October 2009 — Issue 44

Pierre v. Commissioner of Internal Revenue

133 T.C. No. 2 (U.S. Tax. Ct. 2009)

The court decided that transfers of interests in a single member LLC should be valued for gift tax purposes as transfers of interests in the LLC (and thus subject to valuation discounts for lack of marketability and control) rather than transfers of the assets of the LLC. The IRS argued that the transfers should be treated as transfers of cash and marketable securities, i.e., proportionate shares of the LLC’s assets, for federal gift tax purposes because the LLC was disregarded under the check-the-box regulations. The court discussed the historical federal gift tax valuation regime and analyzed the question of whether the check-the-box regulations alter the historical regime. The court concluded that, in the absence of explicit congressional action, the IRS could not by regulation overrule the historical federal gift tax valuation regime in the Internal Revenue Code and well-established judicial precedent, and the court held that the transfers in issue should thus be valued for federal gift tax purposes as transfers of interests in the LLC rather than transfers of proportionate shares of the LLC’s assets.

In re SageCrest II, LLC (SageCrest II, LLC v. Topwater Exclusive Fund, III, LLC)

414 B.R. 9 (D. Conn. 2009)

The court concluded that a redemption provision in the operating agreement of a Delaware LLC was ambiguous with respect to whether members who exercised their redemption right continued to be members of the LLC until they received payment for their interests. Two members of the LLC who exercised their redemption right under the agreement and did not receive payment for their interests claimed they were creditors of the LLC. The parties disputed what it meant to be “redeemed” under the agreement and acknowledged that the terms “redeemed” and “redemption” were undefined terms in the operating agreement and under the Delaware LLC Act. The court discussed definitions of the terms but concluded that many of the “ordinary” definitions were not necessarily applicable in the context of the particular business circumstances, which involved membership interests in an LLC that had investments in real estate and other illiquid ventures. The court noted that Black’s Law Dictionary does not discuss payment in its definition of “redemption.” The court concluded that a reasonable third person reading the redemption provision of the operating agreement in question might be uncertain of the meaning of the terms “redeem” and “redemption” and could understand redemption to mean either that members of the LLC are redeemed on the effective date of redemption or are redeemed on the date upon which they are paid their redemption prices. Given that uncertainty, parol evidence was admissible to assist the court in a proper interpretation.

In re Metcalf Associates-2000, L.L.C. (IAS Partners, Ltd. v. Chambers)

