March 2006 — Issue 2

Securities and Exchange Commission v. Merchant Capital, LLC

400 F.Supp.2d 1336, No. 1:02-CV-2984-MHS (N.D. Ga. 2005)

In this securities fraud action brought by the SEC against the managing general partner (and its two individual principals) of 28 Colorado LLPs formed to purchase and collect debt pools of freshly charged off consumer debt, the court concluded the general partnership interests sold to the investors were not securities under the federal securities laws. The court described in detail the background and structure of the partnerships. Each LLP was limited to 20 investors, and the partnership agreements required each partner to participate in important business decisions and provided the opportunity to be active in the day to day management of the business. The agreements enumerated many powers that were reserved to the partners. Applying the Howey test, the court concluded that the LLP interests were not investment contracts. The court examined the legal powers afforded the partners under the partnership agreement and state law and concluded the partners had the power to control the partnerships. The court distinguished the powers of the LLP partners under the partnership agreements and Colorado law from those of limited partners, pointing out that the LLP partners could dissolve the partnership, bind other partners, and take an active role in management. The court stated that the fact that an individual partner may choose to remain passive does not convert the partner’s LLP interest into an investment contract. The court rejected the SEC’s arguments that the partners were effectively prevented from dissolving the partnership and that restrictions on the ability to remove the managing general partner somehow eliminated the partners’ control over the business. The court also rejected the SEC’s argument that the general partners were so dependent upon the unique entrepreneurial or management ability of the managing general partner and a third party vendor as to make them irreplaceable. Finally, the court concluded that the partners were not so inexperienced or unknowledgeable in business affairs as to be incapable of intelligently exercising their partnership powers. The court agreed with cases that do not require a court to look to the actual knowledge and business experience of each partner to assess the partner’s individual ability to intelligently exercise the powers of a general partner. Having concluded that the LLP interests were not securities under an investment contract analysis, the court also rejected the SEC’s arguments that the interests were certificates of interest or participation in a profit-sharing arrangement. The court characterized the SEC’s theory that the partnership interests became a security because a physical certificate was issued to the partners as elevating form over substance.

Steele v. Rosenfeld, LLC

__ So.2d __, No. 1040568, 2005 WL 3082785 (Ala. 2005)

Elkins agreed to sell the second and third floors of a building to Steele and Glover, respectively. Steele paid $20,000 of the $70,000 price for the third floor, and Glover paid the entire $40,000 price for the second floor. Elkins and Glover formed an LLC to hold title to the building after they received legal advice that it was impossible to do what they intended without a condominium declaration and concluded it was not feasible to do so. The LLC was formed with Elkins owning 2/3 of the membership and Glover owning 1/3 of the membership. Elkins presented Steele with a promissory note for the purchase of a 1/3 interest, but Steele never signed the note. Steele paid Elkins $37,775 of the $70,000 due under their oral arrangement for the purchase of the third floor, but Steele’s name did not appear on the articles of organization or operating agreement. The building was destroyed by fire, and the LLC received the proceeds of two insurance policies. Subsequently, the LLC sold the building. Elkins and Steele could not agree on the resolution of Steele’s rights, and the LLC and Elkins filed a declaratory judgment action to determine the interests of the parties in the LLC and the appropriate disbursement of the insurance and sale proceeds. Steele argued that he obtained a financial interest in the LLC when it was formed, and that he had a contract to obtain full membership, i.e., governance rights, when he completed his payments to Elkins. The court rejected Steele’s argument that he acquired any part of an interest, either financial or governance, in the absence of written consent of the other members, relying on the Alabama LLC statute and the LLC’s articles of organization and operating agreement, which all required written consent to the admission of a member. The court also rejected Steele’s argument that he was entitled to 1/3 of the insurance proceeds on an equitable conversion theory. The court pointed out that an LLC interest is personal property and held that the doctrine of equitable conversion did not apply because the doctrine only applies to real estate contracts that are specifically enforceable. The court declined to entertain Steele’s argument that the court should disregard the LLC entity and treat Elkins, Glover, and Steele as owners of the building because the argument was raised for the first time in a post-trial motion. Finally, the court rejected Steele’s argument that Elkins should be estopped to deny Steele’s status as a member. The court relied upon Alabama partnership case law rejecting estoppel as a basis to allege or deny partner status as among the parties themselves.

