Wednesday, February 22, 2012

Forleo Again Rejected - Officer Not Liable on Contract Entered into During Administrative Dissolution

U.S. District Court Rejects Forleo, Holds Officer Not Personally Liable on Contract Signed While Company Administratively Dissolved
The fact pattern is straightforward – Company is administratively dissolved for failure to file its annual report.  Still it continues in operation and, on its behalf, an officer enters into an agreement with a third party.  Thereafter the Company is reinstated by the Secretary of State.  Eventually Company defaults on the contract, whereupon third party assets that the officer is personally liable on the agreement.  A recent decision of the District Court has rejected that assertion.  eServices, LLC v. Energy Purchasing, Inc., 2012 WL 404957 (E.D. Ky. Feb. 6, 2012).
The argument for officer liability is that from administration dissolution a company is restricted to activities appropriate for its winding up and liquidation.  See, e.g., KRS § 14A.7-020(3).  Actions accomplished by an agent purportedly on behalf of the dissolved company that exceed that limited scope involve purported agency on behalf of a principal who cannot so act.  Not actually acting on behalf of a competent principal, the agent may be held liable on the agreement.  See generally Thomas E. Rutledge, Dissolution of a Limited Liability Company § 9.5, in Limited Liability Companies in Kentucky (UKCLE 2010)
This argument begs a crucial question, mainly the impact of the company’s reinstatement.  The statute provides, inter alia, that reinstatement relates back to and has the effect of nullifying the prior administration dissolution.  See, e.g., KRS § 14A.7-030(3).  The principal’s incapacity having been retroactively cured, the agent was clothed with authority and is therefore not a party to or liable on the agreement.
Because Energy Purchasing was reinstated after Buchart signed the contracts, the corporation is treated as having been in existence when the contracts were signed…
2012 WL 404957,*2
eServices pinned its hopes on the Forleo decision in which, notwithstanding reinstatement, the corporation’s officers were held personally liable on an agreement entered into during the period of administrative dissolution.  Forleo v. American Products of Kentucky, Inc., 2006 WL 2788429 (Ky. App. 2006).  Judge Coffman dissected and discarded any application of Forleo, finding its reasoning unpersuasive, that it conflicts with the operation of the express statutory language and as well conflicts with the published Fairbanks decision.  2012 WL 404957, *2-3; Fairbanks Arctic Blind Co. v. Prather & Assoc., 198 S.W.3d 143 (Ky. App. 2005).
Hopefully this decision will serve as a final nail in the Forleo coffin.
All that said, there are two points in this opinion with which I would quibble.  There is an extensive discussion of limited liability, suggesting that it is the touchstone of the corporate form and must be afforded an officer with respect to obligations undertaken with respect to the corporation.  While limited liability is commonly perceived to be the most important aspect of the corporate form, and its availability has greatly enhanced capital formation for over a century, limited liability is not actually central to the corporate structure.  It is rather a late development with respect to the corporate form, and not all corporations have had this attribute.  Rather, the sine qua non of the corporate form has been continuity of life. 

        Of greater importance is the suggestion that the rule of limited liability somehow impacts upon whether an officer is or is not liable for a contract entered into in the name of the principal.  The rule of limited liability as set forth in the Kentucky Business Corporation Act extends exclusively to the shareholders; it is not this rule that affords either the directors or the officers limited liability from the debts and obligations of the entity.  See KRS § 271B.6-220(2) (referencing shareholders but not directors, officers or agents).  While officers are not personally responsible for the performance on and any default of an agreement entered into on behalf of a corporation, that absence of exposure arises not from the substantive law governing corporations (including the rule that shareholders enjoy limited liability), but rather from the common law of agency.  See, e.g., Restatement (Third) of Agency § 6.01.  As to why directors are not liable for the debts and obligations of a corporation, in that directors are not agents, that is a discussion for another day.

Thursday, February 9, 2012

Improper Assignment of an LLC Interest – Breach of Contract or Void Ab Initio?

Improper Assignment of an LLC Interest – Breach of Contract or Void Ab Initio?

         A recent decision of the Colorado Supreme Court provides helpful guidance with respect to the treatment of anti-assignment provisions in an LLC’s Operating Agreement. Condo v. Conners, 2011 WL 6318980 (Colo. Dec. 19, 2011).

      Banner was one of three members of a Colorado LLC. That LLC’s Operating Agreement provided that “a Member shall not sell, assign, pledge or otherwise transfer any portion of [the Member’s] interest in [the LLC] without the prior written approval of all of the Members.” This provision went beyond the statutory provision to the effect that, while the right to participate in management is not assignable, the right to the economic fruits of the venture is freely assignable. Colo. § 7-80-702(1). Accord KRS § 275.255(i)(a)-(c). Banner, in the course of his divorce, sought to transfer his interest in the LLC to Condo, his former spouse, agreeing as well to exercise his retained management rights under her direction. Both of the other Members objected to this proposed assignment, but Banner went ahead and did it. Ultimately, Banner sold his interest in the LLC to the other two Members, whereupon Condo sued them on theories of tortious interference with contract and conspiracy.

