Ward on Iowa Limited Liability Company Law

Approach Third-Party LLC Opinions with Care

The current newsletter of the ABA's Third-Party Legal Opinion Committee highlights some of the challenges LLCs present for third-party legal opinion givers. 

One of the biggest gotcha's with Delaware LLCs is the fact that a "duly formed"opinion cannot be given with respect to a shelf LLC because Delaware LLCs are required to have an LLC agreement.  A similar problem exists with Iowa LLCs under the current law because Iowa LLCs must have members in order to exist.

Another problem with rendering an opinion regarding Delaware and Iowa LLCs has to do with opining that a contract has been duly authorized by the LLC.  This is generally a problem with interpreting the operating agreement vis a vis the statute.  Both must be read and compared carefully, bearing in mind that the operating agreement will control. But is it clear?  Are you sure?

By the way, a good place to start when confronted with an LLC opinion is the TriBar Opinion Committee's Third-Party Closing Opinions: Limited Liability Companies, 61 Bus. Law 679 (2006).

-Marc Ward

Recent Fiduciary Duty Case Applying Delaware Law

The United States District Court in Maine applies Delaware law in denying the plaintiffs motion for summary judgment on breaches of the duty of loyalty, care and good faith (ugh) in Baldwin v. Bader, 2008 U.S. Dist. LEXIS 56236 (July 23, 2008).

-Marc Ward

Liability of the Majority to the Minority, the Assumption of Fiduciary Duties

A recent decision by the North Dakota Supreme Court may have implications for Iowa LLCs when the new Iowa LLC Act takes effect on January 1, 2009.

The holders of a majority of the limited partnership interests in two North Dakota limited partnerships decided they were not happy with the performance of the partnerships and through a written action without notice to the minority owners removed the general partner in both partners and appointed its replacement.  The majority took a number of other actions in asserting control over the limited partnerships.  Things went from bad to worse, naturally, and the minority owners sued the majority for, among other things, a breach of their fiduciary duties owed by the majority limited partners to the minority limited partners.

The majority limited partners argued that they could not be held liable for breach of fiduciary duties because the North Dakota limited partnership act declares that a "limited partner is not liable for the obligations of a limited partnership unless...the limited partner participates in the control of the business [and in such case]...the limited partner is liable only to persons who transact business with the limited partnership...."

The equivalent provision of the new Iowa LLC Act is 489.304 (2009) which states that the debts, obligations, or other liabilities of a limited liability company are solely the responsibility of the LLC and do not become the responsibility of a member solely by reason of the member acting as a manager.

The North Dakota Supreme Court held that the limited partnership act provision cited above did not address fiduciary duties owed to the other limited partners, but only those obligations of the limited partnership.  Red River Wings, Inc. v. Hoot, Inc. et al, 751 NW 2d 206 (N.D. 2008).

The Court went on to hold that when the majority limited partners took control and dominated the partnerships for their own benefit they "violated the fiduciary duties of good faith, fair dealing, loyalty, and care...."  The Court appears to have gone a little overboard in its enthusiasm for holding the majority liable to the minority and created two additional fiduciary duties in the bargain.

The Court also held that minority limited partners are entitled to bring a direct action against the majority for breach of these fiduciary duties.   The equivalent new Iowa LLC Act provision that supports the concept of direct action for breach of fiduciary duties is 489.901 (2009).  It provides that a member may maintain a direct action against another member to protect the member's interests under the operating agreement or the LLC Act or "arising independently of the membership relationship."

Red Wing is a warning to majority owners that taking control of an LLC without due regard to the operating agreement and the rights of the minority could lead to liability to the minority members for breach of fiduciary duties.

-Marc  Ward

You've Heard of Piercing and Reverse Piercing, Now there is Self-Piercing

In a novel New York case, an organizer of a corporation and an LLC tried to convince a court to disregard one entity and allow the other one to succeed to the legal remedy the disregarded entity was claiming against the defendant in the case.  And it might have worked, if only the disregarded entity could have proved damages.  You got to read it yourself. 24/7 Inc. v. Sony Music Entertainment, Inc., 2008 U.S. Dist. 49993 (NY July 1, 2008).