In re Ehmann (Movitz v. Fiesta Investments, LLC)

334 B.R. 437, Bankruptcy No. 2-00-05708-RJH, Adversary No. 04-00956 (Bankr. D. Ariz. 2005) (withdrawn __ B.R. __, Bankruptcy No. 2-00-05708-RJH, Adversary No. 04-00956, 2006 WL 173688)

This opinion appeared in the advance sheets, but was withdrawn pursuant to a “buy and bury” settlement intended to keep the opinion from having precedential value. In the withdrawn opinion, the court appointed a receiver to operate an LLC of which the debtor was a member prior to filing bankruptcy. In a prior opinion, the court rejected the argument that the trustee acquired only the rights of an assignee with respect to the debtor’s interest in a family LLC, concluding that the debtor’s relationship to the LLC was not an executory contract and that Arizona law restricting the rights of a transferee was preempted by Section 541(c) of the Bankruptcy Code in this case. The court reaffirmed this conclusion, disagreeing with the conclusion reached in In re Garrison-Ashburn, which the debtor relied upon in rearguing the point. Though the court concluded that Section 541(c) overrides state law and contractual limitations on the rights of an assignee, the court commented in a footnote that it was not necessary to determine whether the trustee could exercise the debtor’s vote in the LLC or otherwise participate in management. The court indicated that, at this juncture, it was only determining whether the trustee could enforce a member’s right to have the LLC operated in accordance with the operating agreement. The court determined that the manager was operating the LLC in a manner benefitting favored members to the exclusion of the bankruptcy estate and in defiance of the trustee’s requests. The court characterized the conduct of the LLC and its manager after the trustee’s appointment as demonstrating “an unequivocal intent to operate [the LLC] as if it were a revocable spendthrift trust.” Relying on a court’s authority under the Arizona LLC statute to enforce an operating agreement by injunctive or other appropriate relief, the court concluded that injunctive relief would be inadequate and that the only potentially effective remedy was appointment of a receiver to operate the LLC in accordance with its business purposes, the operating agreement, and state law. The court stopped short of ordering judicial dissolution because the operating agreement expressly waived the members’ rights to seek judicial dissolution under circumstances that might have applied. Noting that the statute precludes waiver of a member’s right to obtain judicial dissolution when it is not reasonably practicable to carry on the LLC business in conformity with the operating agreement, the court suggested that the receiver might be entitled to seek judicial dissolution if the receiver determined that it was not reasonably practicable to carry on the LLC business in conformity with its operating agreement.

In re Turner (Kendall v. Turner)

335 B.R. 140, Bankruptcy No. 02-44874TR, Adversary Nos. 02-7273 AT, 02-7298 AT (Bankr. N.D. Cal. 2005)

After attending a seminar on asset protection, the debtor and his wife, assisted in part by an asset protection attorney and the individual who conducted the seminar, engaged in a series of transactions involving the transfer of their home. This series of transactions included transfer of the home to a Bahamian trust, execution of a transmutation agreement purporting to change the character of the home to the wife’s separate property, creation of a Nevada LLC and a Nevada corporation, transfer of the home to the Nevada LLC, encumbrance of the home in favor of the Nevada corporation, and transfer of the home to the wife. The court set aside the transfer of the home as actually and constructively fraudulent and held that the Nevada LLC and Nevada corporation created by the debtor were the alter egos of the debtor. (The Bahamian trust established by the debtor and his wife was identified as the 99% owner of the LLC, and the Nevada corporation was identified as owning the remaining 1%.) In addressing the alter ego finding, the court commented as follows: “‘Asset protection’ is not illegal and is honored if done for a legitimate purpose. For example, an individual may do business through a corporation or limited liability company and will not be held personally liable for the debts of the entity. The assets of the corporation or limited liability company will not be considered the assets of the individual interest holder. However, an entity or series of entities may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors. Under such circumstances, the law views the entity as the alter ego of the individual debtor and will disregard it to prevent injustice.”

