the transaction.  It must own assets, and it must manage those assets in its own interests, not in the debtor’s interest.  Both parties must structure their transactions in such a way that their economic substance lies outside the Bankruptcy Code.  In this case the SPE lacked the attributes of a legitimate bankruptcy-remote vehicle. It was not independent of the other parties, in particular the hospital from which it purportedly bought the accounts receivable that served as collateral for its loan.  The SPE simply operated as a division of the hospital.  It did not have an office, a phone number, a checking account, or stationary—all of its letters were written on the hospital’s stationary.  There were no financial statements or tax returns filed. 

 There was also little evidence that a “true sale” of assets occurred.  Instead of purchasing the accounts receivables outright, the SPE took a small percentage of the hospital’s proceeds from receivables each month to covers its minimal operational costs.  The hospital even continued to carry the accounts receivable on its own books, as a corporate asset, holding out to other creditors that the SPE merely had a security interest in the accounts. The SPE was nothing but a shell corporation.

  So, rather than keep the accounts receivable out of the hospital’s bankruptcy proceeding, the structure in this case resulted in the receivables being swept into the bankruptcy estate.  The point is this, like piercing the veil cases the courts are going to look through the form of the transaction to its substance.  Lawyers, particularly those called on to render “true sale” opinions need to be cautious and conduct appropriate due diligence when rendering these opinions.

-Allison M. Lindner

Be Careful When Creating a Board of Managers in an LLC Operating Agreement

Even though LLCs are not corporations, owners and their lawyers like for LLCs to look and act like corporations.  One of the most prevalent corporate characteristics seen in LLC operating agreements is the concept of a board of managers intended to act like a board of directors.  Corporate board members, however, do not have an independent right to act on behalf of the corporation.  That may not be the case with managers of an LLC.  Iowa Code Section 489.407(3)(b) says that “Each manager has equal rights in the management and conduct of the activities of the company.”  Depending on the circumstances this may permit one manager among many to act as agent for the LLC.

 The comments to NCCUSL’s Uniform Revised Limited Liability Company Act highlight this issue:

 “The actual authority of an LLC’s manager or managers is a question of agency law and depends fundamentally on the contents of the operating agreement and any separate management contract between the LLC and its manager or managers.  These agreements are the primary source of the manifestations of the LLC (as principal) from which a manager (as agent) will form the reasonable beliefs that delimit the scope of the manager’s actual authority.  Restatement (Third) of Agency § 3.01 (2006).  See also Restatement (Second) of Agency §§ 15, 26….

 “While the individual members of a corporate board of directors lack actual authority to bind the corporation, 2 William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations, § 392 (noting “the overwhelming weight of authority”), subsection (c) does not describe “board” management.  Instead, subsection (c) provides management rules derived from those that govern the members of a general partnership and multiple general partners of a limited partnership.  RUPA, § 401 and ULPA (2001), § 406….

“The common law of agency will also determine the apparent authority of an LLC’s manager or managers, and in that analysis what the particular third party knows or has reason to know about the management structure and business practices of the particular LLC will always be relevant.  Restatement (Third) of Agency § 3.03 cmt. d (2006) (“The nature of an organization's business or activity is relevant to whether a third party could reasonably believe that a [manager] is authorized to commit the organization to a particular transaction.”)…

“As a general matter, however – i.e., as to the apparent authority of the position of LLC manager under this Act – courts may view the position as clothing its occupants with the apparent authority to take actions that reasonably appear within the ordinary course of the company’s business.”

 To boil all this down to one simple rule: If your operating agreement calls for more than one manager, clearly proscribe the limits of the managers management authority and whether or not each has independent agency authority.

 Also keep in mind that 489.407(3(c) does provide a statutory limit on the agency authority of managers when it says “A difference arising among managers as to a matter in the ordinary course of the activities of the company may be decided by a majority of the managers.”

Subsection (d) further limits the authority of managers (unless otherwise provided in the operating agreement) when it provides that the consent of all members is required to sell all of substantially all of the assets of the LLC, merge, convert or domesticate the LLC, take any action outside the ordinary course of business, or amend the operating agreement.

