Ward on Iowa Limited Liability Company Law

Dissociation of a Member from an LLC

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

Charging Orders and the New Iowa LLC Law

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

          

Personal Goodwill in Business Acquisitions

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

Diversity of Citizenship and LLCs for Federal Jurisdiction

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

Reliance on Experts is Not Enough

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.

-Emily S.Pontius

Fiduciary Duties are Negotiable Under the New Iowa LLC Law

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.

-Megan J. Erickson

Ms. Erickson is an associate with the Dickinson Law Firm and a contributor to this blog.

Employers Basic Guide with Forms

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

Second Class of Stock Rules Can Cause Trouble for LLCs Seeking S Corp Treatment

There are situations when it is advantageous to elect S corporation status for a limited liability company.  In a future post I will address the pros and cons of partnership taxation versus S corporation taxation. 

For those LLCs that elect S corporation status it is of critical importance that the operating agreement not create a second class of stock.  More than one class of stock will destroy an entity's S corporation status.

An LLC will be treated as having only one class of "stock" so long as the governing provisions of the LLC (primarily the articles of organization/certificate of organization and the operating agreement) provide that all of the outstanding membership interests/transferable interests "confer identical rights to distribution and liquidation proceeds."  Lackadaisical drafting of the operating agreement or over reliance on forms can lead to unfortunate results in this regard.

At least one respected commentator believes he has yet to see an operating agreement that does not violate the second class of stock rule.  However, there is at least one IRS Private Letter Ruling that did find the operating agreement satisfied the requirement. See PLR 200548021 (August 23, 2005).  The drafting was no doubt precise and the provisions related to distributions and liquidations tied closely to S corporation requirements.

-Marc Ward

IRS Determines that each Series of an LLC is a Separate Entity

In Private Letter Ruling 200803004 the IRS ruled for the first time on the tax status of Series LLCs (Iowa is one of seven states to permit Series LLCs).  The IRS concluded under the facts presented that each series of an LLC is a separate entity for tax purposes and each series could elect its own tax status (assuming it met the conditions required for the chosen tax status).  In this ruling there were one or more series disregarded for tax purposes (meaning it had just one member), taxed as a partnership, and taxed as a C corporation.

Although other taxpayers cannot rely on this PLR, taxpayers can take comfort in the position the IRS took with respect to this Delaware Series LLC.  Iowa Series LLCs can also take comfort in the fact that the new Iowa LLC law mirrors almost word for word the statutory provisions of the Delaware LLC statute.

For an historical perspective, take a look at the National Securities case found at 13 TC 884 (1949) (treating each series of a series trust as a separate entity).  And for an excellent analysis of PLR 200803004, read the article by Steven E. Grob and Norman J. Hannawa in the March/April 2008, Business Entities (WG&L).

-Marc Ward

Series LLCs under the New Iowa LLC Law

Series LLCs are not new under the new Iowa LLC Act, but they are improved.  One of the biggest current concerns is what happens to a Series if the LLC from which it was created dissolves.  Iowa Code 489.1205(1) settles the issue, declaring that a series “is not terminated and its affairs shall continue despite the dissolution of the limited liability company…."

A Series is a separate and distinct part of the LLC.  It has separate members, managers, rights, powers and duties with respect to its own property or obligations as well as its own profits, losses and distributions associated with such property or obligations.  A Series can have a separate business purpose or investment objective than the LLC or another Series.  Its distributions are dependent exclusively on the operations of the Series.  It can be terminated without affecting the LLC or other Series within the LLC.

It is important to know that the debts, liabilities and obligations of a Series "shall be enforceable against the assets of that series only and not against the assets of the limited liability company generally...."  Iowa Code 489.1201(2).  Compare this language with 489.304(1) ("The debts, obligations, or other liabilities of a limited liability company...do not become the debts, obligations or other liabilities of a member or manager solely by reason of the member acting as a members or a manager acting as a manager.")

To establish a Series (a) the operating agreement must create the Series, (b) separate and distinct records must be maintained for the Series and its assets must be accounted separately from the assets of the LLC, (c) the operating agreement must provide for the limitation on liabilities described in 1201(2), and (d) a notice of the creation of the Series must be set forth in the certificate of organization.