Katris v. Carroll

No. 01-04-3639 (LJD 12-23-05)

The court granted summary judgment in favor of two defendants sued for colluding with a non-manager member of an Illinois LLC to breach the member’s fiduciary duty. The court relied upon the Illinois LLC Act, which specifies that a member who is not also a manager owes no duties to the LLC or the other members solely by reason of being a member and imposes fiduciary duties on a member of a manager-managed LLC only where the member exercises some or all of the authority of a manager pursuant to the operating agreement. The plaintiff, a member and manager of the LLC, alleged that Doherty, an LLC member who had developed the Viper software marketed by the LLC, usurped an opportunity of the LLC by working in secret with two other parties to develop a software program that was functionally similar to the Viper software. The court concluded, however, that Doherty did not exercise any authority of a manager pursuant to the operating agreement and thus did not owe any fiduciary duties to the LLC or its members. The court examined the LLC operating agreement and pointed out that the plaintiff and another individual were the “sole managers.” The operating agreement enumerated the powers of the managers and the rights and obligations of the members and did not specify any managerial authority of the members in the provisions setting forth their rights and obligations. Although Doherty was designated “Director of Technical Services” in a written consent of the managers and given “sole management responsibility for developing, writing, revising and implementing the Viper software” for the LLC, the court concluded the written consent of managers did not constitute an amendment of the operating agreement because the two managers held only a combined 50% interest in the LLC, and an amendment of the operating agreement required the vote of members holding a majority in interest. Further, the court found that the written consent, even if viewed as an amendment to the operating agreement, did not change its terms. The written consent, which was executed the same date as the operating agreement, reaffirmed the operating agreement. In the consent, the managers resolved to adopt the operating agreement signed by the members, and the signature lines on the written consent identified the two managers as “all of the managers.” The court stressed that the statutory provision imposing fiduciary duties on a non-manager member applies only where the member exercises some or all of the authority of a manager pursuant to the operating agreement.

Lach v. Man O’ War, LLC

No. 2004-CA-001958-MR, 2005 WL 3116000 (Ky. App. Nov. 23, 2005)

A limited partnership serving as the sole general partner of another limited partnership was reorganized as an LLC, and a limited partner challenged the reorganization on the basis that it was an improper conversion. The reorganization was accomplished by a series of steps involving the formation of the LLC, transfer to the LLC of the partnership’s interest as general partner in the second limited partnership, and dissolution of the limited partnership resulting in distribution of the LLC ownership to the partners in proportion to their interests in the partnership. The plaintiff argued that the transaction amounted to a conversion under Kentucky law and thus required approval of all the partners. The court found there was no conversion because the dissolution did not flow into the formation of the LLC. The formation of the LLC was an event separate from the existence of the LLC. The limited partnership agreement did not carry over into the operating agreement, and the partnership did not evince an intent to convert. The limited partner also argued the effect of the partnership’s actions constituted an “indirect” conversion in violation of Kentucky statutes, but the court concluded a conversion did not occur merely because the LLC retained some of the same business purposes as the partnership and was capitalized by some of the partnership’s assets. The court noted that the transfer of partnership assets and termination of the partnership were within the authority of the general partners as specified in the limited partnership agreement. The court also rejected the limited partner’s argument that the transfer of assets to the LLC made it impossible for the partnership to carry on its business and that the general partners breached their fiduciary duties by transferring the assets to the LLC.