-Marc Ward

Lawyer Liability for Third-Party Legal Opinions

Court opinions regarding third-party legal opinions are rare, so when one is released it is worth taking a look at it.

The Ohio law firm of Purcell & Scott was accused of fraudulently inducing the plaintiff to invest in its client's securities because of an opinion letter the firm issued in connection with the stock offering.  Needless to say, the company tanked soon after the securities offering.

The letter broadly opined that the execution of the stock purchase agreement and the issuance of preferred stock would not violate "any statute, law, ordinance, rule or regulation of the United States of America or the State of Ohio...." (a "no violation of law" opinion).  Nevertheless the court found that this opinion did not include federal or state securities laws for two reasons.  First, the opinion letter incorporated the ABA Legal Opinion Accord (which excludes federal securities and state Blue Sky laws from the "no violation of law" opinion unless explicitly included).

The second reason is more intriguing.  The court concluded that the "no violation of law" opinion like the one in this case, even one given in a legal opinion letter that does not incorporate the Accord, was limited to the execution of the stock purchase agreement and the issuance of the preferred stock, and was not a guarantee of overall compliance with the law.  The misleading statements were in the offering materials and the financial statements, not the signing of the agreement or the ministerial act of issuing the stock.

I do not often run across legal opinions based on the Accord, and we do not use the Accord in our firm, but we always specifically exclude state and federal securities laws.  Based on In re National Century Financial Enterprises, Inc., 2008 U.S. Dist. LEXIS 39931 (May 5, 2008), maybe that is overkill.

-Marc Ward

Economic Rights versus Governance Rights - A Refresher

Many people, including judges and the IRS, continue to confuse limited liability companies with corporations.  They are not interchangeable entities.  One of the most important differences is with respect to the ownership interests of the two companies.

In your typical corporation with one class of stock your economic interests and your voting interests are in direct proportion to the number of shares you own compared to the total number of shares owned by all shareholders.  That may be true in an LLC as well, but it does not have to be.  In fact the default rule under the new Iowa LLC Act is one member-one vote.

More importantly, assuming there is not a buy-sell restriction on your stock, when you sell the stock the voting rights go with it.  This is not the case in an LLC.  Your buyer will only obtain the economic interest; the governance rights can only transfer to the buyer with the unanimous consent of the other members (unless your operating agreement provides otherwise).

The point is this:  The economic rights and the governance rights in an LLC, unlike a corporation, are separate rights, unless otherwise provided in the operating agreement.

-Marc Ward

Words Matter in Operating Agreements - Another Installment

Granting an LLC manager the power to "execute" instruments (for example, a promissory note) does not mean without more that the manager has discretionary authority to borrow money on behalf of the LLC, so says the Kansas Court of Appeals in Sunflower Bank v. Airport Red Coach Inn of Wichita LLC, 175 P 3d 883 (Kan. App. 2008).

The court also concluded that the bank had "knowledge" of the fact that the operating agreement did not grant the manager such authority because it had a copy of the operating agreement in its possession.

The bank bungled this one in two ways.  It didn't require the manager to provide evidence of his authority (by resolution or written consent) and apparently didn't read the operating agreement or at least the loan officer did not understand what he or she read.

-Marc Ward

Major Disaster Leave Sharing Plans

The Internal Revenue Code provides that, except as otherwise provided by law, a tax is imposed on all income from whatever source derived.  Several years ago, the Internal Revenue Service determined that, under certain tightly-defined parameters, an employee who donated leave to a bank which was available for use by other employees with medical emergencies generally did not realize any income.  (In the normal course, the IRS would hold that this was no different than the employee getting cash for the leave and donating the cash, thus creating an income tax liability for the employee making the gift.)

