May 2007 — Issue 15

Securities and Exchange Commission v. Merchant Capital, LLC

__ F.3d __, No. 06-10353, 2007 WL 983082 (11th Cir. (Ga.) 2007).

In this securities enforcement 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 charged-off consumer debt, the Eleventh Circuit Court of Appeals reversed the district court and held that the general partnership interests sold to the investors were securities under the federal securities laws. The district court applied the Howey test and concluded that the partners had legal powers to control the partnership and were not so inexperienced or unknowledgeable in business affairs as to be incapable of intelligently exercising their partnership powers. The court of appeals also applied the Howey test, but reached a different conclusion. The court described in detail the structure and operations of the partnerships. Each LLP was limited to 20 partners. The investors all had a net worth of at least $250,000, and more than three-fourths of the partners reported a net worth in excess of $500,000. Though none of the partners had demonstrated experience in the debt purchasing business, ninety percent of the partners self-reported their business experience between "average" and "excellent." The partnership materials told the partners that they were expected to have an active role in managing the partnership, and the agreement reserved a number of powers to the partners, including the ability to select and remove the managing general partner. In practice, however, the partners exercised little control over the operations. The managing general partner had sole authority to bind the partnership and made the key business decisions. Applying the Howey test and relying on the Williamson case, the court concluded that the LLP interests were investment contracts. The court avoided deciding whether the Williamson presumption that general partnership interests are not securities applies in the case of LLPs since it found that the interests were securities under the Williamson criteria. Noting that the powers in an LLP cannot exceed those in a regular general partnership, and commenting that an LLC interest may be somewhat more likely to be an investment contract because of the incentive against exercising control produced by the liability shield, the court stated that it need not decide the general applicability of the Williamson presumption to LLP interests if any of the Williamson tests were met. Under Williamson, a general partnership interest is an investment contract if (1) the agreement between the parties leaves so little power in the hands of the partner that the arrangement in fact distributes power as would a limited partnership, (2) the partner is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership powers, or (3) the partner is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager or otherwise exercise meaningful partnership powers. The court analyzed each of these tests and concluded that all three were met. The court found that the arrangement distributed power as if the partnerships were limited partnerships because the power to name the managing partner was not significant, the power to remove the managing partner was illusory, and the voting procedures giving partners the ability to approve all obligations over $5,000 were a sham and did not give the partners any meaningful control. The court discounted the fact that one of the partnerships had actually removed the managing partner because the removal occurred in a liquidation context when the managing partner would receive no more fees and did not oppose removal, and the promoters had an active interest at that time in encouraging removal because the SEC investigation was in progress. The court did not view the partners’ remaining powers– the right to inspect books and records, participate in committees, and hold meetings– as providing the partners the ability to control management of the business. The court went on to conclude that the partners were so inexperienced and unknowledgeable in business affairs that they were incapable of intelligently exercising their partnership powers because the investors had no experience in the debt purchasing business. The court stated that the district court had erroneously focused on the general business experience of the investors rather than their experience in the particular enterprise. The court rejected the defendants’ argument that anyone with general business experience could easily learn to be successful in the debt purchasing business, characterizing the debt purchasing business as a complicated and sophisticated business that could not be quickly or easily learned. Finally, the court concluded that the partners were so dependent upon the managing partner that they could not replace it or otherwise exercise meaningful control. The court determined that the partners had no realistic alternative to the managing partner’s management (in addition to having no practical ability to remove the managing partner) because the assets of all the LLPs were combined and invested in pools of accounts owned by a third party servicer. The partnerships had no contractual right to demand the return of the debtor accounts; therefore, even if an individual partnership had replaced the managing partner it would find its major assets were still tied up in fractional form in a third party’s debt pool. The court gave no weight to procedures intended to assist partnerships in removing their assets from the debt pools, noting that these procedures were not devised until after the SEC investigation began and that there were still practical barriers to obtaining the accounts.

Bronstein v. Crowell, Weedon & Co.

No. B191738, 2007 WL 969559 (Cal. App. 2 Dist. April 3, 2007).

