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
On March 14 the Iowa Civil Justice Task Force (“Task Force”) released recommendations for reforming the state’s civil justice system, including a recommendation to implement specialized “business courts” in Iowa.
The business court concept is not new. According to the Task Force’s report, twenty states already have some kind of specialty business court, while another three states are in the process of introducing a specialized docket for business cases.
Before Iowa can launch its own business court system, however, two important issues must be addressed. The first is the scope of the court’s jurisdiction. What kinds of cases will the business court hear? The second issue involves judges. How will the judges be chosen, and what rules will those judges use?
Scope of the Court’s Jurisdiction
Different states have taken different approaches to business court jurisdiction. Some states, like North Carolina, limit the business court’s jurisdiction to “complex cases.” North Carolina defines complexity by the specific subject matter at issue: complex cases are ones involving corporations, securities, antitrust matters, state trademark disputes, unfair competition claims, intellectual property rights, the internet, or tax disputes. N.C. Gen. Stat. § 7A-45.4(a) (2012). New York’s approach is similar to North Carolina’s, but also requires a specific dollar amount in controversy to trigger business court jurisdiction. N.Y. Comp. Codes R. & Regs. tit. 22, § 202.70(a) (2012). Maryland, on the other hand, permits judges to exercise discretion, within a framework, in determining whether a case should be on the busines court docket. Maryland judges consider factors such as the nature of the relief sought, the number of diverse parties, the novelty of the issues, and the degree to which business or technology issues predominate. Md. R. Cts. J & Attys. Rule 16-205 (2012).
The Iowa Civil Justice Task Force recommends an approach similar to North Carolina’s, with certain subject matter areas that would presumptively lead to business court jurisdiction, and without a minimum dollar amount that would determine a case’s qualification for the business docket. A case falling into one of the categories listed below would presumptively be included in business court jurisdiction, although the Task Force points out that other states’ experience with business courts has made clear that flexibility will be key to the docket’s success. In addition, the Task Force recommendations provide that certain cases not meeting the following criteria could opt in to the business docket.
The Task Force also recommends that the following types of cases be presumptively excluded from business court jurisdiction:
Judges and Court Rules
Iowa’s business court, as envisioned by the Task Force, would consist of one to three current district court judges. All judges would be invited to apply. The Iowa Supreme Court would select the judges for the pilot program after consulting with the chief judges in all of Iowa’s judicial districts.
Once the district court judges are selected, those judges would then have the authority to draft special rules for the new court. Task Force members anticipate that in drafting these rules, the business court judges will consult with attorneys who routinely represent clients in business matters.
It seems likely that many of the Task Force’s other recommendations would also be implemented in the specialty business courts. Some of these recommendations include assigning one judge to a single case for the entire duration of a litigation matter, strictly enforcing discovery deadlines through fines, and adopting initial disclosure requirements similar to Rule 26 in federal court.
Conclusion
These specialized courts should be of great interest to Iowa business owners – including community bankers, since commercial bank transactions would presumptively be included within business court jurisdiction. Litigation regarding securities and business contracts would also be steered toward the business docket. If Iowa – like other states before it – is successful in creating a streamlined docket with expert judges who are able to issue consistent rulings, this may provide the state’s entrepreneurs an added measure of reliability when making business decisions.
- John E. Lande
The Nevada Supreme Court ruled in Weddell v. H2O, Inc., 128 Nev. Adv. Op. #9, (Nev. March 1, 2012) that a judgment creditor is like an assignee of a membership interest. The creditor is entitled to only the share of the distributions the member would otherwise have received. The managerial interest of the debtor remains with the debtor.
This case is a good reminder that the charging order is limited to satisfaction of a judgment by petitioning a court to charge the member's interest with the amount of the judgment. In essence, a charging order is similar to a garnishment; it directs the LLC to make distributions to the creditor that it would have made to the member. It does not permit a judgment creditor of a member to affect the management of the LLC or reach its assets.
-Marc Ward
We don’t often see a business judgment rule case emanate from the Iowa Supreme Court, so when one comes along, even in the context of a nonprofit condominium owners’ association I am compelled to comment on it. Oberbillig v. West Grand Towers Condominium Ass'n, 807 N.W.2d 143, 2011 WL 6270701, Iowa, December 16, 2011 (NO. 09-1097).
The crux of the case was whether the board of directors of the condominium association was correct in approving nonemergency repairs to the association’s parking garage. The pertinent provision of the bylaws declares that “the board shall not approve any expenditure in excess of Twenty-five Thousand Dollars ($25,000), unless required for emergency repair, protection or operation of the Common Elements or Limited Common Element….”