Following the Hurricane Katrina catastrophe, the IRS established parameters under which an employer could establish a written major disaster leave-sharing plan.  Like the tax code generally, this type of plan entails some significant IRS-imposed requirements, including that it is available only for a “major disaster as declared by the President under § 401 of the Stafford Act, 42 U.S.C. § 5170, that warrants individual assistance or individual and public assistance from the federal government under that Act.”  In late May, President Bush issued a Stafford Act declaration with regard to certain storms, tornadoes and flooding in Iowa, and that declaration has been subsequently amended.  While many of our clients have established a “disaster leave-sharing program,” we are concerned that other businesses may not be aware of the possibility. 

The parameters established by the IRS for an acceptable plan (that is, one that will not result in income to the leave-donating employee) include that the donated leave may be used only by other employees who have been “adversely affected” (under the IRS standards, “if the disaster has caused severe hardship to the employee or a family member of the employee that requires the employee to be absent from work”) by the major disaster.  The IRS standards also require that the written plan have a “reasonable limit, based on the severity of the disaster, on the period of time after the major disaster occurs during which a leave donor may deposit the leave in the leave bank, and a leave recipient must use the leave received from the leave bank.” 

Following Hurricane Katrina, the IRS also put in place a program under which employees could make a tax-deductible contribution to certain charities by making a donation of “leave” through a program sponsored by an employer.  That program was specific to Hurricane Katrina, and has since lapsed.

If you have questions about creating or operating a "major disaster leave-sharing plan," a "medical emergency leave-sharing plan," or other arrangements whereby your employees may provide assistance, please contact the Dickinson attorney with whom you normally work or a member of the firm's Employment and Labor Law Practice Group at employmentlaw@dickinsonlaw.com.

Payroll Deposits and FDIC Insurance

This is a little off-topic, but important.  Many businesses pay their employees on Fridays.  The FDIC likes to close banks on Fridays. 

Payroll deposits are treated just like any other deposit for purposes of determining whether the deposits are insured by the FDIC.  So for instance if you have a $40,000 operating account at your bank, a $50,000 capital expenditures account, and a payroll account of $30,000, you have $20,000 at risk.

If you fund your payroll account on a periodic basis from other sources timed to meet the Friday payroll, you might be making a deposit at the same time the FDIC is about to close the bank.

The solution might be to start paying your employees on Wednesdays.

"One must be so careful these days."  (T.S. Eliot, The Wasteland)

-Marc Ward

Operating Agreements should be in Writing

OLP, LLC v. Burningham, 185 P. 3d 1138 (Utah App. 2008) is another example of why members of an LLC should put their deal down on paper (i.e. a written operating agreement).  And beginning in 2009 Iowa operating agreements should contain a clause that requires all amendments be in writing.  (Can you think of anything worse than an orally amended written operating agreement?  Chaos!)

The concept of oral and even implied operating agreements is a law professor's construct that should remain in the classroom.

The Burningham case is a good example of two members who have a falling out over an LLC with an oral business arrangement.  The upshot of the case is that Utah recognizes repudiation as a cause of action that can be maintained without challenging the existence of an LLC or lead to its dissolution.

-Marc Ward

The Duty to Disclose Under Delaware Law

Delaware's Chancery Court recently ruled once again that directors/managers have an affirmative duty to disclose material information when asking their investors to take action.  In Marie Raymond Revocable Trust v. MAT Five LLC, et al, 2008 Del. Ch. LEXIS 77 (June 26, 2008) the court also suggested that when a company is asking its members to release it, and its officers, employees and agents from all claims the investors may have against them for essentially taking the company down the tubes, the company has a duty to describe the underlying reasons the release is being sought.

To sustain a a claim for breach of the duty to disclose a plaintiff must identify material information that was reasonably available but omitted from the disclosure document (in this case a tender offer, but it could also be proxy materials).  The standard for materiality is whether a reasonable investor would consider it important in making a decision or would find that the information would alter the "total mix" of information available.

There will be more on this case soon since the hearing on the plaintiff's motion for a preliminary injunction is scheduled for tomorrow.

-Marc Ward

An LLC Can Qualify as a 501(c)(3) Organization

The Service was busy on our nation's birthday.  In another Private Letter Ruling released on July 4, 2008 the IRS spelled out the 12 requirements that both the articles of organization (if state law permits) and the operating agreement must satisfy in order for an Service to recognize the 501(c)(3) exemption of an LLC that otherwise qualifies for the exemption. 