      The validity of Condo’s claims depended upon whether the assignment to her was of itself valid. The trial court rejected the validity of that assignment, and the Colorado Court of Appeals affirmed, but on other grounds.

      When the case came before the Colorado Supreme Court, it focused upon the alternative paradigms for the analysis of an anti-assignment clause. Classically, a violation of an anti-assignment clause was itself a nullity; no transfer took place in that the transferor lacked the capacity to accomplish that act. Under the modern approach, a violation of a limitation upon assignment is seen as a breach of contract pursuant to which the assignment is accomplished, but the assignor is liable for damages. Consequently, if the classic approach was applied, Condo’s interference of contract claim would fail in that she never received the purportedly assigned membership interest. Conversely, under the modern approach, the assignment would have taken place and Condo’s claims against the LLC’s two other members would at least survive summary judgment. 2011 WL 6318980,*7.

      The Colorado Supreme Court ultimately determined that the classical approach would be utilized, justifying that determination on a pair of grounds. First, the Colorado LLC Act contains a freedom of contract provision. Colo. § 7-80-108(4) (“It is the intent of this article to give maximum effect to the principle of freedom of contract and to the enforceability of operating agreements”). Kentucky utilizes the same rule in its LLC Act. See KRS § 275.003(1). This statutory directive was interpreted as sanctioning the capacity of the parties to an operating agreement to restrict, to the degree they determine appropriate, the assignability of any interest in an LLC. Second, utilizing the principles of in delectus personae, the Court thought it appropriate that the parties should be able to restrict the conveyance of any aspect of the interest in the LLC. As to this point, the Court cited with approval RIBSTEIN & KEATINGE ON LIMITED LIABILITY COMPANIES § 7:5 (2011) (“[A]n assignment of financial rights could injure the non-assigning Members by diluting the assignor’s incentives to maximize the welfare of the firm. Thus, the parties should be able to control assignment by agreement.”)

      Ultimately, there having been no conveyance of the interest by Banner to Condo, Condo had no claim against the other members of the LLC.

      While no Kentucky court has yet reviewed this issue, on a similar fact pattern it would appear appropriate to follow the guidance of the Colorado Supreme Court. Kentucky’s LLC Act embodies the same flexibilities as does that of Colorado with respect to the ability of a written operating agreement to restrict the assignability of the economic rights in the venture, the same principle of maximum enforcement of operating agreements and the same principles of in delectus personae.

New York Court Addresses “Not Reasonably Practicable" Standard for LLC Dissolution

New York Court Addresses “Not Reasonably Practicable”
Standard for LLC Judicial Dissolution

      Under Kentucky law, an LLC may be judicially dissolved upon a showing that it is not reasonably practicable to operate the LLC in accordance with its operating agreement. KRS § 275.290(i). This standard was adopted from Section 902 of the Prototype LLC Act, the primary model for the original Kentucky Act. To date no Kentucky court, in a published decision, has interpreted this language. However, a recent decision of the New York Supreme Court (the trial court under the New York system) provides useful guidance both as to the interpretation of this language as well as addressing perceived inequities in dissolution. Mizrahi v. Cohen, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012).

       Mizrahi and Cohen were equal owners in an LLC that owned a commercial office building. A portion of the building was leased to Cohen's professional practice, while another floor was rented to Mizrahi’s professional practice. The LLC was never able to satisfy its obligations from cash flow, and from the first year of operations additional capital was required from the members in order to keep the LLC current on its obligations. Initially Mizrahi and Cohen contributed equally, but after some period of time Cohen failed to keep up, and Mizrahi made disproportionate contributions. Ultimately, Mizrahi contributed some $900,000 to the LLC more than had Cohen. Ultimately, Mizrahi sued for judicial dissolution of the LLC.

       As to the standard to be employed in interpreting the “not reasonably practicable” threshold, in reliance upon In Re 1545 Ocean Ave., LLC, 893 N.Y.S. 2d 590 (N.Y. 2010), the Mizrahi court found that dissolution would be appropriate upon the petitioner’s demonstration that:

In the context of the terms of the operating agreement or articles of incorporation [sic-organization], that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.
      In light of the LLC’s inability to support its operations from its own income, Cohen’s failure to contribute towards the satisfaction of those obligations and the acknowledgement that the LLC would entirely fail should Mizrahi cease making capital contributions, the Court determined that the operation of the LLC was not financially feasible. 2012 WL 104775, *8.

      Having determined that the LLC would be dissolved, the court turned to the mechanisms to be employed. The operating agreement at issue provided that upon liquidation and after satisfaction of creditor liabilities, the remaining assets would be distributed 50% to each member. The operating agreement did not require, as an intermediate step, the return of contributed capital to each of the members. The dissolution had been sought, at least partially, based upon the fact that Mizrahi had contributed $900,000 more to the LLC than had Cohen. Applying the operating agreement as written, Cohen would have received a windfall. For that reason, the court recharacterized Mizrahi’s additional $900,000 not as a capital contribution but rather as a loan to be satisfied before net assets were distributed amongst the members in accordance with the agreed 50%/50% sharing ratios.