213 P.3d 751 (Kan. App. 2009)

In this judicial dissolution action, Chambers, a 50% member of an LLC, appealed the district court’s judgment dissolving the LLC. Chambers argued that the statutory requirements for dissolution had not been met, but the appeals court affirmed the judgment on the basis that the LLC was deadlocked and faced potential irreparable injury. The LLC was managed by a corporation owned equally by Chambers and Hayes. Hayes also controlled the two entities that collectively owned the 50% of the LLC not owned by Chambers. The relationship between Chambers and Hayes soured, and the district court found that the corporate manager of the LLC was deadlocked because Hayes and Chambers, the corporation’s two directors and shareholders, could not agree on anything related to the corporation’s sole function, i.e., management of the LLC. Chambers argued that there was no deadlock of the LLC because there was only one manager and thus no possibility of deadlock. The court concluded, however, that the manager was itself so deadlocked that it could not legally act on any significant issue involving the management of the LLC. The court explained that the Kansas statutes providing for the dissolution of a deadlocked LLC and a deadlocked corporation differ somewhat but both require a dual showing of deadlock and irreparable injury. Under the LLC statute, owners of at least 25% in interest may petition for dissolution if the LLC’s business is threatened with irreparable injury because the members are so deadlocked regarding the management of the LLC that the requisite vote for action cannot be obtained and the members are unable to terminate the deadlock. If these conditions are present, the court is required to order dissolution. Given the structure of the corporation that was the manager of the LLC, the corporation was deadlocked, and this deadlock resulted in deadlock of the LLC as well. The only escape from the deadlock of the LLC was if the members could bypass the manager and handle the business, but the equal members themselves were totally at odds. The operating agreement required the agreement of all members to sell real estate owned by the LLC, and Chambers argued there could be no deadlock because the members had not yet fulfilled the requirement that all agreed it was time to sell. The court described Chamber’s conduct in marketing the property (the result of which was that only Chambers had made an offer to purchase the property) and stated that an LLC could be held hostage by unethical actors if a member could through bad faith dealings avoid a finding of deadlock whenever an operating agreement required unanimous approval for action. As opposed to a specific disagreement over the price of an LLC asset in a sale to a third party, the disagreements of Chambers and Hayes were fundamental disagreements regarding the marketing and sale of the property. The court stated that it might be possible to draft an operating agreement ro require unanimous approval for every significant decision and specifically limit the situations where a court could declare a deadlock, but a provision merely requiring that the LLC’s manager may not without unanimous vote of the members sell or refinance the properties of the LLC did not do so, and the district court’s finding of deadlock was well supported by the record. The court stated that Chambers had a stronger argument regarding the requirement of potential irreparable harm, but the court stated that the legislature, by including the “threat” of irreparable injury, had implicitly rejected Chambers’ argument that judicial dissolution was not permitted as long as an LLC is still solvent. The court agreed with the district court’s conclusion that the lack of effective management posed a threat of irreparable injury to the LLC. The court also addressed the validity of a capital call made by Chambers. Purporting to act as general manager of the LLC, Chambers had made a capital call and contributed his part, which, if recognized as valid, would have reduced the membership shares of the members controlled by Hayes, who did not contribute. The appeals court agreed with the district court that Chambers had no authority to make the capital call because the manager of the LLC was a corporation. Though Chambers was president of the corporation as well as a 50% shareholder, the court concluded that the evidence supported the district court’s finding that Chambers did not have authority to initiate the capital call. The district court noted that the bylaws of the corporation did not authorize the president to act beyond authority granted by the board of directors, and the board did not authorize a capital call or other acts of Chambers as a manager. Chambers sought recovery of his litigation expenses pursuant to provisions of the LLC and corporate statutes permitting corporate officers and LLC members to be indemnified for expenses in suits against them. The district court denied recovery on the basis that Chambers acted in bad faith and thus did not qualify for indemnity under the corporate statute, which permits recovery only if a person has acted in good faith, or the LLC statute, which allows recovery only to successful litigants or as authorized in the operating agreement. Chambers challenged the district court’s finding that he acted in bad faith, but the appeals court found there was ample evidence that Chambers was acting in his own interests and contrary to those of the LLC.

Mostel v. Petrycki

885 N.Y.S.2d 397 (N.Y. Sup. 2009)

The court concluded that the withdrawal of monies by a member of a Delaware LLC was a distribution subject to the three-year statute of limitations applicable to distributions rather than a misappropriation of company funds subject to the six-year statute of limitations applicable to common law fraud or fraud under the New York Debtor and Creditor Law. The plaintiff, a judgment creditor of the LLC, argued that the defendant was not acting in his official capacity as a member of the LLC when he withdrew $300,000 of his capital investment from the LLC. The defendant argued that the withdrawal was a distribution under the New York LLC Law and the Delaware LLC Act, each of which contain a three-year statute of limitations applicable to a claim for return of a distribution. The court noted that the New York LLC Law provides that the laws of the jurisdiction of an LLC’s formation govern the LLC’s organization and internal affairs and the liability of its members and managers, and, without deciding whether New York or Delaware law governs the statute of limitations, assumed that a Delaware court would come to a conclusion similar to the conclusion of New York courts that the statute of limitations applicable to actions to return LLC distributions was intended to override other applicable law. The court distinguished a New Jersey case in which the claims against a member were characterized as embezzlement and misappropriation because the defendant in that case did not assert that the money he received was a return of capital. In the instant case, the plaintiff acknowledged that the defendant’s withdrawal was a return of his capital investment. The court rejected the argument that the member’s withdrawal of funds fell outside the New York LLC statute’s definition of “distribution,” i.e., the transfer of property by an LLC to a member in his or her capacity as a member. The plaintiff argued that the defendant was not acting in his capacity as a member because he used the withdrawn funds for personal use and withdrew them from the LLC without authority. However, the LLC operating agreement gave members the right to request a return of capital, subject to the approval of the managing member, and the agreement required no further procedures when a managing member sought a return of capital; therefore, the court concluded the defendant received a return of his capital in his capacity as a member as only members have the ability to receive a return of invested capital.