The organizational language must:

1.  Include a specific statement limiting the LLC's activities to one or more exempt purposes.

2.  Specify that the LLC is operated exclusively to further the charitable or social welfare purposes of its members.

3.  Require the LLC members to be section 501(c)(3) or (4) organizations or governmental units or wholly owned instrumentalities of a state or political subdivision (a "Qualified Member").

4.  Prohibit any transfer of a membership interest to a transferee other than a Qualified Member.

5.  State that the LLC, interests in the LLC, or its assets may only be availed of or transferred to any nonmember in exchange for fair market value unless the nonmember would qualify as a Qualified Member.

6.  Guarantee that upon dissolution the LLC's assets will continue to be devoted to charitable purposes.

7.  Require that any amendments to the articles of organization and operating agreement must be consistent with 501(c)(3).

8.  Prohibit the LLC from merging with or converting into a for-profit entity.

9.  Require that the LLC not distribute any assets to members who cease to be a Qualified Member.

10.  Contain a contingency plan in the event one or more members ceases to be a Qualified Member.

11.  State that the "LLC's exempt members will expeditiously and vigorously enforce all of their rights in the LLC and will pursue all legal and equitable remedies to protect their interests in the LLC." (Not really sure what that means!)

12.  Represent that all of its organizing document provisions are consistent with state LLC law and are enforceable at law and in equity.

PLR 200827041

-Marc Ward

Has the IRS Gone Soft? PLR 200827029

I'm impressed.  The IRS never rests.  It released Private Letter Ruling 200827029 on July 4, 2008.

And an interesting ruling it is.  Company is an S Corp. One of its shareholders sold all of his Company stock to an LLC that was an ineligible S Corp shareholder.  Oops.  The Company later discovers the transfer and termination of its S Corp status.  Still later these shares were transferred by the LLC to its individual members.

The Company and its shareholders represented that the termination of the S Corp election was inadvertent and the Company was unaware that the LLC was an ineligible S Corp shareholder.

The Service ruled that the termination of the S Corp election was inadvertent and it unrung the bell.  The Company would continue as an S Corp as if the transfer to the LLC never occurred, the individual shareholders to whom the LLC transferred its shares would be deemed shareholders from the time of the original transfer to the LLC, and adjustments would be made for this period consistent with the treatment of the Company as an S Corp and the shareholders as S Corp shareholders. 

The transfer to the LLC never happened.

-Marc Ward

A Charging Order Case to Place in Your Quiver

As Iowa lawyers know, we often lack Iowa corporate/LLC case law to support our legal positions.  This is certainly true of the law of charging orders.

Here is a case from Connecticut that confirms the statutory application of an LLC charging order law very similar to Iowa' s law.  Goldberg v. Winogradow, 2006 Conn. Super. LEXIS 3067 (2006).

-Marc Ward

Anheuser-Busch Sues InBev NV/SA

Alleging an illegal plan and deceptive conduct on the part of InBev, Anheuser-Busch upped the ante in the struggle for its future by filing a lawsuit yesterday in the United States District Court for the Eastern Division of Missouri.  You can read the complaint here.

The complaint seeks an injunction against InBev and its officers, agents, servants, employees and attorneys for violating Section 14(a) of the Securities and Exchange Act of 1934 and SEC Rule 14a-9.

-Marc Ward

Words Matter When Drafting Operating Agreements

Not many state LLC Acts are like the one Iowa has adopted effective January 1, 2009, but the Illinois statute is very similar.  How Illinois courts interpret its LLC law will likely have a great deal of impact on Iowa courts and Iowa LLCs.

Federalpha Steel LLC Creditors' Trust v. Federal Pipe & Steel Corp. et al, 368 B.R. 679 (N.D. Ill. 2006) is worth your time to read.  It illustrates how a third party (the court) may interpret provisions of an operating agreement differently than the drafters (the members) intended.

