New Developments

South Dakota Supreme Court on LLC dissolution

The Supreme Court of South Dakota has held that an LLC may be dissolved when two of four members refuse to renegotiate the terms of an agreement between the LLC and those two members.

 

In Kirksey v. Grohmann, four sisters were left equal ownership interests in a ranch when their mother died in 2001. The ranch had been in the family for over 100 years. They formed an LLC the next year to hold title to the ranch. They did so for tax advantages, to keep the land within the family, and to keep the land out of the hands of the sisters’ spouses. Ms. Grohmann, the eldest, lived on the land and was named manager. Ms. Randell, the next oldest, lived on the land, as well. All four decided that the LLC would lease the land to Grohmann, Randell, and Ms. Kirksey (a third sister), who owned grazing livestock on the land. The fourth sister, Ms. Ruby, neither lived on the land nor grazed livestock on it. The lease was for about $14,000 per year and netted about $4,000 after taxes and insurance. Grohmann and Randell quickly fell out with Kirksey and Ruby and Kirksey sold her livestock to Grohmann and Randell in 2003. Apparently, the land increased in value by a factor of six but the lease payments were fixed. The operating agreement required a majority vote to take action and the sisters were deadlocked as to any action that would change the status quo either by changing the lease terms or by dissolving. Kirksey and Ruby sued for dissolution, which the trial court denied.

 

Justice Konenkamp held that dissolution was warranted under the South Dakota LLC Act, which in pertinent part is identical to the 1996 ULLCA. That act provides for court ordered dissolution when, inter alia, “the economic purpose of the company is likely to be unreasonably frustrated” or “it is not otherwise reasonably practicable to carry on the company’s business in conformity with the articles of organization and the operating agreement”. The complaint apparently did not seek dissolution on the ground of illegal, oppressive, fraudulent, or unfairly prejudicial conduct, though it seems clear from the briefs that such a claim could at least have been made, if not ultimately proven. Nor did the complaint seek damages for breach of fiduciary duty.

 

After canvassing a number of states’ interpretation of the “not reasonably practical” standard, the court held that the economic entity of the ranch could be continued but that leaving de facto control in Grohmann and Randell, who refuse to change the terms of the lease favorable to them, is not reasonably practical in light of the operating agreement. The court suggested that Kirksey and Ruby knew of the favorable terms when they entered into the original lease and surely knew the terms of the operating agreement. Justice Konenkamp also held that that the economic purpose of the LLC is likely to be unreasonably frustrated, essentially for the same reasons.

 

Although the court does not speak in terms of fiduciary duties, the subtext seems to be that Grohmann and Randell had some sort of obligation to renegotiate the terms of the lease so that the other two sisters could share equitably (perhaps equally?) in the economics of the enterprise. It seems not to matter that Kirksey and Ruby willingly agreed both to the LLC operating agreement and to the lease terms. A deal isn’t a deal if it turns out to be too good a deal.

Minnesota Court of Appeals on de facto LLC and LLC-by-estoppel

The Minnesota Court of Appeals has held that the de facto LLC doctrine does not exist in Minnesota and that the LLC-by-estoppel doctrine is inapplicable where a party’s intention to deal solely with an LLC is induced by fraud.

In Stone v. Jetmar Properties, LLC, Ortega gave Hammond an unsecured $200,000 loan to develop property that Ortega had planned to sell to Jetmar, Hammond’s LLC. The sale was not completed because Hammond could not obtain sufficient funds. Although the loan was to be repaid in three days, Hammond never repaid it. A few months later, Hammond met Stone and convinced him to invest more than $50,000 in Jetmar projects. Hammond convinced Stone to quitclaim a rented duplex to Jetmar so that Jetmar’s balance sheet would show sufficient assets to obtain further financing. Hammond promised to reconvey the property in sixty days and told Stone he could continue to keep the rent from the tenants.

Hammond recorded the deed the next day and mortgaged the duplex to Ortega the day after that in exchange for Ortega’s agreement to extend the $200,000 loan. Ortega recorded the mortgage a few days later after confirming that Jetmar had title. Ortega foreclosed on the duplex about seven months later, sending notice to the tenants who forwarded it to Stone. Relying on Hammond’s assurances that all would be well, Stone did not contact Ortega to assert his interest in the duplex. A couple of months later Ortega conducted a foreclosure sale at which he purchased the duplex in return for his $200,000 loan to Jetmar. About a week later, Hammond filed Jetmar’s articles of organization. Apparently neither Ortega nor Stone knew that Jetmar had not been formed. Stone filed suit against Jetmar, Hammond, and Ortega seeking damages and a declaratory judgment that he owned the duplex. Jetmar and Hammond defaulted.