In re General Growth Properties, Inc.

409 B.R. 43 (Bankr. S.D.N.Y. 2009)

The court declined to dismiss the bankruptcy cases filed by numerous direct or indirect subsidiaries of General Growth Properties, Inc. (“GGP”), a publicly traded REIT and ultimate parent of approximately 750 wholly-owned debtor and non-debtor subsidiaries, joint venture subsidiaries, and affiliates (the “GGP Group”). The GGP Group was engaged primarily in shopping center ownership and management. Creditors of certain subsidiaries structured as special purpose entities (“SPEs”) sought to dismiss the bankruptcies filed by these SPEs on bad faith grounds. Most of the SPEs for which dismissal was sought were structured as LLCs. The court described the financing arrangements in which the SPEs were involved and typical SPE documentation, including provisions regarding independent managers who were required to approve a bankruptcy filing by the SPE. The court examined the GGP Group’s financial difficulties and the circumstances surrounding the filing of the bankruptcies and concluded that the record did not support dismissal of the SPE bankruptcies on bad faith grounds. The court relied upon precedent requiring a showing of both objective futility and subjective bad faith in order to dismiss on bad faith grounds, and the court concluded that neither had been established. In support of their contention that objective bad faith was shown by premature Chapter 11 filings on the part of the SPEs, the creditors relied on cases in which Chapter 11 petitions were dismissed because the debtors were not in financial distress at the time of filing, the prospect of liability was speculative, and the evidence indicated the filing was designed to obtain a litigation advantage. The court reviewed the evidence regarding the debtors’ financial distress and concluded that the record demonstrated that the debtors were in varying degrees of financial distress. The court concluded that it was not required to examine the issue of good faith as if each debtor were wholly independent, and the court rejected the creditors’ argument that the SPE or bankruptcy-remote structure of the project-level debtors precluded consideration of the financial problems of the GGP Group. The court stated that the court’s approach need not sacrifice the interests of the subsidiaries or their creditors in favor of the parents and their creditors, but simply included consideration of the interests of the group as well as the individual debtor. The court discussed the “independent manager” provisions of the operating agreements of the SPEs, which required unanimous consent of the managers before an SPE could file bankruptcy. The operating agreements provided that, to the extent permitted by law, the independent managers shall consider only the interests of the entity, including its creditors, in voting on bankruptcy, and further provided that the independent managers shall have a fiduciary duty of loyalty and care similar to that of a director under the Delaware General Corporation Law. The court stated that the drafters of the operating agreements may have attempted to create impediments to a bankruptcy filing, but Delaware law provides that directors of a solvent corporation are required to consider the interests of shareholders in exercising their fiduciary duties. The court pointed out that the Gheewalla decision of the Delaware Supreme Court rejected the proposition that directors of a Delaware corporation have duties to creditors when operating in the zone of insolvency and held that directors of a solvent corporation must continue to discharge their duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholders. Because there was no contention that the SPEs were insolvent, the creditors were not assisted by Delaware law in their contention that the independent managers should have considered only the interests of the secured creditor when making their decisions to file the Chapter 11 petitions. The court stated that creditors were mistaken if they believed that the independent managers could serve on the board solely for the purpose of voting “no” to a bankruptcy filing based on the desires of a secured creditor because the Delaware cases stress that directors and managers owe their duties to the corporation and, ordinarily, the shareholders. Seen from the perspective of the GGP Group, the court found the filings were unquestionably not premature. The court rejected the argument that the discharge and replacement of the original independent managers of some of the SPEs before the decision to file bankruptcy involved subjective bad faith. The operating agreements of the SPEs permitted the independent managers to be supplied by a “nationally recognized company that provides professional independent directors, managers and trustees,” and Corporation Service Company (“CSC”) supplied at least two independent managers who served on the boards of over 150 SPEs. According to the court, these managers did not appear to have any expertise in the real estate business, and some of the lenders thought that the independent managers were obligated to protect their interests alone. The CSC-appointed managers were terminated from the SPE boards prior to the bankruptcy filings and did not learn of their termination until after the filings. Testimony for the SPEs explained that the decision to replace the independent managers was based on a desire by the SPE stockholders and members to have the potential bankruptcies of the SPEs assessed by independent managers with known experience in restructuring environments and complex business decisions. The court concluded that the record did not lead to the conclusion that the admittedly surreptitious firing of independent managers constituted subjective bad faith on the part of the SPEs requiring dismissal of the cases. The organizational documents did not prohibit the action taken or purport to interfere with the rights of the owners to appoint independent managers. Further, the court stressed that, as discussed earlier in the opinion, the independent managers did not have a duty to prevent the SPEs from filing a bankruptcy case. Rather, as managers of solvent companies charged with the duties of directors of Delaware corporations, they had a duty to act in the interests of “the corporation and its shareholders.” The court acknowledged that the creditors had been inconvenienced by the Chapter 11 filings, but rejected inconvenience as a reason to dismiss. The court stated that the fundamental protections negotiated by the creditors and the SPE structures would remain in place during the Chapter 11 cases, including the protection against substantive consolidation. Acknowledging that a principal goal of the SPE structure is to guard against substantive consolidation, the court stated that the question of substantive consolidation was entirely different from the issue of whether the board of a debtor that is part of a corporate group may consider the interests of the group along with the interests of the individual debtor when making a decision to file a bankruptcy case. The court stated that nothing in its opinion implied that the assets and liabilities of any of the SPEs could properly be substantively consolidated with those of any other entity.