It is a lengthy opinion, but let me give you one example.  The operating agreement between two members provided that a member may not "voluntarily withdrawal" and such withdrawal would be considered a wrongful dissociation under the Illinois LLC Act.  Most lawyers, I think, would interpret that to mean a unilateral withdrawal.

Not so fast.  The two members and the LLC subsequently entered into a Withdrawal Agreement in which one of the members withdrew from the LLC.  The court concluded based on the terms of the operating agreement that such withdrawal might be wrongful and even a breach of its fiduciary duty.

-Marc Ward

Vermont's Virtual Farce: Corporate Law Changes Are No Improvement

The state of Vermont is getting some undeserved credit for adopting amendments to its corporate statute that permit so-called virtual corporations.  It is much ado about nothing.

A visiting law professor at New York Law School who doesn't know much about corporate law, David Johnson, is touting the changes as unique in the country.  They are not.  He makes a big deal out of the fact that Vermont corporations will no longer be required to hold face-to-face annual meetings (I can't help but think of the Town Hall meeting episode from "Newhart").  Iowa has permitted telephonic and video conference meetings for years, and written actions without a meeting have been around even longer.

Iowa, and many other states I am sure, is also ahead of Vermont when it comes to filing annual reports online and permitting electronic signatures.

There are unique aspects to the Vermont law.  Start with the name of the legislation, H.0888 Miscellaneous Tax Documents.  Yep. That is the name of the act.  In Iowa it would be unconstitutional.

But it gets better.  Vermont goes off the deep end in a number of places.  Notice to a shareholder can now be delivered by voice mail. (Is it delivered if not listened to?) And, get this, and I quote: "terms of shares may be made dependent upon facts objectively ascertainable outside the articles of incorporation."  Say What?  Are they serious or did the maple syrup ferment?

If anyone wants to read this zany bill you can get it here.

-Marc Ward

Single Member LLCs and Piercing the Veil

As reported in earlier blogs, it appears that it is becoming easier in some states to pierce the veil of limited liability.  Take the case of Network Enterprises, Inc. v. APBA Offshore Productions, Inc., 264 Fed. Appx. 36,2008 U.S. App. LEXIS 2961 (2nd Cir. February 11, 2008).

In this case the Second Circuit Court of Appeals looked at the veil piercing requirements of the states of New York and Florida.  In New York to pierce the veil it takes (1) a showing of complete domination over  the corporation/LLC with respect to the transaction at issue and (2) such "domination was used to commit a fraud or wrong that injured the party seeking to pierce the veil." (underline added)

In Florida, it takes a showing that the corporation/LLC is the mere instrumentality or alter ego of the owner and the owner "engaged in improper conduct."  (underline added)

The Second Circuit concluded that the defendant completely dominated the LLC and was its alter ego (meeting both standards) because (a) he formed the company,  (b) he was the sole member, (c) he conducted all of its business, signed the checks, and signed the contract that was the center of the controversy, and (d) hold on to your hat, "operated the company from the same address where he maintained his law practice."

These characteristics describe the vast majority of single member LLCs in existence (modifying the last one to fit the circumstances).  In other words, according to the Second Circuit all one has to do is prove that a "wrong" has been committed or the defendant engaged in "improper conduct" in order to pierce the veil of a single member LLC.  Whatever happened to piercing being an extraordinary remedy that courts were reluctant to impose?  Whatever happened to fraud being a necessary element to pierce the veil?  Is a single member safe from personal liability only when they do right?  What of the risk-taker, the gambler, the fool?

Fortunately, Iowa looks at piercing a little differently.  Rather than focusing on domination or alter ego tests, the Iowa courts apply a six-factor test: (1) the corporation/LLC is undercapitalized, (2) it lacks separate books, (3) its finances are not kept separate from individual finances or individual obligations are paid by the corporation/LLC, (4) the corporation/LLC is used to promote fraud or illegality, (5) corporate formalities are not followed and (6) the corporation/LLC is a mere sham.

The six-factor test is certainly preferred.  Let us hope Iowa continues to apply it.

-Marc Ward