The plaintiffs, two residents at West Grand Towers, contend that “emergency” modifies repair and protection and operation. The Association believes that “emergency” modifies only repair. The trial court held for the plaintiffs and the Association appealed.
The Iowa Supreme Court reversed. The reversal is not based on the Court believing that “emergency” only modifies “repair” although I suspect it does believe that, but upon application of principles that are far more useful. In essence, the Court concluded that when a bylaw provision is ambiguous, the organizational documents (in this case, the Declaration) grant the board the authority to interpret the bylaws, and the board’s interpretation is reasonable, then the Court will defer to the board’s “interpretation if doing so is consistent with the business judgment rule.”
Here are a couple of takeaways from this case. First, the court applied the “doctrine of the last preceding antecedent” in finding that the bylaw provision quoted above was ambiguous. As the Court has observed in prior cases, qualifying words usually only apply to the immediately preceding antecedent. In this case, emergency only applies to repair. The trial court on the other hand interpreted the clause to actually read “emergency repair, emergency protection or emergency operation of the Common Elements or Limited Common Element” and was castigated by the Court for it (“We should not rewrite bylaws in the guise of interpretation.”). Second, the Court refused to construe the ambiguous language against the Association because the developers, not the Association, drafted the Declaration and bylaws. Third, should non-profit and for-profit bylaws now include a provision that grants the board of directors the authority to interpret the bylaws?
-Marc Ward
With good fortune this unpublished opinion by the Colorado Court of Appeals will be reversed on appeal. Until then, lawyers need to take notice of this case because it is indicative of the risk inherent in operating a single member LLC. Call it limited liability light, but some courts seem to give less deference to the limited liability protections of LLCs compared to corporations.
Dean Freeman owned and managed Tradewinds Group, LLC as a single member LLC. Tradewinds contracted with Robert Martin to build an airplane hangar. Now, follow the dates. In 2006 Tradewinds sues Martin for breach of contract. In 2007 Tradewinds sold its only “meaningful” asset, an airplane, for $300,000 (the court apparently didn’t think the claim against Martin was meaningful). The proceeds of the sale went directly to Freeman, the only member of the LLC. In 2008 a judgment was entered in favor of Tradewinds. In 2009 this judgment was reversed, Martin was declared the winner and awarded costs of $36,645.40. In 2010, following a bench trial, the trial court pierced the limited liability veil and found Freeman personally liable.
The court of appeals decision was split 2-1. The majority apparently didn’t find it significant that Tradewinds sold its only significant tangible asset one year before judgment was entered in its favor against Martin, two years before the judgment was reversed, and three years before the bench trial that led to the eventual piercing of the veil. See Martin v. Freeman, 2012 WL 311660 (Colo. App. 2/2/12).
Instead, the court relied on (1) Tradewinds assets were commingled with Freeman’s and another of his companies, Aircraft Storage LLC (it is not explained how one commingles an aircraft with other assets); (2) the LLC had negligible corporate records (Colorado law declares that the failure of an LLC to observe formalities and requirements is not in itself grounds to impose personal liability); (3) Tradewinds had inadequate records of its substantive transactions; (4) a single person was the LLC’s only member and manager (!?); (5) the entity was thinly capitalized (with an airplane!); (6) cash infusions to pay bills were undocumented; (7) Tradewinds never operated as an active business (never seen this one before); (8) legal formalities were ignored (see above); (9) Freeman paid the LLCs debts without characterizing the transactions; (10) the airplane was used for “nonentity purposes”; and (11) Tradewinds was operated as “a mere assetless shell” and the proceeds from the sale of this assetless shell’s asset went directly to its only member.
The majority overlooks, but the dissent reminds them, that the trial court found the plane was sold in an arm’s length transaction, the proceeds were a lawful distribution to Freeman under Colorado law, he was unaware of any impropriety with respect to the sale, and to his knowledge all debts of the entity were provided for at the time of the distribution.
The court also found that showing that the LLC form was used to defeat a creditor’s rightful claim is all that needs to be shown and “further proof of wrongful intent or bad faith is not required.”
The dissenting judge came to an opposite conclusion, finding that the sale of the airplane and distribution of the proceeds two years before Martin had a claim against Freeman could not be construed to be a use of the LLC form to defeat a creditor’s rightful claim. The dissent cites a host of cases involving corporations where attempts to pierce the veil were thwarted because no wrongful conduct was proven.
