Ward on Iowa Limited Liability Company Law

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 

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

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

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

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

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

US Supreme Court Establishes Nerve Center Test for Corporate Diversity Jurisdiction

In a unanimous ruling the US Supreme Court clarified the meaning of a corporation’s “principal place of business” for Federal diversity jurisdiction purposes in Hertz Corp. v. Friend, (No. 08-1107, February 23, 2010).

A corporation’s PPB is the “place where the corporation’s high level officers direct, control, and coordinate the corporation’s activities.”  To put in simply in the words of the Court, it is the corporation’s “nerve center.”

The Court recognized that even their test was not perfect, but was better than the general business activities test used in some Circuits.  It also affirmed that the burden of establishing diversity jurisdiction lies with the party asserting it.  The filing of a form with the SEC, for example, listing the corporation’s principal executive office would not by itself be sufficient proof that it was the nerve center of the corporation.

-Marc Ward

Addendums and Consideration: Margeson v. Artis

In Margeson v. Artis, 776 NW 2d 652 (Iowa 2009), the Iowa Supreme Court affirmed its commitment to the preexisting duty rule when enforcing contracts. 

 

The Margesons had agreed to sell their weight loss franchise to Artis on October 1, 2004 for $125,000.  On October 7, 2004 an addendum to the contract was signed increasing the sale price to $155,000.  At the closing on October 18 loan proceeds were used to pay the original $125,000 and personal checks from Artis totaling $10,000 were delivered.  The balance was to be paid monthly based on sales.  Disputes subsequently arose between the parties; Artis stopped payment on one of her checks and stopped paying the monthly installments.

 

The Margesons sued for the balance of the contract.  Artis objected, claiming the addendum was unenforceable for lack of consideration.  Both the District Court and the Court of Appeals found for Margesons.  The Supreme Court reversed, holding that there was no consideration given for the addendum since the Margesons had a preexisting duty to sell the business under the terms of the original contract.  The Court made it clear that the actual value of the consideration didn’t matter, it just had to exist. The Court went on to reject the theories of estoppels and waiver advanced by the Margesons.

 

Say what you will about the Supreme Court’s slavish attachment to what many commentators and the UCC consider an outdated contract principle, Margeson stands for the requirement that amendments to purchase agreements changing the purchase price require a recital of the independent consideration, no matter how small. 

 

One has to wonder, however, what motivated the change in the purchase price.  And doesn’t the fact that Artis agreed to the higher price imply that she saw value (consideration) in the increase?

 

-Marc Ward

Restraints on Alienation

The Bankruptcy Appellate Panel for the Sixth Circuit handed down a decision recently that at first blush might give business lawyers pause.  In re Hake, 2009 Bankr. LEXIS 3825 (November 4, 2009) holds that an agreement among shareholders requiring the consent of the other shareholders before stock can be transferred is an unreasonable restraint on alienation under Ohio law.  Curiously, the decision was rendered on the basis of a 1945 Ohio Court of Common Pleas opinion and a 1910 Ohio Supreme Court opinion without referencing the Ohio corporate law statute.  What the panel fails to point out is that this restriction was voluntarily entered into by the owners of the enterprise and was now being undone by the court.  What about freedom of contract?

 

Iowa lawyers have no reason to fear this decision, however.  We here in the Hawkeye state take a much more modern view of stock or unit transfers.  The new Iowa LLC Act only makes one reference to transfer restrictions.  In 489.502(6) the law says “A transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement or another agreement to which the transferor is a party is ineffective as to a person having notice of the restriction at the time of transfer.”  Restrictions are thus implicitly recognized in Chapter 489 and since 489.110 dictates that the operating agreement governs the relations of members as members it is safe to say that the operating agreement restrictions on transfer will control. In addition, unlike Ohio, I could not find an Iowa court opinion striking down a stock transfer restriction on the basis of restraint of alienation.  And Iowa corporate law offers strong evidence that requiring the consent of the other members/shareholders before a transfer is valid would be upheld in Iowa.

Iowa Code Section 490.627 says that the articles, bylaws or agreement among the shareholders may impose restrictions on stock transfers so long as the restriction is for a reasonable purpose and lists as one persmissable restriction requiring the corporation, the holders of shares or another person to approve the transfer “if the requirement is not manifestly unreasonable.” 

Not sure how to balance “reasonable purpose” against a restriction that is not “manifestly unreasonable” but it seems to me that a restriction recognized by statute has to be given a presumption of validity and not wanting unknown outsiders to become part owners of a company is certainly reasonable and one of the main underlying reasons for entering into such restrictive agreements.

