Ward on Iowa Limited Liability Company Law

LLC Managers and Conflict of Interest Transactions

How you draft an operating agreement can have a bearing on who has the burden of proof when a dispute arises.  This is particularly true when managers engage in transactions with the company. 
In the corporate context, by statute in Iowa and most other states, the burden is on the director to prove that the challenged transaction was fair.  But in the case of LLCs the operating agreement can be drafted, intentionally or not, to shift the burden to the unit holder challenging the transaction. 
It all depends on how you write the provision on conflicts of interest.  If you borrow from the corporate world, the burden will be on the managers.  But, as was the case in Zimmerman v. Crothall, 2013 WL 398946 (Del. Ch. 1/31/13), if the operating agreement instead grants the managers the right to contract with the Company so long as it fair, then the burden is on the unit holder.

-Marc Ward

Two Recent, but Frustating Cases Regarding LLCs and Operating Agreements

Culling through LLC cases can be a discouraging business.  I often find cases that are poorly argued by one side or the other or cited provisions of operating agreements that are poorly drafted.  Too often the courts never are allowed to get to the heart of the matter.

Take these two recent cases. Please (apologies to Henny Youngman). In Lakes Region Gaming v. Miller,(No. 2011-394 S. Ct. N.H., February 13, 2013), a 5-member LLC was formed to purchase the Lakes Region Greyhound Park. One of the members, Johnston Development, contributed its right to
purchase the track and another member, Gistis, contributed the down payment to secure the purchase.  What the other members contributed is not stated.  The purchase of the track was never closed due to a grand jury indictment involving the track but not the LLC or its members. The members of the LLC decided to sell its right to purchase the track to recoup its expenses and maybe make a profit. 

Unbeknownst to three of the members, Miller and Johnston Development negotiated and sold the right to purchase the track, pocketing the $900,000 profit for themselves and not the LLC. The other members and the LLC sued Miller and Johnston Development.  A default judgment was entered against Johnston Development and the trial court found Miller breached his fiduciary duty to the plaintiffs, awarding them $900,000 in damages. 

On appeal Miller argued that he did not owe the other members a fiduciary duty since he was a minority member and paragraph 10 of the operating agreement let him off the hook. A ruling on the fiduciary duty issue would have been of interest to all of us, but the appellate court refused to entertain it since Miller did not raise it at the trial level.  What?!  So Miller was left to argue that he “thought” Johnston Development owned the right to purchase the track (even though he was a member of the LLC along with Johnston Development) and the down payment was a loan, not a contribution to the LLC. Neither the trial court nor the supreme court bought that line of reasoning.

This left Miller with arguing that he and Johnston Development were competing with the LLC and paragraph 10 of the operating agreement allowed him to do it. Provisions like paragraph 10 are common in operating agreements.  It provided in short that being a member of the LLC did not prevent a member from engaging in other businesses even businesses that “may be in competition with the Company” and doing so was not “a breach of any fiduciary duty” by a member.  The court easily concluded that using assets of the LLC to enrich himself at the expense of the other members was not competition.

In the other case, McAteer v. Dugan, 5-11-0148, Ill. App., February 10, 2013, we have at issue another provision common to operating agreements, but this one is vaguely drafted.  As a means to resolve disputes, typically between two members, operating agreements allow a member to offer to the other her membership interest at a proposed price. The other member has a certain number of days to accept the offer or turn the tables and sell his membership interest to the member who first made the offer. The chance that you might have to buy the other’s interest at the same price you offered to sell forces you to make a fair offer in the first place.

That is what happened in this case, but the applicable provision of the operating agreement was written with two conflicting ideas in mind.  It started out like a clause of a typical buy-sell agreement, if a member wants to sell or otherwise transfer his interest to a third-party, it must first offer the interest to the other members, but ends up reading like a typical dispute resolution provision.  It would have been interesting to see how the parties would have argued and the court would have discerned the proper interpretation of the confusing language, but because the defendant utterly failed to defend himself we are left with a judgment against the defendant more out of frustration than legal interpretation.

 -Marc Ward

LLC Operating Agreement Can Supplant Implied Duty of Good Faith

The Delaware Court of Chancery recently considered whether a limited partnership agreement provision establishing a good faith standard could replace the implied duty of good faith. In re K-Sea Transportation Partners L.P. Unitholders Litigation (No. 6301-VCP, decided April 4, 2012). 

The relevant section of the limited partnership agreement declared that if the general partner relied on the opinions of investment bankers or other advisors it reasonably believed to be within their professional or expert competence, then the actions of the general partner taken in such reliance “shall be conclusively presumed to have been done or omitted in good faith….” 