 -Marc Ward

IRS Issues Proposed Regulations on Series LLCs

This morning the IRS issued proposed regulations providing that for "Federal tax purposes...a series organized under the laws of the United States or any other State, whether or not a juridical person for local law purposes, is treated as an entity formed under local law."  Since Iowa is one of a handful of states that permit Series LLCs, I'll have more to say on this subject once I digest the 34 pages of explanation of this seemingly simple statement.

-Marc Ward

Something to Keep in Mind when Using LLC Statements of Authority

You might recall an earlier post, I’m talking a year or two ago, about statements of authority.  They are another carryover from the Revised Uniform Partnership Act.  I’m convinced these carryovers from RUPA are a plot by law professors who like to teach partnership law but feel rather silly doing so since no one forms partnerships anymore.  LLCs are an outlet for their frustration. 

Back to the point, by filing a statement of authority with the Iowa Secretary of State (and the county recorder if you are dealing with real estate) you can eliminate any questions regarding the authority of a person to sign a loan agreement, a note, a deed, or any other legal document.  But here is the caution. A Statement of Authority does not necessarily mean that the particular transaction you are concerned about has been authorized by the LLC. 

Let me give you an example.  Let’s say an LLC files a statement of authority declaring that Edward Sharpe has the authority to enter into any transactions on behalf of the LLC and otherwise act for or bind the LLC, including transactions involving real estate.  So long as you do not have knowledge to the contrary you are entitled to rely on this statement expressed by the LLC.  Edward Sharpe would have apparent authority to act on behalf of the LLC. 

But I am not sure that is good enough.  Let’s say I want to buy some farmland from The Nocturnals, LLC.  The basic statement of authority states that Edward Sharpe has authority to sign deeds on behalf of the LLC.  It does not state whether Sharpe has authority to sign my deed.  Do I really want to get bogged down on issues of apparent authority, BFPs, fraud, etc. merely because I was unwilling to go the extra step and request a certified copy of the resolution of the document authorizing the sale of the land to me and while I am at it a certified copy of the operating agreement?  

Which begs the question, what good are statements of authority? They are useful for routine business transactions when the dollars involved don’t justify the extra effort and they are effective immediately upon filing unlike affidavits which cannot by relied on until three years after filing, but I would use them with care.

-Marc Ward

LLC Charging Orders and Their Priority

As readers of this blog should know, a charging order is the exclusive remedy with regard to a debtor’s membership interest in an LLC.  This is true even if a creditor has a security agreement signed by the debtor that assigns all right, title and interest in a membership interest in an LLC to the creditor (courts have found that absent the consents required by the operating agreement the assignment is ineffective).

This does not mean that creditors can’t take steps to improve their position with respect to claims they have on an LLC membership interest. In First Mid-Illinois Bank & Trust v. Parker, 2010 WL 3179734 (Ill. App. 2010) Bank A argued that its charging order should take priority over Bank B’s charging order even though Bank B’s charging order was entered first because Bank A had an attachment lien entered four months earlier. The court agreed finding that because the charging order and attachment lien of Bank A related to the same claim the attachment merged with the charging order and the charging order related back to the date of the earlier attachment filing based on the “relation back” doctrine.

-Marc Ward

Covenants Not to Compete and the Allocation of Goodwill in the Sale of a Professional Business

It is something to ponder during these dog days of August, why would a sole shareholder/dentist enter into an employment agreement containing a covenant not to compete with the PC?  In essence, he agreed not to compete with himself.  Howard v. U.S., (USDT, Eastern District of Washington, July 30, 2010).

That is exactly what Dr. Larry Howard did in 1980.  In 2002, when he sold his practice to a competitor the Asset Purchase Agreement allocated $549,900 to Dr. Howard for his personal goodwill.  On his tax return for 2002, Howard reported $320,358 as long-term capital gain resulting from the sale of the goodwill.  As a result of an audit, the IRS recharacterized the sale of the goodwill as a corporate asset and treated the amount Howard received as a dividend.  This resulted in a $60,129 tax deficiency plus $14,792 in interest.

As the court points out, the case law makes it quite clear that an employee working for a corporation without a covenant not to compete owns the goodwill.  See Martin Ice Cream v. Commissioner, 110TC 189 (1998).  But when an employee works for a corporation under an employment agreement with a covenant not to compete, it is the corporation and not the professional owns the goodwill generated by the professional. Norwalk v. Commissioner, TC Memo. 1998-279.