Judge Lansing held that Stone’s quitclaim dean to Jetmar was void because Jetmar did not exist at the time. Neither the de facto entity doctrine nor the entity-by-estoppel doctrine prevented Stone from reclaiming title to the duplex. Judge Lansing held that an element of the de facto doctrine was not met because Hammond made no colorable attempt to form the LLC at the time Stone conveyed the duplex. She further held that the de facto entity doctrine cannot apply to LLCs. Minnesota’s corporations act, which is based, in pertinent part, on the MBCA of 1950, abolished the de facto corporation doctrine. The reporter’s notes to the Minnesota LLC statute state that corporate law should apply to analogous portions of the LLC statute. Because the LLC statute’s section stating that an LLC’s existence begins at filing is based on a similar corporations act section, the de facto entity doctrine cannot apply to LLCs.

The entity-by-estoppel doctrine was not abolished by statute but does not allow Ortega to retain the duplex. Although Stone intended to deal only with Jetmar, not Hammond, that intention was induced by fraud, which allows the court to decline to apply the entity-by-estoppel doctrine. Thus Stone cannot be estopped from seeking to recover the duplex.

As a policy matter, it makes sense to be consistent in applying the defective formation doctrines of de facto entity and entity-by-estoppel. The drafters of the current MBCA concluded that the 1950 MBCA’s attempt to end the de facto corporation doctrine was misguided; courts continued to provide equitable relief despite the statute. Whether the drafters were right in that conclusion is less than obvious and the survival of the 1950 MBCA provisions in a few states, such as Minnesota, suggests that the appropriate policy choice is not obvious. The entity-by-estoppel doctrine is so amorphous that perhaps the best one can say is that, if their courts are consistent, then they’ve made an appropriate choice in terms of defining the doctrine.

This case could be taught in Chapter 19 either right before or just after P.D. 2000, L.L.C. v. First Financial Planners, Inc., on casebook page 745. It would make a good contrast with P.D. 2000, L.L.C. on the entity-by-estoppel question.

One other aspect of this case caught my eye. Jetmar’s counsel was Alex W. Russell, Esq. Mr. Russell practices with, and, in fact, seems to be the only lawyer at, the firm called, “Evening & Weekend Law Offices”. This is an interesting marketing technique and I wonder whether Mr. Russell’s practice is helped or hurt on the whole by his choice of firm name.

Connecticut Court of Appeals on LLC promoter liability/power

The Appellate Court of Connecticut has held that a promoter of an LLC is liable on a contract made in the LLC’s name but before formation and therefore had the power to transfer the contract to another entity that could sue to enforce the contract. In BRJM, LLC v. Output Systems, Inc., Nicholas Kepple agreed to purchase real estate from Output Systems, Inc. The purchase contract was made in the name of M & K Realty, LLC, which was an entity to be co-owned by Kepple and his friend McGuiness (gee, how’d they think of THAT name?). After the contract was formed, McGuiness pulled out and Kepple assigned the contract to BRJM, LLC, an entity he owned. When a subsequent appraisal revealed that the property was worth twice the contract price, Output Systems refused to close and BRJM sued. One defense was that the contract was void because M & K Realty, LLC had not been formed when the contract was executed.

Justice Schaller held that, as a matter of first impression, the individual entering into a contract on behalf of a non-existent LLC is personally liable. The court relied on Restatement (Third) of Agency § 6.04 for the proposition that an “agent” is liable on a contract entered into on behalf of a non-existent principal. Justice Schaller acknowledged that this rule was to protect third parties, not to empower individuals who contract on behalf of non-existent entities. The court also drew an analogy to promoter liability in the corporate setting, both under common law and under MBCA § 2.04, which would hold the promoter liable.

Although the court acknowledged that the Restatement section and promoter liability rule are intended to protect third parties rather than to empower promoters, it held nonetheless that those rules allow promoters to enforce such contracts as well. Thus Kepple was liable on the contract, could enforce it, and thus could (and did) assign it to a third party.