Why create a Series?  One reason is to coordinate discrete but related business ventures.  For example each of a score of nursing homes may be owned by a different mix of investors but with a common manager.  A real good reason to create a Series is to protect the core business from a risky venture.  If your core business is selling widgets and you decide to dabble in real estate development, doing so within the same traditional LLC structure exposes your core widget business to the real estate division's creditors.  Simply forming a separate LLC may not be enough because of the threat that the LLC veil will be pierced.  A Series may protect you from veil piercing.

A careful reading of the Series provisions of the new Act (modeled after the Delaware statute) suggests that a Series may provide greater protection from veil piercing than forming a separate LLC, although it is untested in court.  Go back and read 1201(1) and 304(1), above, to see what I mean.

-Marc Ward

(I wondered while writing this post whether an LLC can own an interest in its own Series?  Interesting....)

Balmer v. 1716 Realty LLC and 1716 Realty Corp: A New Twist on the Pierce

Balmer v. 1716 Realty LLC and 1716 Realty Corp, 2008 U.S. District LEXIS 38113 (E.D. N. Y. May 9, 2008) is a clever twist on the traditional piercing the veil cases. For one thing, unlike most piercing cases, this one succeeds.  More important, it's a case of an affiliate piercing the veil of other affiliates.  Intriguing,  no?

Balmer is the receiver of Olympia Mortgage Corporation, a company best known for defrauding Fannie Mae of millions of dollars.  Olympia was owned by six individuals who also owned all of the equity interests in 1716 Realty LLC and 1716 Realty Corp.  To make a long story short, these dudes capitalized the affiliates with Olympia's money, paid the affiliates' expenses with Olympia's money, transferred Olympia's real property to the affiliates and repaid the mortgage loans with Olympia's money, and used Olympia's employees, offices, addresses, stationary, and phones as if they were their own.  There was no evidence that these affiliates abided by any corporate formalities or even elected directors or managers.  In other words, they had no existence separate from Olympia.

Ordinarily, plaintiffs seek to pierce the veil to get at the assets of the owners of the entity.  In Balmer, Olympia's receiver sought the assets of the affiliates. The receiver argued that the assets of 1716 Realty LLC and 1716 Realty Corporation should be used to pay off Olympia's creditors rather than benefit the mutual owners of the affiliated entities.

The court agreed and declared Olympia the legal owner of the assets of 1716 Realty LLC and 1716 Realty Corporation.

-Marc Ward   

Don't Sit on Your Rights!

In Roemmich v. Eagle Eye Development, LLC, 2008 U.S. App. LEXIS 10239 (8th Cir. 2008), we have yet another case of a family business venture leading to family litigation. Leland and Jane Bertsch (husband and wife) formed Eagle Eye Development, LLC, on June 12, 1995, to construct and lease post office buildings to the U.S. Postal Service. They brought in Jane’s brother, Bruce Roemmich, to oversee construction and development of two such projects in Florida. Eventually, the deal matured (or devolved, depending on how you look at it) into Roemmich getting a 30 percent ownership interest in Eagle Eye and a salary of $400 per week. Leland Bertsch owned the other 70 percent. Jane Bertsch originally owned a 5 percent interest, but she signed it over to her brother early on—perhaps she sensed trouble coming.

Roemmich became Secretary, Treasurer, and Governor of Eagle Eye. Jon Wagner later replaced him as Secretary. The opinion doesn’t really identify Wagner’s relationship to the endeavor. He just kind of lurks throughout like that guy on your college campus who graduated a long time ago but never left… Anyway, financial difficulties plagued the Florida projects and Reommich decided to walk out during June 1996. Leland Bertsch hired someone else to complete the work. Not surprisingly, the relationship between Roemmich and the rest of the Eagle Eye team deteriorated to the tune of physical and verbal threats. When Leland called the next meeting of the LLC, he was the only member in attendance, but he got a lot done. He removed Roemmich as Governor and Treasurer and appointed his wife Governor. As Executive Vice President and 30 percent owner, Roemmich continued to receive financial statements. By November, he suspected fraud, tax violations, and criminal conduct. He did not, however, exercise his right to call a meeting or request detailed financial information.