Dees v. Kidney Group, LLC

16 So.3d 277 (Fla. App. 2009)

(plaintiff member’s right to discovery re transactions between LLC and non-parties in breach of fiduciary duty and judicial dissolution action).

Moede v. Pochter

No. 07 C 1726, 2009 WL 2748954 (N.D. Ill. Aug. 27, 2009)

(reasonableness of member’s delay in making capital contribution; effect of delay in making capital contribution on admission to membership).

In re Suhadolnik (Denmar Builders, Inc. v. Suhadolnik)

Bankruptcy No. 08-71951, Adversary No. 08-7116, 2009 WL 2591338 (Bankr. C.D. Ill. Aug. 20, 2009)

(analysis of veil piercing of LLCs under Illinois law).

Emprise Bank v. Rumisek

215 P.3d 621 (Kan. 2009)

(members’ right to indemnification under LLC operating agreement and Kansas law (relying on Delaware law for guidance); former member’s inability to recover for manager’s breach of fiduciary duty with respect to conduct occurring after termination of membership; discussion of alter ego doctrine as applied to LLC).

Smith v. New Leaf Associates, L.L.C.

Civil Action No. 05-919-C, 2009 WL 2475072 (M.D. La. Aug. 12, 2009)

(discussion of personal liability of persons transacting business on behalf of LLC prior to formation under Florida law).

Pactiv Corporation v. Perk-up, Inc.

Civil Action No. 08-05072, 2009 WL 2568105 (D.N.J. Aug. 18, 2009)

(discussion of LLC veil piercing under New Jersey and New York law).

Automated Teller Machine Advantage LLC v. Moore

No. 09 CIV 3340(RMB)(FM), 2009 WL 2431513 (S.D.N.Y. Aug. 6, 2009)

(analysis of whether LLC interests were securities for purposes of federal RICO action).

Herrick Group & Associates LLC v. K.J.T.

L.P., Civil Action No. 07-0628, 2009 WL 2596503 (E.D. Pa. Aug. 20, 2009)

(discussion of Nevada LLC revival and reinstatement processes).

In re Klingerman (Klingerman v. Execucorp, LLC)

Bankruptcy No. 07-02455-5-ATS, Adversary No. S-08-00017-5-AP, 2009 WL 2423992 (Bankr. E.D.N.C. Aug, 4, 2009)

(judicial dissolution of North Carolina LLC based on deadlock and discord).

In re White (Williams v. White)

412 B.R. 860 (Bankr. W.D. Va. 2009)

(discussion of requirements to pierce LLC veil under Virginia law).