Ward on Iowa Limited Liability Company Law

Should LLCs Issue Ownership Certificates?

The answer is generally no.  Like the corporate seal, certificates are fast becoming anachronisms whose only purpose is to be lost (See Iowa Code 490.625(1) which implies that corporate stock certificates are no longer necessary). 

Because of, let’s be optimistic for a moment, the completeness of operating agreements, all of the components of ownership should be adequately explained in the agreement.  Including certificates in addition to the operating agreement runs the risk of confusion if the operating agreement is subsequently amended, but the certificates are not.  The existence of certificates also may lead to transfers contrary to the terms of the operating agreement that may nevertheless raise bona fide purchaser issues.

Now, having said that, there is one instance where certificates may be necessary.   If the ownership interests are to be pledged as security for a loan most lenders will require certificates and for the LLC to opt into Article 8 of the Uniform Commercial Code.  Section 554.8103(3) of the Iowa Uniform Commercial Code provides that an interest in an LLC is a security under Article 8 if its terms expressly provide that it is a security governed by the Article.  A share of stock in a corporation is always a security under Article 8.  See Iowa Code Section 554.8103(1).

If you need an LLC ownership certificate to pledge to a lender or just for old-times’ sake, I’ve attached a form of one for your use here.

-   Marc Ward

LLCs are Preferred in Iowa by more than 3 to 1

The formation of Iowa LLCs continues to outpace corporations.  In 2009, 8,422 LLCs were organized in Iowa compared to just 2,571 for-profit corporations.  This is a better than 3 to 1 ratio. This is consistent with almost every other state in the Union save California and New York.

Why are corporations still favored over LLCs in these two states?  In New York it has to do with the holding of the Tax Appeals Tribunal that all members of a limited liability company are subject to per se liability for the taxes due from the limited liability company. 

In California it has to do with the unreasonable fear of the trial lawyers and their influence on legislation that prevents most businesses that need a license under the California Code (for example, contractors and physicians) from operating as LLCs.  In addition, LLCs in California are subject to a substantial tax on gross receipts over $250,000.  This tax does not apply to corporations or limited partnerships.

In case you are wondering about the number of other entities formed in Iowa last year, there were 83 general partnerships, 418 limited liability partnerships, 33 limited partnerships and 33 limited liability limited partnerships. 

A big thank you to Harry Davis of the Iowa Secretary of State’s office for gathering this information for me.

-Marc Ward

Prohibiting Certain Classes of Individuals from Serving on Corporate Board Upheld

Interesting case, Ute Indian Tribe v. Ute Distribution Corporation, 2010 U.S. Dist. LEXIS 22928, (C. Div. Utah, March 12, 2010).  The plaintiff, the Ute Indian Tribe of the Uintah and Ouray Reservation (the "Ute Tribe"), sought to have certain amendments to the articles of incorporation of Ute Distribution Corporation (the “UDC”) declared void. UDC is a non-profit, Utah corporation organized to manage and distribute assets held by the Ute Tribe and the former members of the Ute Tribe.  Since the formation of the UDC there has been extensive and pervasive hostility and disagreement between the Ute Tribe and the UDC.

The main amendment of interest prevents Ute tribal members and Ute tribe employees and agents from being on the UDC Board of Directors. The Ute Tribe sought to have the court reverse the vote of the shareholders because the amendment disenfranchised them as shareholders and in effect created two classes of stockholders necessitating separate class votes (See e.g., Iowa Code Section 490.1004).  About 70% of the UDC shareholders voted in favor of the amendments. The Ute Tribe, the holder of approximately 20% of the UDC shares, opposed the amendments.

The rationale for the amendment has to do with the joint management of the joint assets of the Ute Tribe and the former members of the Ute Tribe now referred to by the court as mixed-bloods.  The Tribal Business Committee represents the interests of the Ute Tribe. The UDC represents the interests of the mixed-bloods.  Neither the UDC nor its mixed-blooded shareholders have representation on the Tribal Business Committee which manages the Ute Tribe’s interests in the joint assets.

 The UDC argues that allowing members of the Ute Tribe to sit on the UDC board would undermine the UDC's role in administering the assets on behalf of the mixed-bloods because tribal members have inherently opposing and conflicting interests.

Recognizing that the Utah corporate statute permitted the bylaws to provide for qualifications of a corporation’s directors, but with scant case law in support, the court concluded that eligibility restrictions could include not only “age, education, experience and knowledge suitable to advance the purpose of the corporation, but also the ability to require that directors not be constrained by relationships that call into question their ability to exercise complete loyalty and fidelity to the corporation and shareholders they have been elected to serve.”

In essence, the court approved an amendment that prejudged a class of individuals, shareholders no less, as inherently unable to act in the best interests of the corporation because of their status.  And it reversed the statutory construction by permitting disqualifications rather than qualifications for board service.