As the dissent reasonable explains, two years before Martin had a claim against the LLC, Tradewinds sold its primary asset, “it made sense that the business would be closed…and its funds taken by its sole member.”
What this case says to SMLLCs is simple. You need to document your transactions, keep your funds separate and mind your p’s and q’s to a much greater extent than if you were a corporation. I wish this wasn’t the case, but this opinion and a host of others suggest to me that some courts have yet to grasp the fact that LLCs and corporations should be treated the same when it comes to limited liability protections.
-Marc Ward
On January 27, 2012, the Delaware Chancery Court (Chancellor Strine) issued what one commentator has called a magnum opus in the case of Auriga Capital Corp. v. Gatz Properties LLC. This 75-page opinion explains how fiduciary duties are owed by a manager to a LLCs members absent an expressed limitation or elimination in the operating agreement.
For Iowa LLCs the take away is to be aware of the default statutory fiduciary duties In Iowa Code Section 489.409 and the ability to limit or eliminate these duties per Section 489.110 (but only if such limitations or eliminations are not “manifestly unreasonable”, whatever that might be found to mean). Delaware does not have default statutory fiduciary duties, relying on the common law instead.
-Marc Ward
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
Here is an interesting article about the mass production of paper businesses. Expect regulation soon. http://finance.yahoo.com/career-work/article/113032/little-house-secrets-great-plains-reuters
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
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
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
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
Look out! Another SMLLC is effectively disregarded by the court, seemingly for no other reason other than the composition of the members. In Rossignol v. Rossignol, 2011 WL 723041 (N.Y.3d Dept., Mar. 3, 2011) the Supreme Court, Appellate Division in New York, affirmed a decision that found when spouses are the sole members of an LLC, the divorce action could provide complete relief. The court found that since the spouses were the sole members of the LLC and both spouses were parties to the divorce action, the consolidation of the divorce action and the action to dissolve the LLC was proper as there would be no issues left for resolution after the distribution of the marital property. Not only does the court disregard the entity itself, the court implies that through the divorce action the court has the power to dissolve the LLC due to the court’s empowerment to provide complete relief under the local Domestic Relations law and through the equitable distribution of marital property.
There has also been an interesting comparison to the Olmstead v. FTC case, where the Florida Supreme Court expanded the rights of personal creditors of the single-member of an LLC. (See Professor Rosins blog posting on Unincorporated Business Entities Law). We will just have to wait to see how far Rossignol actually opens the door to Olmstead’s expansive view.
-Allison M. Lindner/Dickinson Business Law Associate
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
In a comprehensive, 153-page ruling, Chancellor Chandler (say that 5 times real fast) provides a detailed overview of the responsibilities of a target board when faced with a structurally non-coercive, all-cash, fully financed hostile takeover. In his opinion in Air Products and Chemicals, Inc. v. Airgas, Inc. (Civil Action No. 5349-CC and Civil Action No. 5256-CC, February 15, 2011), Chandler almost begs the Delaware Supreme Court to overrule him. He feels compelled, however, to rule in light of Delaware precedent that so long as the target board meets the 2-prong test of Unocal(legally cognizable threat to the corporation and a reasonable response proportionate to the threat) it has the power to defeat what it perceives to be an inadequate offer without giving the shareholders an opportunity to decide for themselves. On several occasions he implies that he is not happy with that conclusion, but feels obligated to follow precedent in reaching it.
While the length of the opinion is daunting, it is well worth the read. The events of leading up to the decision, including the shareholders tossing out 3 incumbent directors and replacing them with Air Products nominees who then side with the rest of the board in rejecting Air Products' offer and the attempt by Air Products to shorten the time between annual meetings so it could replace the directors serving staggered terms quicker, are unique. And the Chancellor's opinion thoughtfully and carefully outlines the case law on hostile takeovers, particularly poison pills and their proper place in corporate governance.
- Marc Ward
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
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
In an attempt to avoid some income from his psychiatric practice from being subject to federal self-employment tax, a Denver psychiatrist with the help of his CPA/attorney set up two corporations to perform certain management services. Trouble was neither corporation did anything. Neither had employees or assets and in the case of one, it didn’t even have a bank account. Nevertheless the psychiatrist operated his practice as if the companies were for real and thereby deflected some income away from his W-2.