In 2004, he brought suit against Eagle Eye, Leland, Jane, and that Wagner guy. Roemmich claimed their actions were unfairly prejudicial, breached fiduciary duty, and the duty to act in good faith owed to him as a member and minority shareholder. He also said he was denied his right to vote as a member and mom always liked Jane better. Defendants counterclaimed based on Roemmich’s untimely departure from Florida back in 1996.

The essence of Reommich’s claim was self-dealing. In April 1997, Eagle Eye received $152,247.35 from the Postal Service and turned around and paid it to Bertsch Construction as reimbursement for “expenses.” Bertsch Construction also got 3 percent of project costs for support services but the fee was never approved by Eagle Eye governors or members. Eagle Eye also granted Bertsch Construction a contract (with really nice profit margins) to do repair work on Eagle Eye properties in Florida after hurricanes hit. Oh what a tangled web we weave when our family corporation is paid by our family LLC… The LLC also paid Leland $400 per week for services for two years, and made payments on behalf of the Bertsch’s for non-LLC related expenses.

The problem, of course, is that Roemmich let his anger boil for too long. The district court applied North Dakota’s six-year statute of limitations for tort, contract, and statutory causes of action and barred claims accruing prior to April 13, 1998. Pretty much everything happened before April 13, 1998, and Roemmich had notice before then, too. Roemmich argued that the defendants’ acts were a continuing violation that continued into the last six years because the conduct, when cumulative, froze him out of the LLC. This argument failed because he didn’t need cumulative activity to have notice of his claims. He had enough information about significant and distinct actions to do something within the limitations period. He just didn’t do it.

He also argued that the six year period did not apply to this violation. He preferred the ten year statute of limitations for violations not provided for in the Code, and argued that North Dakota’s LLC Act did not specifically address the freezing out of LLC members. The Court didn’t buy the argument, and said the LLC statute covered freeze-outs quite sufficiently, thank you very much, and the six year period for statutory violations applied.

Roemmich made some arguments about events that took place after April 13, 1998, but he did not provide enough evidence to support the allegations or did not provide enough evidence as to when the events occurred. Roemmich was beaten not only because he slept on his rights, but because his case was not well presented.

The 8th Circuit also concurred with the district court’s findings that Roemmich had no reasonable expectation of employment by Eagle Eye, especially after he walked out on the Florida projects; that the Bertsch’s did not engage in improper self-dealing; and that Reommich never had a reasonable expectation that he would be a decision-maker for Eagle Eye, especially given his own “inequitable” conduct.

Adding insult to injury, the 8th Circuit made Roemmich pay for the Defendants’ reasonable expenses, including attorney fees, because of his arbitrary, vexatious, or bad faith conduct. The district court found that Roemmich made baseless accusations of fraud and illegality, and attempted to disrupt Eagle Eye’s business relationships, and the 8th Circuit did not find anything to the contrary. Seems Roemmich would have been better off sleeping on his rights for a little while longer.

-Emily Pontius

Ms. Pontius is an associate at Dickinson, Mackaman, Tyler & Hagen, P.C. and a contributor to this blog.

LLCs and the Attorney-Client Privilege

LLCs are commonly referred to as hybrid business entities.  So when it comes to the attorney-client privilege, are they more like corporations or partnerships?  What is the difference, you ask?  The difference is in defining who is the client.

There is a split among the courts regarding corporations.  At the federal level and in some states, the corporation is the client and the privilege belongs to current management.  When control goes over to new management, the corporation's attorney-client privilege moves with them.  The seminal case on this topic is CFTC v. Weintraub, 471 US 343 (1985). 

Other courts apply the "collective corporate client" rule (this seems more likely to be the case in closely held corporations) holding that directors (including former directors) and the corporation hold the privilege allowing them access to documents that might otherwise be privileged under the Weintraub analysis.  See e.g. Kirby v. Kirby, 1987 WL 14862 (Del. Ch. 1987).

The courts are also split when it comes to partnerships, some apply the same rule as applied to corporations, but some cases have found that the "client" is not just the partnership, but also the partners because they owe fiduciary duties to one another and have broader powers than shareholders.  Wortham & Van Liew v. Superior Court, 188 Cal. App. 3d 927 (1987).