In this case the general partner had approved a merger of the limited partnership into another entity only after inducing the acquirer to increase its bid to include an $18 million payment to the general partner for certain units only it held (and arguably worth only $100,0000).   A well-known investment banking firm issued a fairness opinion favorable to the transaction. 

Noting that the implied covenant of good faith is only a gap-filler and cannot be used to contradict an unambiguous contractual right, the court concluded that the plaintiff’s claims of breach of a fiduciary duty must be dismissed.  (For a variety of reasons the court narrowed the scope of the claims to an inquiry of bad faith.  See the opinion if you want to learn more.) 

Because of the similarities between limited partnerships and limited liability companies and their respective governing agreements, the principle in this case is easily applicable to LLC operating agreements.  Drafters may want to consider establishing a process by which managers of LLCs can be deemed to act in good faith and avoid application of the implied duty of good faith.

-Marc Ward

Boiler Plate in LLC Operating Agreements is Risky Business

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

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

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

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

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

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

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

-Allison M. Lindner

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

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

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

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

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

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

-Ben Bruner

Explicit Provisions in an Operating Agreement may create Implicit Provisions

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

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

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

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

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

- Allison M. Linder

Creditors of an LLC can Collect from Members in Certain Cases

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

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

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

-Ben Bruner, Dickinson associate

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

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

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

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

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

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

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

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

 - Allison M. Lindner

Associate, Business Law Section of the Dickinson Law Firm

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

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

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

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

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

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

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

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

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

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

 -Marc Ward

LLC Operating Agreements Must be Drafted with Care

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

 

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

 

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

 

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

 

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

 

-Marc Ward

LLC Buy-Sell Provisions Should Cover a Change in Control

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

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

-Marc Ward

LLC Operating Agreements and the Statute of Frauds

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Put your deals in writing!

 

-Marc Ward

It Depends on the Meaning of "If"

Consider a partnership or LLC Agreement that says a partner/member may withdraw from the partnership/LLC "at any time if" (a), (b), (c) or (d) occur and if a partner/member withdrew for one of the four reasons, then specific consequences would result (termination of the partnership/LLC interest, etc.) Would you consider the four events to be the only reasons a partner/member could withdraw? Or does it just describe what happens if one of these four events occurs, leaving open the possibility that a partner/member may withdraw for other reasons without violating the partnership/LLC agreement?

In St. Alphonsus Diversified Care, Inc. v. MRI Associates, LLP, 2009 Ida. LEXIS 198 (Idaho Supreme Court, October 21, 2009), the court held the latter.  The court concluded that "if" was not exclusive, but really meant "in the event that."  With this meaning the pertinent provision of the partnership agreement merely described what happened under four circumstances resulting in a withdraw.  It did not prohibit other reasons for withdrawal.  The court went on to conclude that the partner's withdraw was not wrongful under the RULPA because it did not violate an "express provision" of the partnership agreement (same language can be found in the Iowa RULPA and the Iowa LLC Act, Section 489.601(2)(a)).

Based on this decision, to write an ironclad operating agreement provision limiting the right of a member to withdraw from an LLC do not use "if" but instead use something like this "A member shall not withdraw from the LLC except...." or "A member may only withdraw from the LLC under the following circumstances..."

-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

Members of 490A LLCs May Owe Fiduciary Duties to Each Other

In Bushi v. Sage Healthcare PLLC, 203 P. 3rd 694 (Idaho 2009), the Idaho Supreme Court held that members of Idaho LLCs owe one another fiduciary duties.  The court reached this conclusion even though the applicable Idaho LLC Act was silent on the issue (like Iowa, Idaho is transitioning from an original LLC statute to a new one, the latter providing that members do owe each other the fiduciary duties of care and loyalty).

These fiduciary duties can be breached even if the members act within the letter of the operating agreement.  In Bushi, the majority of the members, all save Bushi himself, amended the operating agreement to allow a member to be dissociated by majority vote and then promptly removed Bushi by a similar vote.  They contended that they had good reason to dissociate him because he was dating an employee and had used a company line of credit to pay personal expenses.  Bushi argued that he was dissociated in order to advance their personal financial interests.  Because taking an action that improperly advances their financial interests can be a breach of a fiduciary duty even if technically allowed by the operating agreement, the court concluded that a material factual issue remained that negated the entry of summary judgment.