It’s not clear to me that this case must be correct. Certainly the legal rules the court invokes do not stand for the result the court reached. The doctrine of entity by estoppel might do the trick. Here, Output Systems intended to deal solely with M & K Realty, LLC, which could induce the court to hold that Output Systems was estopped to challenge that entity’s existence. That doesn’t, by itself, permit Kepple to transfer the contract in M & K Realty’s name to another entity, though. However, given that the plaintiff is, in effect, a limited liability entity owned and controlled by Kepple, one might analogize this situation to the entity by estoppel setting.

This case could be taught after, or instead of, P.D. 2000, L.L.C. v. First Financial Planners, Inc. on page 745.

Washington Court of Appeals on fiduciary duty of LLC member-managers

The Washington State Court of Appeals has held that member-managers of an LLC are analogous to partners and hence owe one another the same fiduciary duties as partners under the UPA. In Bishop of Victoria Corporation Sole v. Corporate Business Park, LLC, Finley owed money to the Bishop of Victoria Corporation Sole (Bishop), which is the Canadian corporation that owns the real property of the Roman Catholic diocese of Victoria, British Columbia. Finley and the Bishop formed an LLC to purchase a specific plot of land that Finley believed was being sold for one-third its value. The parties intended to resell the property quickly and pay off Finley’s debt to the Bishop. The parties were the only manager-members of the LLC.

The LLC obtained a purchase money mortgage in an amount greater than the purchase price and intended to use the excess borrowing to pay the principal and interest on the mortgage until the property could be sold. The property proved difficult to sell, the reserve ran out, and the Bishop began making payments on the mortgage.

A new bishop replaced the retiring bishop as the head of the Bishop and the new bishop’s staff changed their investment intent to one of simply selling the property for enough money to pay off the mortgage without any additional profit. The Bishop missed a payment, which caused the interest rate to rise, and the lender obtained a judgment of about $8.2 million and a decree of foreclosure. The Bishop raised money from parishioners by issuing debentures. The money was put in Fisgard, a trust entity that then purchased the judgment from the lender. The Bishop filed an action seeking appointment of a receiver. The receiver was unable to sell the property and later gave a deed-in-lieu of foreclosure to Fisgard. Finley sued the Bishop for breach of the LLC operating agreement and breach of fiduciary duties. A jury returned a verdict for Finley on both claims for about $12.4 million.

Judge Penoyar first held that the fiduciary duties of member-managed and manager-managed LLCs are identical and that they spring from the relation of trust between the parties. He then held that members in a member-managed LLC are analogous to partners in a general partnership, who owe each other fiduciary duties, which Judge Penoyer describes as “candor and the utmost good faith”. He then ticks off the fiduciary duties of partners under section 404 of the UPA. On these facts, the court held that the Bishop did not breach any fiduciary duties.

This opinion is interesting in several respects. First, the authority Judge Penoyer cites for the proposition that LLC members have fiduciary duties stemming from their trust relationship does not address LLCs in particular. Certainly the Washington LLC statute does not impose fiduciary duties on either members or managers. Second, the authority he cites for the proposition that members of member-managed LLCs are like partners and therefore owe each other partnership duties is simply a suggestion in a law review article. Third, Judge Penoyar’s source for the proposition that those duties are “candor and the utmost good faith” is a case that pre-dates the current UPA, which distinctly constricted the fiduciary duties partners owe. In the end, he finds no breach here, but the bases on which he defines the governing standards are problematic.

Indiana Court of Appeals on disregarding an LLC

The Court of Appeals of Indiana, in a case of first impression, has held that the criteria for piercing the corporate veil apply to whether an LLC should be disregarded and its managers held personally liable. In Troutwine Estates Development Co., LLC. V. ComSub Design and Engineering, Inc., ComSub provided engineering services to Troutwine, which owned raw land it intended to develop. Troutwine did not pay for all the services rendered and ComSub sued for breach of contract. ComSub also sued two individuals, the Jordans, and an entity they owned, Master Mark, the developer that purchased the land from Troutwine.