So, what does manifestly mean?  One author has noted, although "numerous cases apply the concept they rarely explain why a provision is found manifestly unreasonable.” The 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."  Perfectly clear, right?

 

-Marc Ward

When Shall Doesn't Mean Shall

The courts seem to be throwing curve balls lately on the interpretation of some rather common words. In my previous post I discussed the interpretation of "if" by the Idaho Supreme Court.  TonightI am writing about the Iowa Court of Appeals ignoring the word "shall" in ruling that Wild Rose Entertainment, L.L.C. did not breach a contract with John Pavone and Signature Management Group, L.L.C. (Pavone v. Kirke, No. 9-412/08-0180, Ia. Ct. Apls., Nov. 25, 2009).

Wild Rose and SMG entered into an agreement regarding the operation of a casino in Ottumwa (the "October Agreement").  This agreement contained a provision stating that if the Ottumwa project was completed "Wild Rose shallenter into an exclusive management agreement with [Pavone]...This Management Agreement shall provide for an annual management fee equal to four percent (4%)...The terms of the Management Agreement shallbe similar to...the gaming development agreement between Wild Rose and the City of Ottumwa, Iowa."

The court's opinion notes that the parties orally agreed that this agreement would also apply to a possible casino in Emmetsburg.  Presumably then with respect to Emmetsburg the references to Ottumwa should be changed toEmmetsburg.  The Ottumwa casino was rejected by gaming authorities, but the Emmetsburg casino was approved.

The jury found for Pavone and awarded him $10 million. The district court refusedto issue a JNOV.  the court of appeals reversed the trial court and held that this section of the agreement was nothing more than an agreement to agree and was therefore unenforceable.

First, the court held that the October Agreement was a consulting agreement, not a management agreement.  It is not clear why the characterization of this contract is relevant.  Whether the October Agreement is a management agreement or a consulting agreement is not the point.  Pavone was contending that Wild Rose was required to enter into a management agreement because the Emmetsburg casino was approved.

Next, the court found that the October Agreement failed to contain many key terms regarding the management agreement including the hiring and firing of key personnel, the term of the agreement and the scope of services.  However, as the district court pointed out in its ruling, the referenced agreement with Ottumwa contained all of these terms and it was reasonable to assume that management included the hiring and firing of key personnel.

The fact that the district court and the court of appeals could come to different conclusions should have been enough to find that a jury could too, but I find it very interesting that the use of the word "shall" was never discussed.  Lawyers choose their words carefully.  What did they mean when both sides agreed to the use of the word "shall"?

Dictionary.com says it means "must or is obliged to."  Merriam-Webster's says it is used to express what is mandatory.  That is how I use the word. Apparently, the Iowa Court of Appeals thinks otherwise.  So what are lawyers now supposed to think it means?

-Marc Ward

On the Road Again

I just finished two days of LLC seminars in Des Moines and Cedar Rapids and will be appearing at the ISBA's Travelling Seminar in Sioux City on Tuesday, September 29.  Mark your calendars for the Iowa Law School's Corporate Law Seminar on November 6.  I'll be discussing the latest LLC developments at that seminar too.

-Marc Ward

Ethics Committee Issues Opinion 09-03 Affecting Business Lawyers

The issue addressed by Ethics Opinion 09-03 is whether a law firm can represent a client in litigation arising out of a business transaction in which the firm also represented the client.  The Opinion applies two tests for determining whether a lawyer can continue her representation of the client.  The first concerns whether the representation will be materially limited by the personal interest of the lawyer to defend her own work product.  The second test concerns whether the lawyer will be a necessary witness in the trial.  The thrust of the opinion leans towards finding a conflict of interest in such cases.

Here is a link to the opinion: http://tinyurl.com/ksn65l.

-Marc Ward

Senate File 413 Must be Defeated

I know it seems early to be concerned with the 2010 Iowa Legislature, but there is a bill carried over from last year that the Bar Association and others have been told will certainly become law if something isn't done about it.  And it is a bill that should not become law.

Why am I so concerned with SF 413?  Because by creating a new Iowa Code Section 91A.15 it imposes personal liability on officers of corporations, members and managers of LLCs and partners in partnerships "for a judgment obtained against an employer for failure to pay wages dues pursuant to Iowa Code Chapters 91A or 91D (Wage Payment Collection and Minimum Wage, respectively).  It is such a poorly written bill that it excludes corporate directors and shareholders, but includes LLC managers and members, the drafter apparently not realizing that they are practically interchangeable concepts.  It is also unclear whether it applies to LLPs and LLLPs.