The plaintiffs sought to pierce the veil of a Delaware LLC and hold a 30% owner liable under the alter ego doctrine. The court noted the application of the alter ego doctrine to LLCs under the California LLC statute and stated that the alter ego doctrine is also applicable to Delaware LLCs. The court stated that the liability of members of a foreign LLC is governed by the law of the state of formation under California law. The court concluded that the plaintiffs failed to present evidence raising a triable issue of fact as to whether the 30% owner of the LLC was liable under the alter ego doctrine, finding that the owner’s alleged concealment of his ownership in the LLC was insignificant inasmuch as a 30% interest is insufficient to make a controlling decision in a Delaware LLC. The court acknowledged the limited liability of members in a Delaware LLC (noting as well the comparable provision under California law) and concluded that the plaintiffs failed to raise a triable issue of fact as to whether the owner of the LLC should be liable on a theory that the LLC was a joint venture, stating that any joint venture or partnership terminated upon the LLC’s formation.

Butler v. Adoption Media, LLC

No. C 04-0135 PJH, 2007 WL 963159 (N.D. Cal. March 30, 2007)

After a general partnership refused to post the profile of a gay couple on the partnership’s website facilitating adoption, the couple sued the partnership, its two individual partners, two Arizona LLCs subsequently formed by the individuals, and two corporations formed by the individuals to serve as members of the LLCs. The plaintiffs argued that the LLCs were liable as successors of the partnership and that the LLCs and other entity defendants were all alter egos of the individuals. After the partnership refused to post the plaintiffs’ profile on its web site, the individual partners formed the two LLCs, transferred assets from the partnership to the LLCs, formed two corporations (one owned by each of the individuals) to serve as members of the LLCs, and transferred their membership interests in the LLCs to the corporations. Applying California successor liability rules to the analysis of whether the LLCs were liable as successors of the partnership, the court concluded that there was no basis for successor liability because there was no express or implied assumption, the requirements of the de facto merger and mere continuation doctrines were not met (since the partnership continued to exist), and there was no evidence that the partnership transferred assets to the LLCs for a fraudulent purpose. Applying California law to the analysis of whether the LLCs and other entity defendants were alter egos of the individuals and one another, the court granted summary judgment to the defendants. The plaintiffs argued that the business entity defendants were all alter egos of the two individuals because they failed to maintain their separateness and confused the various entities. The plaintiffs also contended that it was the individuals’ intent to create a business structure in which no single entity or individual could be held liable for the discriminatory practice of not allowing same-sex couples to post on the adoption profile web site. The court reviewed the parties’ arguments regarding the evidence bearing on the alter ego issue and concluded that the plaintiffs provided some evidence of a material dispute with regard to a unity of interest and ownership among the individuals and entity defendants; however, the court characterized the evidence of the individuals’ occasional disregard of corporate formalities and distinctions among the entities as “not particularly compelling,” stating that the interests of management and ownership generally collide in a closely held corporation and that lack of formality is not unusual in a closely held corporation. More important, the court said, was the plaintiffs’ failure to provide any evidence of bad faith or that the LLCs were created to avoid the operation of a statute. The plaintiffs failed to rebut the defendants’ evidence of legitimate business and estate planning reasons to form the LLCs and corporations. Finally, to the extent triable issues were raised, the court stated that they were not material inasmuch as the plaintiffs had argued that an inquiry into alter ego liability would be superfluous.

Duke v. Graham

__ P.3d __, No. 20051036, 2007 WL 942055 (Utah 2007)

The court concluded that provisions of the Utah Limited Liability Company Act providing for judicial expulsion of members and judicial removal of managers did not strip arbitrators of the authority to remove members and managers. Because the statute also contains provisions authorizing expulsion of members and removal of managers as provided in an operating agreement, the court concluded that expulsion of members and removal of managers may be accomplished through mechanisms described in an LLC’s operating agreement, including an agreement to arbitrate. Thus, an arbitration award expelling members of an LLC and removing one of them as a manager in an arbitration proceeding brought pursuant to an arbitration clause in the operating agreement did not exceed the arbitrator’s power. The court stated that its conclusion that the legislature did not limit the mechanism for expulsion and removal to a judicial decree is also consistent with the Utah Arbitration Act.

Kasten v. MOA Investments, LLC

Nos. 2006AP386, 2006AP1405, 2006 AP1510, 2007 WL 677804 (Wis. App. March 7, 2007).