Now explain to me again, why did he agree not to compete with himself?  I smell another victim to form practice.

-Marc Ward

LLC Operating Agreements Must be Drafted with Care

An opinion from the Superior Court of Vermont indicates once again why LLC operating agreements need to be drafted with care.  In Casella Waste Systems, Inc. v. GR TEchnology, Inc., 2009 Vt. Super. LEXIS 10, the question before the court was whether it had subject matter jurisdiction to dissolve two LLCs organized under Delaware law.  The plaintiff sought to have two LLCs judicially dissolved by the Vermont court because the management of the companies was so divided that the members’ business relationship was “irretrievably broken.”

 

The operating agreements of both LLCs permitted dissolution by “the entry of a decree of judicial dissolution pursuant to the Delaware LLC Act.”  Section 18-802 of the Delaware LLC Act provides that “on application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.”

 

The Vermont court concluded that because the operating agreements specifically referred to the Delaware LLC Act and that act specified the Delaware Court of Chancery as the court with jurisdiction over judicial dissolutions of Delaware LLCs, the Vermont court could not exert subject matter jurisdiction over the dissolution of the LLCs even though the LLCs presumably were owned by Vermont residents and did business in Vermont.

 

This case raises two points.  First, if you choose to form a Delaware LLC, consider whether Section 18-109(d) and Section 18-111, when read together, permits an operating agreement to designate another jurisdiction other than Delaware to have authority over the LLC, its members and managers.  Section 18-109(d) clearly permits the members and managers to choose another jurisdiction, but it just as clearly omits LLCs.  Unless it can be read that the members or managers may choose on behalf of the LLC to choose another jurisdiction.  Section 18-111 uses the word “may” instead of “shall” when stating that the Court of Chancery has authority to “to interpret, apply or enforce the provisions of” an operating agreement.

 

Second, if you are not going to do business in Delaware, why choose to organize a Delaware LLC?  Like all LLC acts, the Delaware LLC Act is nuanced and littered with traps for those unfamiliar with its terms.  When in doubt, stay home.

 

-Marc Ward

Single Member LLCs are Not Always Disregarded for Tax Purposes

For federal income tax purposes, single member LLCs are disregarded.  That is not the case with respect to gift taxes.  In Pierre v. Commissioner, 133 T.C. 24 (2009) the Tax Court held that a single member LLC would not be disregarded for gift tax valuation purposes under the IRS "Check the Box" regulations.  What this meant in Pierre was that the taxpayer's transfer of an interest in a single member LLC was treated as just that, a transfer of an interest in an LLC, and not a transfer of a proportionate share of the assets owned by the LLC.  Thus, the transfer was subject to discounts for marketability and for lack of control.

Bankruptcy Courts Weigh in on the Fiduciary Duties of Directors

A lot of corporate law is being made in bankruptcy court these days.  Take for example In re Midway Games Inc., 428 B.R. 303 (Bankr. Ct. Delaware 2010).  A committee of unsecured creditors challenged the actions of the board of directors of Midway for obtaining additional financing for the company instead of filing for bankruptcy.  The company was insolvent at the time and presumably an earlier bankruptcy would have benefited the unsecured creditors while the additional financing provided the company with some needed cash but only prolonged the company’s agony.  Along the way the majority shareholders also sold their 87% interest in the company and $70 million in debt to an individual for a mere $100,000.

The bankruptcy court reaffirmed the Delaware courts’ objection to the “deepening insolvency” theory (essentially that a board of directors must look to help the creditors over the interests of the company once a company becomes insolvent and stop the bleeding.)  Delaware law is clear that directors are not liable for taking actions to make a corporation viable once it is insolvent.  A board “does not have a duty to protect creditors of an insolvent corporation at the expense of the corporation and its shareholders."  Thus, the court found no breach of the duty of care by the board.

