Section 1541 of Maine’s Limited Liability Company Act provides that, in the absence of a Statement of Authority, any manager, member, president or treasurer has the authority to bind the limited liability company. The Maine LLC Act Drafting Committee added this provision to the LLC Act to address concerns of the real estate and commercial finance bar. In retrospect, I don’t think we (the Committee) have done enough to explain to the rest of the Maine Bar the potential for damage and mischief this provision creates, and why filing a Statement of Authority is so critical to limiting or eliminating this potential. This post is my attempt to define the potential. The idea for the post came to me from reading some recently issued opinions from California and New York. These cases provide examples of harm that could have been avoided with carefully crafted limits on apparent authority.

Apparent Authority – Cases in Point

A limited liability company does not act on its own. It acts through natural persons. Only natural persons authorized to act on the LLC’s behalf can legitimately bind the LLC. Authorizing persons to act on its behalf allow the LLC to borrow money, buy and sell assets, contract for services, and otherwise engage in commercial transactions with others to conduct its business. In other words, authorizing persons to act on its behalf is essential to the achieving the LLC’s purposes.

However, authorizing persons to act on its behalf also exposes the LLC to risks. In the absence of checks on the power of these persons, the LLC could suffer significant losses. Two recent court opinions highlight these risks. The first opinion comes from the Second Appellate Division of New York’s Supreme Court[1] and concerns the case of CitiMortgage, Inc. v. Kenneth Caldaro, et. al., 145 A.D.3d 851 (2016). Per the facts of the opinion, Vicky Caldaro, a member of R.V.P. Associates, LLC, deeded R.V.P.’s real estate to herself and Kenneth Caldaro. That raises the first issue:  did Vicky have the authority from the other members of R.V.P. to do that? Vicky and Kenneth then borrowed money from QuickenLoans, pledging a mortgage interest in their recently acquired (from R.V.P.) real estate as collateral for the QuickenLoans debt. QuickenLoans then sold the debt and the security interest in the real estate to CitiMortgage. Presumably, Vicky and Kenneth defaulted on that debt because CitiMortgage attempted to enforce its claimed rights against the real estate pledged as collateral.

When CitiMortgage sought to enforce its rights to the real estate, it discovered that the deed from R.V.P. to the Caldaro’s was never recorded. Further, according to the Caldaro’s, the deed was lost. CitiMortgage then went to court to force R.V.P. to execute a deed to the Caldaro’s so CitiMortgage could enforce its claim against the real estate pledged to it. R.V.P. said, “not so fast”. They said Vicky did not have authority to convey the real estate to herself and Kenneth.

The Appellate Division judges held that Vicky had apparent authority to bind the LLC. She had apparent authority because she was listed as a member of the LLC on the LLC’s Statement of Organization. In fact, she was the only person listed as a member on the Statement of Organization. Further, the members of R.V.P. never executed an LLC Agreement or Operating Agreement. Based on the Statement of Organization and the absence of any contrary documents available to CitiMortgage, Vicky had apparent authority to bind R.V.P. As CitiMortgage had no notice that Vicky intended to defraud it in pledging an interest in the real estate as collateral, CitiMortgage was a bona fide encumbrancer. In other words, CitiMortgage had a valid mortgage interest in R.V.P.’s property.

The other members of R.V.P. seem like innocent victims here. However, they were not completely powerless to prevent the real estate from being pledged as collateral. At the very least, they could have amended the Statement of Organization and entered into a binding Operating Agreement. Still, they were (it seems) victims of risks created by unchecked apparent authority.

The second opinion was issued in the case of Western Surety Company v. La Cumbre Office Partners, LLC, — Cal.Rptr.3d — (2017), 2017 W.L. 445408 comes from California’s Court of Appeal for the Second District. To get the gist of the case, imagine that you become a member of an LLC (La Cumbre) with others to acquire a medical office building in Santa Barbara. One of the members of the LLC (Crespano) is an LLC owned by Melchiori. Melchiori is the managing member of La Cumbre’s manager, MIC. Melchiori also owns a majority interest in a construction company, MCC.