Which leads us to today's case, Montgomery v. eTreppid Technologies, LLC, 2008 U.S. Dist. Nev. LEXIS 35561 (April 18, 2008), one of only three cases that analyze the attorney-client privilege with respect to LLCs.  Montgomery and the other two cases apply the law of corporations to LLCs.  Montgomery is a well-reasoned case that rejects the joint client theory for corporations and follows the single client theory of Weintraub and Milroy v. Hanson, 875 F.Supp 646 (D. Neb. 1995).

The other two LLC attorney-client cases are Moore v. Commissioner of Internal Revenue, T.C. Memo 2004-259 (2004) and In re Tri-River Trading, LLC, 329 B.R. 252 (8th Cir. 2005).  The Tri-River decision is troubling because it applies the collective or joint client theory without any analysis.  Under this  theory, since there is no expectation of privacy between joint clients (in this case a member and her LLC) otherwise privileged communications were not prohibited from disclosure at trial. 

Because this is an Eighth Circuit decision Iowa lawyers should realize that the joint client theory could be applied to them and their LLC clients.  This is particularly true for member-managed LLCs under Iowa Code 489.409(1) of the New Iowa LLC Act.

-Marc Ward

Breaking Up is Hard to do

Before taking the LLC plunge, you probably drafted an operating agreement, but did you think about a pre-nup?  After reading about this case, you might.

Old National Villages, LLC v. Lenox Pines, LLC, 2008 Ga. App. LEXIS 363 (March 25, 2008) is one of those cases that will draw a laugh or a groan after you read it, and a universal "Are you kidding me?"

David Smith and James Cline are co-trustees of a trust.  They create Lenox Pines LLC as the investment vehicle for the trust.  David is the managing member of Lenox Pines. David and his wife Valerie decide to mix business with pleasure and form Old National Village, LLC.  Valerie is the sole member (how sweet) but David is the manager with "full, exclusive, and complete discretion, power, and authority... to manage, control, administer, and operate the  business and affairs of the company... and to make all decisions affecting such business and affairs." (not so sweet and certainly not trusting). The operating agreement also lists nine specific actions that could not be taken without the approval of the member.  This becomes important, as we shall see. (Right, Valerie?) And the registered agent of Old National is James Cline, the presumably loyal factotum and co-trustee of the trust serving as the source of funds for Lenox Pines.

Lenox Pines loans Old National $1.4 million to buy 34 acres of land.  David says this loan was memorialized by a loan agreement and was not paid back.  Valerie says there was no loan agreement and it was repaid.  Talk about he said-she said! 

Two years later the land is sold at a profit and things start to get interesting.  Valerie files for divorce and starts using Old National's cash like it was alimony (including repaying her daughter's car loan); without the knowledge or consent of David the manager (naturally).

Finally Ol' David has enough and Lenox Pines (David) sues Old National (Valerie) for $1.2 million.  The petition is served on the registered agent (James) who delivers it to Old National's manager (David).  The manager (David) on the same day files a confession of judgment on behalf of Old National (Valerie) in favor of Lenox Pines (David).  A few days later Lenox Pines (David) sucks Old National's (Valerie's) bank accounts dry (garnishment in legalese).

Valerie isn't ready to throw in the towel.  She hires a lawyer to set aside the judgment on the grounds that she should have been notified of the lawsuit because she was sole member of the LLC. Had the court agreed it would have turned LLC law on its head.  Thankfully, although it confused a "limited liability corporation" with a "limited liability company" it got the law right.

The court confirmed that an LLC is a separate legal entity from its sole member and that a member of an LLC is not  a proper party in a proceeding against an LLC.  It also confirmed the importance of operating agreements as the source of authority over LLCs.  The court found that it was significant that the operating agreement listed nine things that the manager could not do without the consent of the member and settling a lawsuit or entering a consent judgment "on behalf of the corporation" (ugh) was not one of them.