A minority member of an LLC brought suit individually and on behalf of the LLC asserting that the corporate member holding the largest interest in the LLC and the corporate member’s shareholders breached fiduciary duties and acted unfairly in transferring assets and business opportunities away from the LLC. The court held that the plaintiff member was disqualified from asserting claims on behalf of the LLC because the suit was not authorized by a vote of the members. The court found that the plaintiff member was disqualified from voting because she sought judicial dissolution and thus had an interest in the outcome of the suit that was adverse to the interests of the LLC. The court concluded that the corporate primary injury rule applies to LLCs and that the member’s claims alleging diversion of the LLC’s assets, inappropriate payments of LLC funds, and diversion of business opportunities were derivative claims that she was not authorized to bring. The plaintiff’s individual claims that she was improperly denied voting rights were without merit because the LLC’s manager or a supermajority of members controlled the LLC and the plaintiff was not damaged by any lost opportunity to vote. The court stated that a claim for minority oppression is not itself a cause of action but merely a standard for judicial dissolution, and the plaintiff’s claim for judicial dissolution was abandoned by repeated assertions in the lower court that the plaintiff did not want to dissolve the LLC. The court upheld amendments to the operating agreement permitting members with a financial interest in the outcome of a pending action to vote to dismiss, requiring members asserting or maintaining a derivative action without approval to indemnify the LLC, and imposing a one year limitation on claims asserted by a member against the LLC or other members. The court found the consent resolution adopting the amendments was valid because it was adopted by a supermajority of members and it was not unfair for the LLC or its members to take action to preserve its business against a complaint for dissolution, particularly when the plaintiff’s derivative claims were not properly authorized.

Browning Ferris Industries, Inc. v. United States

75 Fed.Cl.591, 99 A.F.T.R.2d 2007-1312, 2007-1 USTC ¶ 50,374, No. 05-738T (Fed. Cl. 2007).

Effect of conversion of Delaware parent corporation to disregarded LLC for purposes of serving as agent of consolidated group in asserting claim for refund.

Union Square Grill Hospitality Group, LLC v. Blue Smoke American Bar & Grill LLC

No. 3:06-CV-00976 (PCD), 2007 WL 869024 (D. Conn. March 19, 2007)

Requirement under Connecticut LLC statute that notice of LLC’s dissolution be given to known claimants; personal liability of member for assets distributed after failure to give notice of dissolution; LLC’s liability for judgment against predecessor LLC under “continuity” doctrine of successor liability.

Wellman v. Dow Chemical Company

Civ. No. 05-280-SLR, 2007 WL 842084 (D. Del. March 20, 2007)

Treatment of Delaware LLC like corporation for liability purposes; insufficiency of record to support piercing veil of LLC.

Garfield v. Suntrust Bank

__ F.Supp.2d __, Nos. 06 60351 Civ Lenard, 06 60551 Civ Torres, 2006 WL 4102210 (S.D. Fla. 2006)

Lack of standing of members’ trustees to sue with respect to losses of LLC, requirement under Florida and Nevada law that plaintiff be member to sue derivatively on behalf of LLC.

Global Diagnostic Development, LLC v. Diagnostic Imaging of Atlanta

__ S.E.2d __, Nos. A06A1728, A06A1729, A06A1730, A06A1731, 2007 WL 686155 (Ga. App. 2007)

Insufficiency of common ownership of corporation and LLC as grounds to disregard separate existence of LLC.

Moise v. Moise

__ So.2d __, No. 06-CA-876, 2007 WL 753210 (La. App. 2007)

Characterization of husband’s LLC interest as separate property; status of member’s wife as manager, not member, despite being identified as member on lease and sharing in profits.

In re Reserve Capital Corp; In re Hawkins Development LLC; In re Hawkins; In re Hawkins Family, LLC; In re Hawkins Manufactured Housing, Inc.; In re Forest View, LLC; In re Wooded Estates, LLC; In re Tioga Park, LLC

Nos. 03-60071, 03-60072, 03-60073, 03-60074, 03-60075, 03-60076, 03-60077, 03-60078, 2007 WL 880600 (Bankr. N.D. N.Y. March 21, 2007)

Analysis and denial of motion for substantive consolidation of bankruptcy cases of individuals and various LLCs and corporations.

Brownstone Investment Group, LLC v. Levey

468 F.Supp.2d 654 (S.D. N.Y. 2007)

Sufficiency of member’s claims of fraud, conspiracy, aiding and abetting breach of fiduciary duty; analysis of injury as direct or derivative).

McFarland v. Virginia Retirement Services of Chesterfield, L.L.C.

__ F.Supp.2d __, Civil Action No. 3:06CV651, 2007 WL 749672 (E.D. Va. 2007)

Limited liability of member of Virginia LLC; personal liability of member who personally participates in tortious conduct of LLC.

Didion Milling, Inc. v. Agro Distribution, LLC

No. 05-C-227, 2007 WL 702808 (E.D. Wis. March 2, 2007

Interpretation of net cash flow term of contract with corporate buyer where contract was subsequently assigned by corporation to LLC disregarded entity.