Ward on Iowa Limited Liability Company Law

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