Next, the court looked at the duty of loyalty that directors owe to a corporation.  Although it held in the directors favor, this case does serve as a reminder to directors that they cannot become complacent about their role because they have an affirmative duty of oversight encapsulated in the duty of loyalty they owe to the corporation.  If directors fail to act in the face of a known duty to act and they demonstrate “a conscious disregard for their responsibilities" as directors, then they have breached the duty of loyalty.  I have noted in earlier posts that this breach of the duty of loyalty looks an awful lot like the duty of care and may have been constructed to get around the exculpatory clauses found in many articles of incorporation that prohibit monetary damages being assessed against directors for the breach of the duty of care, but so far no one else has taken up that banner.

So what about the sale of the 87% interest and $70 million in unsecured notes for $100,000?  The court found nothing wrong there either because the shareholders/noteholders “had the unfettered right to dispose of their Midway interests as they saw fit.  The board was not involved in the transaction and could not prevent it.  The stockholders qua stockholders owed no duty to the corporation.

-Marc Ward

Charging Orders and Single Member LLCs

Applying partnership principles to single member entities can sometimes create havoc.  Enter the case of Olmsted v. FTC (SC08-1009, June 24, 2010).  The 11^th Circuit Court of Appeals certified a question of Florida law to the Florida Supreme Court asking the Florida court if the charging order provision of Florida’s LLC Act permitted a court to order a debtor to surrender all of his or her rights in a single member LLC membership interest to a judgment creditor, not just the economic rights (the right to distributions).  Applying the hoary judicial principle if you don’t like the answer change the question, the Florida Supreme Court broadened the question to ask whether Florida law permitted the surrender of the entire interest (the right to vote and manage the affairs of the LLC in addition to receiving distributions).

The Florida Supreme Court answered its own question in the affirmative, relying on the theory that LLC interests were akin to corporate stock (wrong!) and therefore subject to the general execution laws of the state.  It also relied on the fact that unlike the Florida partnership and limited partnership statutes that made charging orders the exclusive remedy for judgment creditors, the Florida LLC provision on charging orders omitted the word exclusive.

This decision will create confusion in those states that likewise do not include the word exclusive in their statutes.  Charging orders effectively preclude creditors from becoming “partners” with the other non-debtor owners of the entity.  In single member LLCs it makes sense that charging orders are not the exclusive remedy, albeit it takes some judicial jujitsu to get there.  It does not make sense in LLCs with more than one member, and in effect makes LLC interests more like corporate stock than they are intended to be.

Fortunately, this should not be an issue under Iowa’s new LLC Act because it is the exclusive remedy.  (Iowa Code Section 489.503). Iowa has its own peculiar provision, one that is straight from the Revised Uniform Limited Liability Company Act.  It says that if it can be shown that the distributions from an interest will not be sufficient within a reasonable period of time to satisfy the charging order, then the court can foreclose the lien and sell the interest.  Of course, it depends on the size of the lien, but if the interest isn’t generating enough money to pay the charging order, exactly what will be gained by selling the interest?  Presumably, only the economic interest is sold.  Right?

-Marc Ward

LLC Buy-Sell Provisions Should Cover a Change in Control

Under the new Iowa LLC Act, transferees of membership interests do not become members of the LLC without the consent of all of the other members.  See Iowa Code Sections 489.401 and 489.502.  But what happens if a member who is not an individual merges with another entity?  The definition of “transfer” in 489.102 includes transfers by operation of law.  A merger in which the member is not the surviving entity will result in the surviving entity becoming a transferee, not a member, unless the operating agreement provides otherwise.  However, if the member is the surviving entity even if the original owners lose control, then the desire of the other members to have control over the LLC’s membership is thwarted.

To avoid this result, buy-sell provisions or agreements should include a provision that covers situations where there is a change in control of the entity-member.  This is usually defined as more than 50% of the voting interests or stock in the entity.

-Marc Ward

Connecticut High Court Rules on LLC Piercing Case

In the March 2010 decision of Naples v. Keystone Bldg. & Dev. Corp., 295 Conn. 214, the  Connecticut Supreme Court ruled that courts will not pierce the corporate veil of an LLC without a showing of fraud or other injustice.  Connecticut courts use the mere instrumentality test and the identity test in determining when to disregard the separate legal entity and impose personal liability. In Naples, there was much evidence the owner controlled the financial affairs of the homebuilding business under the mere instrumentality test, and a unity of interest under the identity test, but both tests also require a showing of fraud or injustice. Though the homebuilders were negligent in their construction, there was no showing of fraud such that piercing the LLC veil and holding the owner personally liable was appropriate. The court applied the same test for an LLC as it had previously applied for corporations.  This is similar to what the Iowa Supreme Court did in Cemen Tech, Inc. v. Three D Industries, L.L.C., 753 N.W.2d 1 (2008) when it applied the test for piercing the corporate veil to an LLC.