While there are many morals to this story, and it is my hunch that the last chapter has yet to be written (they are not divorced yet), the lesson for LLCs is that operating agreements will control outcomes and care should be taken in making lists of do's and dont's.  They can come back to haunt the Valeries of the world.

What is disappointing about this case is that it is pretty clear the Georgia appellate court thinks of LLCs as just another type of corporation.

-Marc Ward

 

Recent Indiana and Texas Veil Piercing Cases and How They Affect Iowa

A couple of recent cases highlight attempts to pierce the parent-subsidiary corporate veil.  There is no reason not to apply the reasoning in these two cases to LLCs.

In a case arising out of a 2004 natural gas explosion in Evansville, Indiana, Williams v. Iowa Pipeline Assoc., Inc, et al, 2008 U.S. Dist. Lexis 35679 (April 29, 2008), Vectren Corporation,a supplier of natural gas to homes and businesses, sought indemnification from Semco Energy, Inc. and its wholly-owned subsidiary, Enstructure Corporation for the construction work that resulted in the death of two individuals (I'm ignoring a complex set of mergers and acquisitions that resulted in Semco Energy,Inc. and Enstructure Corporation as the defendants in the case).  Vectren claimed that Semco and Enstructure were the alter ego of Iowa Pipeline and consequently their corporate veils should be pierced.

The federal district court made the point emphatically that the veil will be pierced under Indiana law only to protect a party from fraud or injustice; the presence of the indicia of an alter ego (undercapitalization, commingling of assets, absence of corporate records, etc.), is not enough.  According to the court, the alter ego analysis is only undertaken after fraud or injustice has been found. Sometimes it is unclear which comes first, the fraud/injustice or the ability to pierce the veil, so this case is helpful for this reason alone.

The court is also helpful in clarifying three things that do not permit a court to pierce the parental veil:  (1) undercapitalization at the time of the alleged fraud/injustice is irrelevant, the test for undercapitalization must be made at the time of incorporation; (2) a loan by a parent to a subsidiary is not commingling of assets; and (3) common directors and officers between the parent and subsidiary without more does not indicate an alter ego.

A Texas case involving patent infringement differs with the Indiana court with respect to the first two of these three observations.  In TIP Systems v. SBC Operations, Inc., 536 F. Supp.2d 745 (S.D. Tx. 2008) and citing US v. Jon-T Chems., Inc., 768 F. 2d 686 (5th Cir. 1986), the court noted that a corporate parent financing a subsidiary and a subsidiary operating with grossly inadequate capital were factors to  be considered in piercing the corporate  veil.  These two factors were 2 of 12 factors listed by the court. (Among the 10 other factors two are rather meaningless, bordering on silly: the  parent and subsidiary file consolidated tax returns and the parent incorporated the subsidiary.)

Because there was nothing untoward in the business relationship, the Texas court concluded, like the Indiana  court, that the veil should not be pierced.  Like the Indiana decision, the Texas court views corporate veil piercing cases as a two-step analysis:  if a fraud or injustice has been perpetrated, an alter ego determination will be made. 

In Iowa the corporate form (and the LLC form per the Cemen Tech case discussed in an earlier post) will be disregarded 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."  Briggs Transp. Co. v. Starr Sales Co., 262 NW2d 805, 810 (Iowa 1978).  Briggs, as well as C. Mac Chambers Co. v. Iowa Tae Kwon Do Academy, Inc., 412 NW 2d 593 (Iowa 1987) and In re Ballstaedt, 606 NW 2d 345 (Iowa 2000), cite six factors the existence of which would support piercing the corporate veil.

The six factors are (1) the corporation 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, (4) the corporation is used to promote fraud or illegality, (5) corporate formalities are not followed and (6) the corporation is a mere sham.

A couple of observations.  Iowa sides with Texas and looks at the capitalization of the LLC at the time of the alleged fraud or injustice, not when the entity is organized, as Indiana courts do, but I have to wonder if the court has thought about it very carefully.  The concept is contrary to the notion that the "debts, obligations or other liabilities of a limited liability company, whether arising in contract, tort, or otherwise...are solely the debts, obligations, or other liabilities of the company." Iowa Code 489.304.