In re Inselman

334 B.R. 267, No. 2-05-06272-RJH (Bankr. D. Ariz. 2005)

Interpretation of liability provisions of Arizona privilege tax in LLC context

Ney v. Murray

No. B174255, 2005 WL 3220269 (Cal. App. 2 Dist. Dec. 1, 2005)

LLC member’s limited liability; veil piercing of LLC

Symes v. Harris

No. Civ.A. 03CV02272RPM, 2005 WL 3358848 (D. Colo. Dec. 9, 2005)

LLC as indispensable party to action to determine its members

In re 4 WHIP, LLC

332 B.R. 670, No. 04-33293 (ASD) (Bankr. D. Conn. 2005)

De facto LLC as “person” eligible to be debtor under Bankruptcy Code

Zanker Group, LLC v. Summerville at Litchfield Hills, LLC

No. NNH-CV-04-4015239S, 2005 WL 3047268 (Conn. Super. Oct. 24, 2005)

Member’s fiduciary duty of disclosure; tolling of statute of limitations based on continuing course of conduct doctrine

Foster-Thompson, LLC v. Thompson

No. 8:04-CV-2128T30EAJ, 2005 WL 3093510 (M.D. Fla. Nov. 18, 2005)

Derivative nature of member’s conversion and breach of fiduciary duty claim; sufficiency of complaint as notice to members of statutory duties under Florida LLC statute

Blue Paper, Inc. v. Provost

914 So.2d 1048, No. 4D04-4176 (Fla. App. 2005)

Liability of individual signing contract prior to LLC’s formation; mutuality of remedy under contract

In re Carlson (Pierce v. Carlson)

334 B.R. 626, Bankruptcy No. 04-73994, Adversary No. 05-7004 (Bankr. D.C. Ill. 2005)

Absence of fiduciary relationship between co-equal members of LLC for purposes of exception to discharge under Bankruptcy Code Section 523(a)(4)

Vision Information Services, LLC v. Tocco

No. 258422, 2005 WL 3479839 (Mich. App. Dec. 20, 2005)

Power and authority of LLC

Blanton v. Prins

So.2d __, No. 2002-CA-01464-COA, 2005 WL 3046501 (Miss. App. 2005)

Lack of standing to assert derivative claim on behalf of LLC due to failure to make demand; absence of duty on part of LLC’s attorney to LLC’s members

Mall at IV Group Properties, LLC v. Roberts

No. Civ.A. 02-4692 (WHW), 2005 WL 3338369 (D. N.J. Dec. 8, 2005)

LLC veil piercing; interpretation of non-recourse provision of lease in veil piercing context

Consolidated Lint, LLC v. Waller

No. Civ.A. BER-C-293-05, 2005 WL 3416174 (N.J. Super. A.D. Dec. 2, 2005)

Interpretation of indemnification provisions of LLC operating agreement; request for injunctive relief against allegedly removed

Mata v. Mata

No. SOM-C-012086-05, 2005 WL 3312943 (N.J. Super. Ch. Dec. 6, 2005)

Statutory information rights of LLC members and access to LLC books and records

Jackson v. Corporategear, LLC

No. 04 Civ. 10132(DC), 2005 WL 3527148 (S.D. N.Y. Dec. 21, 2005)

Standing of LLC creditor to pursue veil piercing action after closing of LLC’s Chapter 7 bankruptcy case

Sachs v. Adeli

804 N.Y.S.2d 731, 2005 N.Y. Slip Op. 09049 (N.Y. A.D. 1 Dept. 2005)

Governing law in suit involving foreign LLC; LLC member’s right to obtain state sales tax records based on statutory inspection rights and case law

Triangle Equities, LLC v. Whitestone-Triangle, L.P.

No. 601659/05, 2005 WL 3076317 (N.Y. Sup. Oct. 28, 2005)

interpretation of right of first refusal provision in LLC operating agreement

Direct Reimbursement Administrative Services Ltd v. Vitek

No. 20996, 2005 WL 3446277 (Ohio App. Dec. 16, 2005)

Material issues of fact as to breach of fiduciary duty claim

Allen v. Greenville Hotel Partners, Inc.

405 F.Supp.2d 653, Nos. 6:04-2327-HMH, 6:04-1260-HMH, 6:04-2338-HMH, 6:05-2142-HMH (D. S.C. 2005)

Liability of LLC owner to guests injured or killed in hotel fire based on owner’s execution of hotel franchise agreement in individual as well as representative capacity