The case also mentions a provision in the operating agreement that lawyers should consider inserting into their forms.  The operating agreement stated that "no Member shall have any vested rights in the [operating agreement] which may be modified through an amendment to the [operating agreement]."  This provision negated Bushi's assertion that he was denied the benefits of the original operating agreement.  In its original form the operating agreement did not permit the members to essentially expel another member.

-Marc Ward

A Troubling Development out of Delaware re Operating Agreements

In Mickman v. Am. Int'l Processing, LLC, 2009 Del. LEXIS 43 (April 1, 2009) the Delaware Chancery Court drew this conclusion in a comparison to corporations: "Based on the flexible and less formal nature of LLCs, it is reasonable to consider evidence beyond the four corners of the operating agreement, where, as here, the plaintiff has presented admissible evidence that, notwithstanding the language of the operating agreement, suggests the parties to that agreement intended to make, and believed they had made, the plaintiff a member of the LLC."

At first blush I thought an integration/merger clause in the operating agreement would solve this or a provision requiring all amendments to be in writing.  The opinion is silent as to whether the operating agreement in this case contained such provisions.  But I am not so sure.  Then I remembered something from law school called the parol evidence rule and thought that should clear things up.  Nope.

In Iowa the parol evidence rule "forbids the use of extrinsic evidence to vary, add to, or subtract from a written agreement." Montgomery Props. Corp. v. Econ. Forms Corp, 305 NW 2d 470, 476 (Iowa 1981).  But this is limited to negotiations or agreements that are prior to or contemporaneous with the written instrument. Garland v. Brandstad, 648 NW 2d 65, 69 (Iowa 2002).

In this case you have an operating agreement that presumably identified two persons as the members of an LLC and extrinsic evidence after the fact (i.e. a tax return) showing three. 

I take exception with the Chancery Court that LLCs are less formal than corporations, less rigid, yes, and certainly more flexible, but in any case no less entitled to application of the same contract rules as apply to corporations.

The reason the Iowa LLC Committee adopted 489.111(4) (there is no comparable provision in the Uniform Act) was to avoid this situation.  Section 111(4) says "An operating agreement in a signed record that excludes modification or rescission except by a signed record cannot be otherwise modified or rescinded."

Is this court saying that such a limitation can be ignored because LLCs are informal organizations and members don't mean what they say in a contract?  I hope not.  It does reinforce in my mind the absolute necessity of restricting amendments to those that are in writing and agreed to by (usually) all of the members.

-Marc Ward

Default Language that Didn't Go Away

Both the Iowa Uniform Limited Partnership Act (Iowa Code Chapter 488) and the new LLC Act (Iowa Code Chapter 489) provide statutory default language that a partnership agreement or LLC operating agreement can only be amended by the unanimous consent of the partners or members.  The unanimity requirement can be overridden by the terms of the respective agreements.  Oh, really?

Not so held the In re: LJM2 Co-Investment, L.P. Limited Partners Litigation court.  The opinion of the Delaware Chancery Court can be found at 866 A. 2d 762 (2004).

The limited partners of LJM2 tried to weasel out of their obligation to heed a capital call by amending the limited partnership agreement to eliminate the obligation (after the general partner had properly made the call!).  They also canned the general partner, replacing it with a more friendly one.

A majority of the limited partners, but not all of the limited partners approved the amendments.  The limited partners relied on a provision of the agreement that authorized amendments "in any respect" upon the agreement of a majority of the limited partners.  However, this provision contained the proviso, and possible boilerplate term, that no amendment could change the percentage necessary for any consent unless the amendment was approved by the same percentage.  So what is the catch?

The Delaware RULPA contained a default provision that an obligation of a limited partner to make a contribution may be compromised only by the consent of all partners.  Iowa has a similar provision at Iowa Code Section 488.502.  The Delaware Court read this default provision into the partnership agreement notwithstanding the "in any respect" language.

This decision should be a concern for Iowa limited partnerships since the Delaware and Iowa RULPAs are very similar.  It is not an issue for Iowa LLCs because there is no similar provision regarding obligations to make agreed to capital contributions.

-Marc Ward

Be Careful What You Wish For!

In Fuiaxis v. 111 Huron Street, LLC, 2009 WL 203625 (N.Y. A.D. 2 Dept. 2009) the plaintiff got hoisted on the operating agreement.

Fuiaxis withdrew from an LLC and then brought an action against the LLC and the three remaining members for among other things judicial dissolution.  The LLC and the three defendants turned around and made a demand on the plaintiff for $10,000 to defend the litigation and to pay for fines imposed by the City of New York for boiler violations.