The Iowa Court's use of the word "is" it implies that members have an ongoing responsibility to maintain the capitalization of the LLC, and if they don't they could be held personally responsible.  This is contrary to Iowa Code 489.304(1)(b) (such debts "do not become the debts, obligations, or other liabilities of a member...solely by reason of the member acting as a member...."). Talk about an injustice! This could be a dangerous concept for Iowa businesses.

The second and third factors are consistent with other jurisdictions, but the fourth one does not make sense (if there is fraud the corporate veil will be pierced if there is fraud). The fifth factor is not applicable to Iowa LLCs (489.304(2)). And the sixth factor states a conclusion that would be reached if the other factors are found, it is not an element to be proved.

So, in Iowa we are really down to a three factor test.  The veil of an LLC will  be pierced if it is being used to perpetuate a fraud or promote injustice if (1) the LLC is undercapitalized, (2) it lacks separate books, and (3) its finances are not kept separate from individual finances or individual obligations are paid by the corporation.  It is not clear if all of these factors must be present, but that would be the right view.

-Marc Ward 

LLC Management Under the New Iowa LLC Act

As mentioned in an earlier post, under the New Iowa LLC Act (489.301(1)) members are not agents of an LLC merely by being members.  This is a break from the statutory apparent authority concept found in the current Iowa law and dating back to the 1914 Uniform Partnership Act.  This does not mean that a member's conduct cannot otherwise bind the LLC.  For instance, as the commentary to the RULLCA points out, the law of apparent authority, respondeat superior or negligent supervision might result in liability of an LLC for a member's conduct  (See 489.301(2))

By default under current law an LLC is managed by its members unless the articles of organization or operating agreement provide for management by managers.  This concept is carried over to the New Iowa LLC Act provided that it is only the operating agreement that can change management of an LLC from member-managed to manager-managed.  The operating agreement must expressly provide that (a) the LLC is "manager-managed" (b) the LLC is "managed by managers" (c) management of the LLC is "vested in managers" or (d) words of similar import.  Be safe, use one of the first three phrases recognized by the Act to avoid all doubt.

Now this is where things get a little complicated.  To fully understand the management options available under the new Iowa LLC Act (as well as other provisions of the Act) you have to go back to 489.110(1) and (2).  This is where the concept of the LLC as a contractual construct and not a creature of statute is expressed. 

Section 489.110(1) establishes the primacy of the operating agreement by declaring that it governs (a) relations among the members as members and between members and the LLC, (b) the rights and duties of the managers, (c) the activities of the company, and (d) amending the operating agreement.

Section 489.110(2) establishes the Act as the place to turn to fill in the gaps, if any, not covered by the operating agreement ("To the extent the operating agreement does not otherwise provide for a matter described in subsection (1), this chapter governs the matter.")

Section 489.110(3) takes back some of the broad authority granted to the operating agreement in subsection (1).  More about subsection (3) in a later post.

Back to 489.407 and the default rules for managing an LLC.  Unless the operating agreement provides otherwise the following rules apply to a member-managed LLC: (a) management is vested in the members, (b) each member has equal rights in the management of the LLC, (c) differences as to matters in the ordinary course of business are decided by majority of the members, (d) decisions  outside the ordinary course of business including a sale of all or substantially all of the LLCs assets require unanimous consent of the members, (e) amending the operating agreement requires unanimous consent of the members, and (f) mergers, conversions and domestications require unanimous consent under Article 10.

If the operating agreement provides for a manager-managed company, the following rules apply: (a) except as provided elsewhere in the Act matters related to the activities of the LLC are decided  by the managers, (b) each manager has equal rights in the management of the LLC, and (c) differences arising among the managers in the ordinary course of business are decided by a majority of the managers.

Decisions outside the ordinary course of business in a manager-managed LLC,including a sale of all or substantially all of the LLCs assets, mergers, and conversions, as well as amendments to the operating agreement, require unanimous consent of the members.

Managers are selected by a majority of the members and can be removed at any time by a majority of the members without notice or cause.

One final point appoint the default decision-making rules under the new Act.  Unlike the current default rule that provides for members voting power to be weighted based on the capital contributions of the members, the new Iowa LLC Act provides for votes based on one member, one vote.