The Tax Court, in Robucci v. Commissioner, T.C. Memo. 2011-19 (filed January 24, 2011) saw through this canard. The court first noted that “a corporation will be recognized as a separate taxable entity if (1) the purpose for its formation is the equivalent of business activity or (2) the incorporation is followed by the carrying on of a business by the corporation.” (citing Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943) and Achiro v. Commissioner, 77 T.C. 881 (1981). The court also quoted Judge Learned Hand (I love that name) who wrote in Nat’l Investors Corp. v. Hoey, 144 F. 2d 466 (2d Cir. 1944) that “to be a separate jural person for purposes of taxation, a corporation must engage in some industrial, commercial, or other activity besides avoiding taxation….”
As mentioned, the two corporations set up by Robucci didn’t do anything. They looked quite impressive on paper, but in fact, they couldn’t do anything. They didn’t have assets or employees in order to perform any “industrial, commercial, or other activity besides avoiding taxation.” Both were disregarded by the court for tax purposes and their income was allocated to the psychiatrist as a sole proprietor.
- Marc Ward
One of the opportunities that S corporations afford its shareholders/employees is the ability to divide its net income between wages and dividends. The advantage of course is that dividend payments are not subject to FICA or other employment related taxes. Thus, there is a desire on the part of shareholder/employee to have as much of the corporation’s net income paid as dividends as possible. The trick is knowing the right proportion that will not raise the interest of the IRS. A recent case gives us guidance on the test to use to determine the right proportion.
In Watson v. US, 2010 WL 5369530 ( S.D. Iowa, December 23, 2010) the court considered the case of an S corporation that together with other S corporations was the owner of an accounting firm. The S corporation’s sole shareholder, director, and employee was an accountant that performed accounting services for the accounting firm through his S corporation. The Service had recharacterized dividend and loan payments from the S corporation to the accountant as wages. The accountant paid the assessment and then challenged the recharacterization in court.
The IRS retained an expert who used compensation data from Robert Half International and the Management of an Accounting Practice survey conducted by the American Institute of Certified Public Accountants to conclude that the accountant’s wages from his S corporation were about one-fourth of what they should have been.
The court concluded that regardless of the form of the payment, distributions to a shareholder/employee that represent remuneration for services would be treated as wages. In making this determination the court looked at “(1) the employee’s qualifications; (2) the nature, extent, and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the gross income and the net income; (5) the prevailing economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer as to all employees; and (9) in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years.”
Applying these factors the court concluded that the S corporation structured the salary and dividend payments to avoid paying the federal employment taxes. The court also adopted the IRS expert’s determination of what constitutes a reasonable salary for the accountant.
- Marc Ward
In re First Protection, Inc., 2010 WL 5059589 (9Th 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 9th 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
Paloian v. LaSalle Bank, N.A., 2010 WL 3363596 (7th 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
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
This morning the IRS issued proposed regulations providing that for "Federal tax purposes...a series organized under the laws of the United States or any other State, whether or not a juridical person for local law purposes, is treated as an entity formed under local law." Since Iowa is one of a handful of states that permit Series LLCs, I'll have more to say on this subject once I digest the 34 pages of explanation of this seemingly simple statement.
-Marc Ward
You might recall an earlier post, I’m talking a year or two ago, about statements of authority. They are another carryover from the Revised Uniform Partnership Act. I’m convinced these carryovers from RUPA are a plot by law professors who like to teach partnership law but feel rather silly doing so since no one forms partnerships anymore. LLCs are an outlet for their frustration.
Back to the point, by filing a statement of authority with the Iowa Secretary of State (and the county recorder if you are dealing with real estate) you can eliminate any questions regarding the authority of a person to sign a loan agreement, a note, a deed, or any other legal document. But here is the caution. A Statement of Authority does not necessarily mean that the particular transaction you are concerned about has been authorized by the LLC.
Let me give you an example. Let’s say an LLC files a statement of authority declaring that Edward Sharpe has the authority to enter into any transactions on behalf of the LLC and otherwise act for or bind the LLC, including transactions involving real estate. So long as you do not have knowledge to the contrary you are entitled to rely on this statement expressed by the LLC. Edward Sharpe would have apparent authority to act on behalf of the LLC.
But I am not sure that is good enough. Let’s say I want to buy some farmland from The Nocturnals, LLC. The basic statement of authority states that Edward Sharpe has authority to sign deeds on behalf of the LLC. It does not state whether Sharpe has authority to sign my deed. Do I really want to get bogged down on issues of apparent authority, BFPs, fraud, etc. merely because I was unwilling to go the extra step and request a certified copy of the resolution of the document authorizing the sale of the land to me and while I am at it a certified copy of the operating agreement?