The demand was based on paragraph 17 of the operating agreement which permitted the LLC to make a capital call on the members and allowed the membership interest of a defaulting member to be purchased by the other members.  The court refused the plaintiff's request that the demand not be enforced because the New York LLC Act authorized such a demand.  Ouch!

My thanks to Professor Dan Kleinberger for bringing this case to my attention via the lnet-llc list serve.

-Marc Ward

Begin the New Year by Reading a Sample Operating Agreement!

As you know, tomorrow brings significant changes to Iowa limited liability companies.  All LLCs formed after today will be subject to new Iowa Code Chapter 489.  Existing LLCs will need to start transitioning to Chapter 489 effective January 1, 2011.  All operating agreements of LLCs formed prior to 2009 should be reviewed and necessary amendments made prior to December 31, 2010.

To assist in the process I have prepared a sample operating agreement based on the default provisions of Iowa Code Chapter 489.  You can find the form here.  It should be used as a guide only, modified to fit the needs of each particular situation.  Non-lawyers should not use it without consulting with a lawyer.

Have a happy New Year!

-Marc Ward

The Unwritten Written Operating Agreement

There will be many opportunities to screw up when the new Iowa LLC Act takes effect on January 1, 2009.  While existing LLCs can wait until 2011 to worry about it, your 2008 forms may need sprucing up before you start drafting agreements for new LLCs. (I know readers of this blog write all their documents from a blank slate, but some lawyers are known to use versions of previous agreements when writing new ones -- this post is for them.) Here is one example.

Under current law operating agreements must be in writing (unless the articles permit otherwise) which implies that all amendments must be in writing.  The new Iowa LLC Act will allow operating agreements to be oral in all cases.  It will also, and this is the rub, allow written operating agreements to be amended orally unless the operating agreement limits amendments to those in writing.  There is also the possibility of an implied amendment based on conduct.

Now, it is common for most written agreements to provide that all amendments must be in writing signed by all parties.  But you better make sure beginning in 2009.  And what about your clients who wrote their own operating agreements?

-Marc Ward

Eighth Circuit: The Power to Redeem includes the Power to Remove

In an operating agreement the members authorized the redemption of all or part of their interest by the LLC.  The LLC could exercise this right by written approval of the holders of more than 65% of the distribution percentages and notice to the ousted member.  A separate section of the operating agreement required payment of the redemption price within 10 business days. 

Three LLCs were at issue.  The same three members owned each LLC.  Two of the members owned more than 65% of the distribution percentages of each LLC. The expelled member (and plaintiff) owned less than 35% of each LLC.

The redemption notice was signed by the managing member of the two majority members of the 3 LLCs.  The plaintiff was "removed from [the 3] companies" pursuant to the letter, but the redemption price was never paid.

The removed member brought suit claiming that it was still a member of the LLCs because the operating agreement authorized redemption, not removal.  Redemption was not properly approved, notice of redemption was not given, and the redemption price was not paid.  Urban Hotel Development Company, Inc.v. President Development Group, L.C., 2008 U.S. App. LEXIS 15982 (July 29, 2008).

The district court held that the plaintiff was properly removed from the LLC because the power to redeem included the power to remove.  The companies were liable for breach of contract, however, for failure to pay the redemption price.  The Eighth Circuit agreed.

-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

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

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

Member Approval of Mergers Under the New Iowa LLC Law

A merger of an LLC requires the unanimous consent of the members of an LLC under the new Iowa LLC Act, but the operating agreement may provide otherwise.  It will not be unusual for operating agreements to provide for less than unanimous approval of mergers, but what will the minority members expect in return for giving up their right to approve a merger?

If the history of corporations is any indication, appraisal rights will be the protection sought by minority members.  As many of you know, corporate law use to require unanimous shareholder approval of mergers.  The modern trend, adopted by Iowa and most other states, allows mergers to be approved by a majority of the shareholders but also allows shareholders who dissent to the proposal to assert appraisal rights as the "exclusive remedy" if they believe they are not receiving fair value for their shares.

That sounds reasonable enough, but be careful when drafting such a provision for your operating agreements.  It will be important to make it clear that appraisal is truly the exclusive remedy for dissenting members.  Several courts have interpreted the "exclusive remedy" or similar language in the corporate statutes not to be exclusive when the majority shareholders are using the merger process to eliminate minority shareholders.  See McMinn v. MBF Operating Acquisition Corporation, 164 P. 3d 41 (New Mexico 2007).  These courts have allowed claims for breach of fiduciary duty to survive in such circumstances.

-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