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The factors for piercing the LLC veil in Iowa are (1) undercapitalization of the LLC, (2) lack of separate books, (3) commingling of finances, and (4) using an LLC to promote fraud or illegal activity. (See Cemen Tech for the original factors, and also Iowa Code § 489.304(2) eliminating the fifth factor and the May 11, 2008 posting concluding the sixth factor is not a separate element.)  The Naples case from Connecticut reaffirms that veil piercing is an exceptional remedy used only when recognition of the separate entity would “defeat justice” and “perpetrate a fraud or other injustice.” In Iowa, this is recognized by the fourth factor.

 

Although fraud or some other injustice is required to successfully pierce the veil and impose personal liability, cases like Naples highlight that the other factors are equally important.  To avoid litigation costs, clients should be reminded to properly capitalize the LLC, keep separate books, and keep accurate records of the assets of the LLC.  

-Jana Luttenegger

Summer Associate

A Good Reminder that LLCs and Corporations are Not Perfect Liability Shields

The facts of this case and its outcome should make you sit up and take notice. Jay Dackman was a member of Hard Assets, LLC.  Presumably, although the court opinion does not say so, he was also the manager of the LLC or at least the member in charge of management because he is described as the person “responsible for managing its day-to-day affairs.”

Hard Assets was in the business of buying real estate out of foreclosure and then reselling the real estate.  In this case it bought a building in Baltimore, Maryland. No one visited the building on behalf of Hard Assets before or after it bought it and Hard Assets never intended to lease the property to anyone.  But lo and behold, someone was living there; Monica Allen and her two children.  When Hard Assets found out, it immediately and successfully took action to evict the squatters. It was just seven months from purchase to eviction, so no one could claim Hard Assets sat on its hands.  And during this period no rent was requested and none was paid.  In fact, Allen did not know Hard Assets owned the property until the eviction process was commenced three months after it purchased it.

Ms. Allen later brought an action against Dackman claiming he was personally responsible for the lead paint poisoning of her two children caused by the lead paint at the premises.  Common law principles and the LLC and corporate statutes of every state provide that a member of an LLC is not liable for the contracts or torts of the entity solely by reason of being a member or shareholder.  However, and this is the key, particular statutes and even city ordinances can overrule this general limitation.  And that is what happened to Dackman in Allen v. Dackman, 2010 Md. LEXIS 82 (Md. Ct Appls. March 22, 2010)(the Court of Appeals is Maryland’s highest court).

Without going too much into the details of the City of Baltimore Housing Code, the Court of Appeals determined that a reasonable trier of fact could conclude that Dackman was an “owner” of the property in addition to the LLC because “he had the ability to change or affect the title to the property purchased in the name of Hard Assets.”  The Court based its decision on these facts: Dackman signed the certification when Hard Assets bought the property, signed the complaint seeking removal of Allen and her children, signed the deed when Hard Assets sold the property, and there was no evidence that anyone else had similar responsibilities on behalf of Hard Assets.  Thus, Dackman “was the person who made decisions affecting title to the property.”  Because the Housing Code had an expansive definition of “owner” to the extent that it included not only holders of title to property but those who control title, Dackman could be found to be an owner.  It didn’t seem to matter to the Court that he was signing those documents not in his individual capacity but in his capacity as a representative of Hard Assets and that Hard Assets could not do any of the things mentioned without an individual signing in a representative capacity, a point that the two enlightened but albeit dissenting judges point out.

I wonder if a provision in an operating agreement that disavowed the authority of anyone signing on behalf of an LLC from having any authority to affect title to property of the LLC - reserving such authority exclusively to a majority vote of the members/managers - would have made a difference?