Judge Robb affirmed the trial court’s holding that no enforceable contract existed between Troutwine and ComSub but that ComSub was entitled to damages from Troutwine on a quantum meruit theory. The court reversed the imposition of individual liability on the Jordans and Master Mark on the ground that the trial court did not enter findings of fact and conclusions of law on this issue.

The court quoted the Indiana statute granting limited liability to LLC members, managers, agents, and employees. Judge Robb then reasoned that, “Because the Indiana Business Flexibility Act [the LLC statute] provides protections to limited liability companies like those of corporations, to circumvent those protections we apply an analysis similar to that for determining the personal liability of a corporation’s officers.” The court cites as authority a case, Brant v. Krilich, that is completely inapposite. Brant dealt with so-called reverse piercing of a corporation. Judge Robb goes on, though, to cite cases from California, New York, Georgia, and Connecticut for the proposition that corporate piercing principles are applicable to LLCs. In reversing personal liability the court also observed that personal liability might well be imposed on the Jordans or Master Mark under quantum meruit principles. That is, they might be directly rather than indirectly liable.

Once again a court has the opportunity to be thoughtful about the principles by which an LLC may be disregarded and its owners held personally liable. Once again the court declined to be thoughtful. The Indiana LLC statute language is comparable, but not identical, to the Indiana corporation statute language, which is the MBCA language from § 6.22. As a final note, the Jordans were described as Troutwine’s managers, rather than members. I suspect they were also the members. To the extent the court means what it says and is willing to hold LLC managers liable on corporate piercing theories, there is even less rationality to the result.

Illinois Appellate Court on piercing a limited liability company

The Illinois Appellate Court has held that an Illinois LLC may not be disregarded and its member held personally liable for the LLC’s obligations. In Puleo v. Topel, Thinktank, LLC, a web design and marketing firm, was dissolved for failure to file its annual report. Topel, the sole member, apparently continued to do business under the entity name for three months after dissolution, whereupon the business was discontinued. Thinktank’s mployees and independent contractors sued Topel for debts incurred to them by Thinktank between dissolution and the cessation of business.

Presiding Justice Quinn held that the Illinois LLC Act is silent on whether an LLC’s veil may be pierced but until 1998 the Act required piercing in situations in which a corporation’s veil would be pierced. Justice Quinn reasoned that the 1998 amendment indicated an intent to prohibit piercing an LLC’s veil. Further, the Act has no analogue to the Illinois Business Corporation’s version of MBCA § 2.40 that would render Topel liable assuming he knew Thinktank had been dissolved.

The pre-1998 version of the Act read:

A member of a limited liability company shall be personally liable for any … liability of the limited liability company … to the extent that a shareholder of an Illinois business corporation is liable in analogous circumstances under Illinois law.

The present version reads:

[T]he debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.

Quaere whether the court drew the correct implication from the 1998 amendment. The court reasoned that the negative pregnant of the change was to prohibit piercing. Isn’t it equally possible that the legislature’s intent was simply to eliminate compulsory piercing under corporate law principles and leave the question of LLC piercing to the courts? If so, it is not immediately apparent that the court’s decision was correct. The current LLC Act language is similar to MBCA § 6.22, which surely permits piercing.

This case must have been particularly demoralizing to plaintiffs’ counsel. The trial court denied plaintiffs’ summary judgment motion even though Topel did not file a response to the motion. Then in the Appellate Court, Topel did not file a brief but the plaintiffs lost again.

West Virginia case on defective entity formation

The West Virginia Supreme Court of Appeals has held that a deed is valid and enforceable by a grantee business entity that was not in existence when the deed was executed if the deed was executed in anticipation of the entity’s formation and is properly delivered to the entity after formation. In Heartland, L.L.C. v. McIntosh Racing Stable, L.L.C., (W.Va.2006) three individuals negotiated to purchase a horse stable and real estate. At a pre-closing all parties agreed that the individuals would form Heartland, L.L.C. to purchase the property, the deed was executed naming Heartland as the grantee, and Heartland’s Articles of Organization were signed. The Articles were not filed for six months and the next day the buyer filed suit to compel specific performance. The seller defended on the ground, inter alia, that it had not entered into a binding contract because the purchaser was not in existence when the contract was signed. The court upheld the validity of the deed citing to precedent from 1889 and 1900 and also citing to P.D. 2000, L.L.C. v. First Financial Planners, Inc., (casebook page 745).