-Marc Ward

Tax Court Endorses LLCs for Estate Planning

We may have seen the demise of family limited partnerships (FLPs) with the decision of the Tax Court in Estate of Mirowski, TC Memo 2008-74 (March 28, 2008).  The taxpayer funded a new LLC with $63 million of mostly marketable securities and immediately gifted 16% interests in the LLC to her three children, leaving her with 52% and the manager of the LLC.  A short time later she died.  The Tax Court held that the assets transferred to the LLC were not includable in her gross estate under IRC 2036(a) and applied a 40% discount to her interest in the LLC.

This case is important for LLCs for two reasons.  First, is the recognition by the Tax Court that involving the family in the management of the LLC's investments is a sufficient non-tax reason for forming the LLC (thus meeting one of the tests to qualify for the 2036(a) exception).  But most intriguing is the Tax Court's response to the IRS argument that the assets should be included in her estate because she was the sole, exclusive manager of the LLC with the right to control distributions from the LLC.  The Tax Court rejected this reasoning because it believed the fiduciary duties imposed on the taxpayer as manager of the LLC under the Maryland LLC Act together with the obligation contained in the operating agreement to distribute the LLC profits annually limited her discretion as manager.  This is a long way from being a limited partner with no ability to manage or control the operation of the limited partnership.  On the strength of Mirowski is there any reason to use family limited partnerships for estate planning purposes anymore?

For a recent perspective on the use of FLPs see Joe Kristan's Tax Update Blog.

For more information about estate planning contact my colleague, David Repp

-Marc Ward

IRS Ruling Grants Relief to LLC that wants to be an S Corporation

In PLR 200818017 (January 31, 2008/Released May 2, 2008) the Service granted relief to an LLC desiring to become an S corporation for federal income tax purposes that inadvertently failed to timely file either Form 8832 (to become an association taxable as a corporation) or Form 2553 (to become an S corporation).

The LLC was formed on A.  In B, after becoming a single member LLC instead of an entity taxable as a partnership (presumably a multi-member LLC) the company and its accountant decided the LLC should become an S corporation by making the appropriate election effective in C.

The Service granted the LLC an extension of time of 60 days under Treas. Reg. 301.9100-1 to file Form 8832 (entity classification election) effective C.  The IRS further found that the LLC had reasonable cause for failing to make the S corporation election and granted it 60 days to file Form 2553 effective C.

-Marc Ward

Statements of Authority Clarify Responsibility and Real Estate Transactions

In this post I will look at two real improvements to Iowa's LLC law.  Currently, all members of an LLC are agents of the LLC unless the articles of organization provide otherwise (Iowa Code 490A.702).  Beginning in January 2009 Iowa Code Section 489.301(1) will provide that a member is not an agent of the LLC merely because he or she is a member.  The risk of a rogue member binding or otherwise obligating LLC will be gone.

To clarify the lines of responsibility further, Iowa Code Section 489.302 will permit an LLC to deliver to the Secretary of State for filing a statement of authority. The statement will be notice of who does or does not have authority to act for the LLC to execute an instrument transferring real property or to enter into transactions on  behalf of or otherwise act for or bind the LLC.  The statement can state the authority or limits on authority by position (e.g. manager or president) or a specific person or persons.

Filing the statement of authority in the recorder's office will be conclusive in favor of a person who gives value for real property in reliance on the statement.  Likewise, a recorded statement limiting the authority of a person or position to transfer real property will be notice to all.

A statement of authority will expire 5 years after it or the most recent amendment becomes effective, unless canceled earlier.

-Marc Ward

Iowa Supreme Court Applies Piercing the Corporate Veil Factors to an LLC

Last week, probably without realizing it was doing so, the Iowa Supreme Court applied its piercing the corporate veil factors to a limited liability company for the first time.  In Cemen Tech, Inc. v. Three D Industries, L.L.C., 2008 Iowa Sup. LEXIS 63 (May 2, 2008), the Court reaffirmed its 6-factor piercing test and applied the factors with respect to two Iowa LLCs.

The six factors are (1) undercapitalization of the LLC, (2) lack of separate books, (3) commingling its finances with individuals or paying obligations or debts owed by individuals, (4) using an LLC to promote fraud or illegal activity, (5) not following LLC formalities, and, the catch-all, (6) the LLC is a sham.