Which begs the question, what good are statements of authority? They are useful for routine business transactions when the dollars involved don’t justify the extra effort and they are effective immediately upon filing unlike affidavits which cannot by relied on until three years after filing, but I would use them with care.
-Marc Ward
As readers of this blog should know, a charging order is the exclusive remedy with regard to a debtor’s membership interest in an LLC. This is true even if a creditor has a security agreement signed by the debtor that assigns all right, title and interest in a membership interest in an LLC to the creditor (courts have found that absent the consents required by the operating agreement the assignment is ineffective).
This does not mean that creditors can’t take steps to improve their position with respect to claims they have on an LLC membership interest. In First Mid-Illinois Bank & Trust v. Parker, 2010 WL 3179734 (Ill. App. 2010) Bank A argued that its charging order should take priority over Bank B’s charging order even though Bank B’s charging order was entered first because Bank A had an attachment lien entered four months earlier. The court agreed finding that because the charging order and attachment lien of Bank A related to the same claim the attachment merged with the charging order and the charging order related back to the date of the earlier attachment filing based on the “relation back” doctrine.
-Marc Ward
It is something to ponder during these dog days of August, why would a sole shareholder/dentist enter into an employment agreement containing a covenant not to compete with the PC? In essence, he agreed not to compete with himself. Howard v. U.S., (USDT, Eastern District of Washington, July 30, 2010).
That is exactly what Dr. Larry Howard did in 1980. In 2002, when he sold his practice to a competitor the Asset Purchase Agreement allocated $549,900 to Dr. Howard for his personal goodwill. On his tax return for 2002, Howard reported $320,358 as long-term capital gain resulting from the sale of the goodwill. As a result of an audit, the IRS recharacterized the sale of the goodwill as a corporate asset and treated the amount Howard received as a dividend. This resulted in a $60,129 tax deficiency plus $14,792 in interest.
As the court points out, the case law makes it quite clear that an employee working for a corporation without a covenant not to compete owns the goodwill. See Martin Ice Cream v. Commissioner, 110TC 189 (1998). But when an employee works for a corporation under an employment agreement with a covenant not to compete, it is the corporation and not the professional owns the goodwill generated by the professional. Norwalk v. Commissioner, TC Memo. 1998-279.
Now explain to me again, why did he agree not to compete with himself? I smell another victim to form practice.
-Marc Ward
A lot of corporate law is being made in bankruptcy court these days. Take for example In re Midway Games Inc., 428 B.R. 303 (Bankr. Ct. Delaware 2010). A committee of unsecured creditors challenged the actions of the board of directors of Midway for obtaining additional financing for the company instead of filing for bankruptcy. The company was insolvent at the time and presumably an earlier bankruptcy would have benefited the unsecured creditors while the additional financing provided the company with some needed cash but only prolonged the company’s agony. Along the way the majority shareholders also sold their 87% interest in the company and $70 million in debt to an individual for a mere $100,000.
The bankruptcy court reaffirmed the Delaware courts’ objection to the “deepening insolvency” theory (essentially that a board of directors must look to help the creditors over the interests of the company once a company becomes insolvent and stop the bleeding.) Delaware law is clear that directors are not liable for taking actions to make a corporation viable once it is insolvent. A board “does not have a duty to protect creditors of an insolvent corporation at the expense of the corporation and its shareholders." Thus, the court found no breach of the duty of care by the board.
Next, the court looked at the duty of loyalty that directors owe to a corporation. Although it held in the directors favor, this case does serve as a reminder to directors that they cannot become complacent about their role because they have an affirmative duty of oversight encapsulated in the duty of loyalty they owe to the corporation. If directors fail to act in the face of a known duty to act and they demonstrate “a conscious disregard for their responsibilities" as directors, then they have breached the duty of loyalty. I have noted in earlier posts that this breach of the duty of loyalty looks an awful lot like the duty of care and may have been constructed to get around the exculpatory clauses found in many articles of incorporation that prohibit monetary damages being assessed against directors for the breach of the duty of care, but so far no one else has taken up that banner.
So what about the sale of the 87% interest and $70 million in unsecured notes for $100,000? The court found nothing wrong there either because the shareholders/noteholders “had the unfettered right to dispose of their Midway interests as they saw fit. The board was not involved in the transaction and could not prevent it. The stockholders qua stockholders owed no duty to the corporation.
-Marc Ward