Subsection 2 of this proposed new 91A.15 attempts to soften the liability exposure of subsection 1 by limiting it to persons (a) who control, supervise or have authority over wages and (b) who have a controlling interest or ownership in the entity and knowingly violate 91A or 91D.

This is not as limiting as it might seem because none of the terms are defined.  What is "control"?  Is being a manager having "authority for"?  What does it mean to "knowingly" violate?

If this law is passed you can kiss LLCs in Iowa good-bye.  The Legislature will also make it very difficult for out-of-state businesses organized as LLCs to do business in this state.  In other words, the preferred business entity, chosen by 77% of all new businesses in the State of Iowa, will be persona non grata.  Don't let any legislator who votes for this bill try to tell you they are pro-business or an advocate of business development in Iowa because they are not.

I appreciate what the sponsors of this bill are trying to do, but there is a better way to do it: Codify the elements of piercing the corporate veil.  Doing so will give clear guidance to owners and courts alike and see that people are punished for their conduct, not merely their ownership.

-Marc Ward

Words of Wisdom from the Solo and Small Firm Seminar

Last Friday Steve Roy, Frank Carroll and I spoke to the Solo and Small Firm Seminar about the new LLC law.  It is always good to hear from others in the profession about a subject that has a lot of open questions.  Here are some pearls of wisdom from the panel:

1.    Read the operating agreement.  This gem is from Frank Carroll.  He noted that he has run across a lot of lawyers including in-house counsel that will read a particular section of the act, such as the provision that calls for unanimous votes to amend the operating agreement, and assume that it is the new law in the Tall Corn State.  Of course readers of this blog should know otherwise.  The operating agreement will still control if it speaks to the issue.  The statute is the default rule in the absence of words to the contrary in the operating agreement.  Which leads me to the second pearl.

2.    The default rules stink.  Steve Roy delivered this line.  And it is so true.  Imagine an LLC that shares distributions on a per member basis regardless of the investment by the members, that requires the members to manage the company with each member having one vote on all matters that come before them, and requires unanimous consent to change the "operating agreement" that can be oral, written or implied.  I am afraid there might be quite a few out there already and they don't even know it.

3.    Read Section 110, read it and understand it.  This section explains how the operating agreement interacts with the Act.  Understanding section 110 is critical to drafting an operating agreement.

4.    Try to get your clients to focus on their fiduciary duties.  Because the duties of care and loyalty can be altered and in some cases eliminated, bringing this issue up early with your clients is of critical importance.  It is also difficult in practice if you are dealing with neophytes.  I've run into cases where the clients' eyes glaze over as you talk about their fiduciary duties and how they should consider addressing them up front.  They just want to sign the papers and start making money (hopefully).

5.    Clients need to deal with single member LLCs carefully.  The casebooks, at least figuratively in this digital world, are full of cases of the veil being pierced when the LLC or corporation is owned by only one person.  Dot the i's and cross the t's when organizing them and for God sake keep the money separated between the company and the owner.

-Marc Ward

Fooling with the Shareholder Franchise Could Invite Judicial Scrutiny

As you all know, loan agreements include financial and non-financial covenants imposed on the borrower.  Failure to maintain a covenant leads to an event of default.  A financial covenant might be maintaining a certain debt-to-equity ratio.  A non-financial covenant might be preventing a change in control of the board of directors.  Changing the make-up of a board of directors, is of course, the right of the shareholders.  When a board of directors agrees that such a change could trigger a default under a loan it may be impermissibly intruding on the shareholders' franchise.

Here is what Vice Chancellor Lamb had to say on the subject in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., 2009 WL 1337150 (May 12, 2009):

“This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. In the context of the negotiations of a debt instrument, this is particularly troubling, for two reasons. First, as a matter of course, there are few events which have the potential to be more catastrophic for a corporation than the triggering of an event of default under one of its debt agreements. Second, the board, when negotiating with rights that belong first and foremost to stockholders (i.e., the stockholder franchise), must be especially solicitous to its duties both to the corporation and to its stockholders. This is never more true than when negotiating with debtholders, whose interests at times may be directly adverse to those of the stockholders. Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.”

The case is on appeal.

-Marc Ward

8th Circuit Makes General Contractors their "Brother's Keeper"

On February 26, 2009, in Secretary of Labor v. Summit Contractors, Inc., 2009 U.S. App. LEXIS 3755, the United States Court of Appeals for the Eighth Circuit overturned the decision of the Occupational Safety and Health Review Commission (“OSHRC”) and held that a controlling employer can be cited for OSHA violations even when it did not create the hazard and none of its employees were even exposed to the hazard giving rise to the citation. 
 