Cases cited in support of this proposition were three.  Only one, McKee & Co. v. First National Bank, 265 F. Supp. 1, 5 (S.D. Cal. 1967), supported the court’s holding.  Of the other two, one concerned the ability of the shareholders to remove a director who was disloyal, and the other did not involve the qualification of directors at all, but concerned the ability of a board to impose restrictions on the transfer of a corporation’s stock after it is issued (it can).  Tu-Vu Drive-In Corp. v. Ashkins, 391 P.2d 828, 829 (Cal. 1964).

Against this backdrop the court noted that the argument of disenfranchisement was ineffective because the Ute Tribe could not have set on the board in any event and it was still free to nominate and vote for individuals to be directors of the UBC (so long as they weren’t members, employees or agents of the Ute Tribe).  The court reasoned that so long as “the qualification is reasonably designed to promote the legitimate purpose of advancing the best interests of the corporation and does not violate other laws, such as a restriction on race or national origin, principles of corporate governance must allow the shareholders to make decisions about who will best protect their interests.”

Oddly, the court waited to the end of its opinion to cite an Iowa case that happened to be right on point and then cited it merely for the proposition that the business judgment rule also protected the actions of the UDC board.  See Cent. Iowa Power Coop. v. Consumers Energy, No. 7-402/06-1060, 2007 Iowa App. LEXIS 988, at *8 (Iowa Ct. App. Sept. 19, 2007) (amendment to the articles could prohibit officers and employees of co-op members from sitting on the board).  That, my friends, is the take away from this case.   

-Marc Ward

IRS Throws in the Towel on Passive Activity Losses and LLCs

After losing for the fourth time in court, the IRS has decided to accept the fact that under present regulations a member’s interest in an LLC taxed as a partnership is not equivalent to a limited partnership interest for purposes of the passive activity loss rules.  See Newell v. Commissioner, Dec. 58,127(M), T.C. Memo 2010-23.

The question now becomes what will happen to those LLC members who want to be treated as limited partners for purposes of SECA, the self-employment tax.  Can they have it both ways?

-Marc Ward

Baur v. Baur Farms, the Iowa Court of Appeals Weighs in on Minority Oppression

The Iowa Court of Appeals has issued another interesting opinion.  In Baur v. Baur Farms, Inc., (No. 9-931/09-0480, February 10, 2010), the court considered whether the statute of limitations had run on a claim of minority shareholder oppression.  The applicable statute of limitations in this case is five years as set forth in Iowa Code Section 614.1(4).

 

The plaintiff in this case owned a minority interest in a family farm corporation.  The corporation was incorporated in 1966 by two brothers.  Because only one of the two brothers had a child interested in farming, the brothers agreed that the stock would be owned 51% to 49% with the majority interest going to the brother with the son willing to continue the farm.  The plaintiff in this case is the son of the original minority shareholder and owns 26.29% of the stock.  The defendant owns the 51% inherited from his father.

 

The court noted that certain alleged oppressive acts by the majority shareholder were discrete acts clearly time barred (removal of the plaintiff as an officer, land purchases, use of a corporate vehicle, expansion of the board of directors).  However, the plaintiff also alleged that the defendant’s refusal on numerous occasions, most recently 2007, to purchase his minority interest without a minority discount was also an oppressive act.  The court agreed that the defendant’s insistence on a minority discount along with other potentially wrongful conduct could be oppressive and raised a sufficient issue of material fact to avoid summary judgment on the basis of the statute of limitations.

 

The problem with the court’s analysis is its reliance on Iowa Code Section 490.1301(4).  This section defines “fair value” of a shareholder’s stock in the context of a shareholder vote that if approved would force a change in the status of a minority shareholder.  The specific actions outlined by the Code are mergers, share exchanges, sales of assets, reductions of a shareholder’s shares to a fraction if the corporation can then purchase the fractional interest, and conversions to another entity.  In each of these situations, the minority shareholder’s interest in the corporation is being changed by the actions of the majority.  In Baur the defendant was merely offering a counterproposal. The status of the plaintiff as a shareholder was not being affected.

 

The court’s reliance on Security State Bank v. Ziegeldorf, 554 NW 2d 884 (Iowa 1996) is likewise inappropriate.  In that case the minority shareholder was forced by the actions of the majority shareholder to be paid for his stock subject to a discount for lack of marketability as a result of a reverse stock split.

 

By applying the definition of fair value outside the context of 490.1301 et seq the court of appeals is in effect saying that majority and minority shareholders cannot freely negotiate a price for the minority’s shares; the price is fixed at the statutory definition of fair value.

 

How far can this case go?  Does it mean that a majority shareholder must accept an offer to buy a minority shareholder’s shares at fair value?  That is, can a majority shareholder just say no and refuse any offer?  Or would such refusal be considered oppressive conduct by the court of appeals?

 

-Marc Ward