The Court failed to acknowledge that the fifth factor is inapplicable to Iowa LLCs because neither current law, Iowa Code Section 490A.603(2), or the new law, Iowa Code Section 489.304(2), permits a court to impose liability on the members of an LLC for failure to observe such formalities as holding periodic meetings.

The Court also needs to clarify whether the undercapitalization test is applied at the time the business is organized or at the time of the events giving rise to the litigation.  As I will be writing about in a future blog, courts around the country view this issue differently.

-Marc Ward

Shelf LLCs under the new Iowa Limited Liability Company Act

Currently, Iowa LLCs cannot exist without members.  Technically speaking, articles of organization should not be filed for an LLC until it has at least one member.  This probably comes as a surprise to many Iowa lawyers.

Shelf LLCs are limited liability companies permitted by state law to be formed without members and put on the shelf until needed.  They clear up many issues with regard to valid existence and due organization, but they run contrary to the idea that an LLC is an association of members, not an entity whose existence is created by a filing with the state government.  This subject was the single most contentious issue debated by the National Conference of Commissioners on Uniform State Laws Drafting Committee for the Revised Uniform Limited Liability Company Act.

The NACCUSL committee compromised and the official Revised Uniform LLC Act allows LLCs to have a shelf life of 90 days before needing at least one member.

In Iowa, we took a more practical approach.  Shelf LLCs can be formed under the new LLC Act, but LLCs will need at least one member in order to operate and do business.  Until an LLC has at least one member it can only (a) deliver filings to the secretary of state; (b) admit a member; and (c) dissolve.

An LLC with at least one member may ratify an act or activity that occurred when the company lacked  members.

-Marc Ward 

Incorporation Transparency and Law Enforcement Act

US Senator Carl Levin, joined by Senators Coleman and Obama, introduced the Incorporation Transparency and Law Enforcement Act on May 1.  If enacted, the law will require every LLC and corporation in America to report annually to their state of organization or incorporation the names and other information about their owners.  The idea behind the bill is to provide civil and criminal law enforcement authorities with a data base to find those business entities "being misused to commit terrorism, money laundering, tax evasion, or other misconduct."  A lot of this information is already available to the IRS.

There will be exceptions for publicly traded corporations and business entities which a state "with the concurrence from the Homeland Security and Justice Departments" has decided "should be exempt because requiring beneficial information from them would not serve the public interest or assist law enforcement."   According to Senator Levin, "these exemptions are expected to be narrowly drafted and rarely granted."

Millions of small businesses will be burdened with the time and expense of this law, and pay the penalties for errors and forgetfulness, so the federal government can smoke out a few evil doers (as if they will comply with the law or not find a loophole in the first place.)

Wouldn't a much better solution be to identify those businesses or transactions most susceptible to abuse and require those members/shareholders to be revealed?  Financial institutions already have to identify their owners to regulators and those shareholders owning 10% or more must submit to background checks.  A narrowly written and less intrusive law should not be that difficult.

The Iowa Secretary of State already asks Iowa limited liability companies to voluntarily reveal their ownership in biennial reports even though neither the current Iowa LLC Act (Iowa Code 490A.131) or the new Iowa LLC Act require such information (similarly situated are corporations under Iowa Code 490.1622). 

-Marc Ward

No More Articles

Beginning January 1, 2009, new LLCs will file certificates of organization, not articles of organization, to get things started.  And the certificates live up to their names.  The only information required in the certificates is the name of the LLC and the street and mailing addresses of the registered office and the registered agent.

It will be no longer necessary to state that the LLC has a perpetual existence; by law all LLCs will have a perpetual existence.  The other key difference from current law is eliminating the necessity of relieving members and managers from liability to the limited liability company for monetary damages except for (1) breach of the duty of loyalty; (2) improper receipt of a financial benefit; (3) making an improper distribution to members; (4) intentional infliction of harm on the company or a member; and (5) an intentional criminal violation.  This limitation of liability must be in the operating agreement,not the certificate, in order to be effective and bind the LLC.