Summit Contractors (Summit) was the general contractor for a construction project in Little Rock, Arkansas.  It subcontracted the entire project, and therefore had only 4 employees on the site:  a project superintendent and three assistant superintendents.  All Phase Construction (All Phase) was the subcontractor responsible for the exterior brick masonry work.  On two or three occasions Summit’s project superintendent observed All Phase employees operating without personal fall protection on scaffolds lacking guard rails.  The superintendent advised All Phase to correct the problems; however, when the All Phase employees moved the scaffold to another location, they would again work without fall protection and guardrails.  None of Summit’s employees were exposed to the hazard. 
 
An OSHA Compliance Safety and Health Officer observed All Phase employees working on scaffolds over ten feet above ground without fall protection or guardrails.  In addition to citing All Phase, the officer issued a citation to Summit, based on OSHA’s controlling employer citation policy.   That policy provides that OSHA may issue citations to general contractors at construction sites who have the ability to prevent or abate hazardous conditions created by subcontractors through the reasonable exercise of supervisory authority, regardless of whether the general contractor created the hazard or whether the general contractor’s own employees were exposed to the hazard.
 
The OSHRC had held that the multi-employer policy violated 29 C.F.R. §1910.12(a), which provides:
The standards prescribed in part 1926 of this chapter are adopted as occupational safety and health standards under section 6 of the Act and shall apply, according to the provisions thereof, to every employment and place of employment of every employee engaged in construction work.  Each employer shall protect the employment and places of employment of each of his employees engaged in construction work by complying with the appropriate standards prescribed in this paragraph.
 
The Eighth Circuit concluded that the plain language of the regulation does not preclude the Secretary of Labor’s controlling employer citation policy and therefore the Commission abused its discretion in determining that the controlling employer citation policy conflicted with § 1910.12(a). 
 
As the Eighth Circuit acknowledged, the controlling employer citation policy places an enormous responsibility on a general contractor to monitor all employees and all aspects of the worksite.   “Control” resulting to exposure to a citation under the policy can be established by contract, or by the exercise of control in practice.  Even in the absence of explicit contract provisions granting the right to control safety, or where the contract says the employer does not have such a right, an employer may still be found to be a controlling employer, based on a combination of contractual rights that give it broad responsibility at the site involving almost all aspects of the job.  Responsibilities of key significance in this analysis include the authority to resolve disputes between subcontractors and  set schedules and determine construction sequencing, because of the likelihood that these matters may affect safety. 
 
It is of small consolation that the standard OSHA will use to determine if the controlling employer exercised reasonable care to prevent and detect violations on the site is a lower one than that required of an employer with respect to protecting its own employees. How frequently and closely a controlling employer must inspect to meet its standard of reasonable care will depend upon the scale of the project, the nature and pace of the work, and how much the controlling employer knows about the safety history and practices of the employer it controls.  More frequent inspections are needed if the controlling employer knows that the other employer has a history of non-compliance, or, at the beginning of a project if the controlling employer has no knowledge of the other employer’s compliance history. 
 
Challenges to OSHA’s controlling employer citation policy can be expected to continue.  The two to one decision in Summit was a narrow one and it included a vigorous dissenting opinion.  The decision did not evaluate OSHA’s overall multi-employer citation policy and, although the issue was not raised by the parties, the Court suggested that OSHA may need to submit the policy to the informal rulemaking process for continued use in enforcement.  Nevertheless, at the present time, general contractors and construction managers must be vigilant in their supervision of the worksite to avoid liability for the safety infractions of other employers. 

-Joan Fletcher

jfletcher@dickinsonlaw.com

Walker, Ward and Nelson to Write Sample Forms

David Walker and I have been tapped to write sample forms for the Iowa State Bar Association's Business Law Manual.  Chris Nelson of the Belin law firm will also assist.  We expect to have the samples ready this Spring and include a form for the Statement of Authority.

Small Bank Tax Equity Act

Legislation that would permit state chartered banks to operate as LLCs has been introduced in Congress by Senators Orrin Hatch and Blanche Lincoln.  Many state laws, including Iowa's, and FDIC regulations allow banks to operate as LLCs, but IRS regulations require such entities to be taxed as corporations.  The Small Bank Tax Equity Act would change that.

The American Bankers Association and the Independent Community Bankers support the bill.

-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

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