As a postscript, you may be wondering what duty Dackman or anyone else would have any duty to a squatter.  Two reasons are given. First, the Housing Code imposed strict liability.  Second, the Court found that the Housing Code protected “occupants” and defined occupants to be any “person who actually uses or has possession of the premises.”  In the Court’s view this included persons who had no legal right to be there.

- Marc Ward

LLC Operating Agreements and the Statute of Frauds

Section 489.102(15) of the new Iowa LLC Act contains a rather expansive definition of “operating agreement.”  It says that an LLC operating agreement can be oral, written or implied.  And a written operating agreement can be modified orally or by implication.  Oral operating agreements or operating agreements implied by the conduct of the members are problematic, let alone a written operating implicitly modified by conduct or oral agreement.  This is the reason the drafters of the Iowa LLC Act added a provision allowing written operating agreements to include a clause that only requires amendments to be in writing. See Iowa Code Section 489.111(4).

 

But what about written operating agreements that do not contain that provision or LLCs without a written operating agreement?  Does the statute of frauds apply to them?

 

Iowa’s version of the statute of frauds is found at Iowa Code Section 622.32.  It provides that evidence of a contract that is not to be performed within one year of its making is not valid, unless the contract is in writing and signed by the party against whom the contract is to be enforced.

 

All states have essentially the same statute of frauds and Delaware is no exception.  The Delaware Supreme Court considered the application of the statute of frauds to operating agreements for Delaware LLCs in Olson v. Halvorsen, 986 A.2d 1150 (December 15, 2009).  In that case Olson sought to enforce an unsigned operating agreement that would have paid him an earnout when he left a hedge fund he owned with two other individuals.  When he departed the hedge fund the only signed operating agreement entitled him to his capital account and earned compensation, a paltry $100 million.

 

Olson argued that the Delaware statute of frauds did not apply because the Delaware LLC Act permitted operating agreements to be “written, oral or implied” and declared that an LLC is bound to an operating agreement whether or not it signs it.  For similar Iowa provisions see Iowa Code Sections 489.102(15) and 111(1).  Olson also noted that the Delaware LLC Act seeks “to give maximum effect to the principal of freedom of contract and to the enforceability of limited liability company agreements."

 

Olson attempted to convince the Delaware Supreme Court that these provisions of the LLC law overruled the statute of frauds and precluded its application to operating agreements.  The Delaware Supreme Court disagreed.  In the eyes of the court, the LLC law did not “guarantee enforcement of all oral or implied LLC agreements.”  The law simply recognized that an LLC agreement could be oral or implied, but like all other contracts must comply with the statute of frauds.

 

It is reasonable to conclude that the Iowa Supreme Court would come to the same conclusion.  Accordingly, except in the rare case that an LLC is designed to last less than a year (e.g., the voluntary withdrawal of a member terminates the LLC), even though an Iowa LLC operating agreement can be oral or implied it will only be enforceable if it is in writing.

 

So what rules apply to an LLC that does not have a written operating agreement?  It stands to reason that the terms of the new Iowa LLC Act will apply to all oral or implied operating agreements.  This has serious and potentially harsh consequences to the members because the default rules under the Iowa law require that (1) all income be distributed equally among the members of the LLC regardless of their relative investments, (2) the LLC will be member-managed, and (3) all members will participate equally in the management of the LLC regardless of their relative investments.

 

Put your deals in writing!

 

-Marc Ward

Eighth Circuit Rules Against Taxpayer in Gift Tax Case

In a 2-1 decision a panel of the Eighth Circuit ruled in Holman v. Commissioner, (No. 08-3774, filed April 7, 2010), that a taxpayer who formed a limited partnership to hold only shares of Dell, Inc. did not meet the “bona fide business arrangement” test of IRC Section 2704(b)(1).  If it had as well as met the tests of subsections (2) and (3), the restrictions on transferability of the limited partnership interests owned by the taxpayer’s children would have applied in determining their value for gift tax purposes.  The court saw no need to address subsections (2) and (3) since the partnership agreement failed the first test.

The key to the court’s decision appears to be the taxpayer moving the publicly traded and therefore very liquid Dell shares into a “mere asset container,” a very illiquid limited partnership.  In addition, the lack of an articulated business purpose (in essence, a non-tax purpose) by the taxpayer doomed his case.

-Marc Ward