MCC acquires surety bonds to provide financial backing for its obligations under construction contracts. The surety bonds are issued by Western Surety. Under the bonds, if MCC defaults on its construction contracts, Western Surety will make the damaged parties whole, financially speaking. As a condition of issuing the bonds, Western Surety demands to be indemnified. Like any other person in its business, it will seek an indemnity promise from MCC and any person related to MCC. So, when MCC asked Western Surety to issue the surety bonds, MCC sought an indemnity from Melchiori. In satisfying Western Surety’s diligence demands, Melchiori submitted his financial statement. His financial statement showed his (indirect) interest in La Cumbre.

While the parties dispute how this happened, La Cumbre became a party to Western Surety’s indemnity agreement. However, Western Surety’s counsel made a significant error in drafting the signature page of the Indemnity Agreement. He drafted the signature block for La Cumbre as follows:

LA CUMBRE

 

By: _____________________

Melchiori, Managing Member

Melchiori, however, is not the managing member of La Cumbre. He is the managing member of MIC. MIC is the manager of La Cumbre. So, the signature line should have been drafted as follows:

LA CUMBRE

By: MIC, its Manager

 

By: ____________________

Melchiori, Managing Member

Judge Yegan, writing for the Appeals Court, stated that, under California law, Melchiori’s signature binds La Cumbre, even though he signed as managing member of La Cumbre. Melchiori was, in fact, the managing member of MIC, the Manager of La Cumbre. The right person signed the Indemnity Agreement, even though the position granting him the power to bind La Cumbre was misstated. If the person with apparent authority for an LLC signs an agreement on the LLC’s behalf, his or her signature binds the LLC, even if his or her position is misstated.

That Western Surety dodged the proverbial bullet in this case is interesting, but not central to our issue. Our issue is about the apparent authority Melchiori had and which, had he signed a properly drafted agreement, would not have been questioned. Because Melchiori had this authority, and Western Surety could rely on it, La Cumbre’s medical office building was now subject to Western Surety’s claims for indemnity. So, imagine how you would feel when you realize that your share of about $3.65 million of capital contributions made to La Cumbre was subject to risks that had nothing to do with La Cumbre’s business and of which you were completely unaware.

Back to the Maine Act

Section 18-402 of the Delaware LLC Act effectively limits apparent authority to the authority provided in the LLC Agreement. In other words, under Delaware law, apparent authority of LLC members and managers is governed by the LLC Agreement. If the LLC Agreement does not address the authority of members and managers, any member or manager may bind the LLC.

The Maine Act addresses apparent authority similarly to the Delaware Act. However, instead of requiring third parties to reference the LLC Agreement, the Maine LLC Act makes the Statement of Authority the central and primary governing document for apparent authority. To the extent it addresses apparent authority, the Statement of Authority governs. In the absence of a Statement of Authority, pretty much anyone connected with a Maine LLC has authority to bind the LLC. As the two cases above illustrate, a situation in which a large group of people have authority to bind an LLC is not a good situation. Ideally, apparent authority would be limited to persons who have actual authority, and their apparent authority would be no greater than their actual authority.

Tailoring apparent authority to match apparent authority can be accomplished by restating in a Statement of Authority relevant provisions of the LLC Agreement. But, that’s not a perfect solution. The authority provisions of the LLC Agreement could be amended. If that happens, and the Statement of Authority is not amended, then the Statement differs from the LLC Agreement, and that could be bad.

Perhaps, there’s another way of tailoring apparent authority to match actual authority. Perhaps you can file a Statement of Authority that simply states, for example, “[T]he Managers of the Company have the power and authority to conduct the business and affairs of the Company per the terms of the [LLC Agreement], as amended.” Would that, in effect, give you the same result that applies under the Delaware LLC Act?

Apparent authority of the members and management of a Maine LLC should be addressed.  The best way to address apparent authority is to file a Statement of Authority. Failing to file the statement creates, in many cases, unnecessary risks.

[1] The Supreme Courts in New York are trial courts. The Appellate Courts of the Supreme Courts are the intermediate appeals courts. The Court of Appeals is the highest appeals court.

Partnerships do not pay federal income tax. Instead, the partners of the partnership pay income tax on their distributive shares of the partnership’s income. Their distributive shares of income are determined under the partnership agreement, if the partnership agreement properly allocates the partnership’s income.

One method of allocating partnership income is the “targeted capital account” method. Thoughtful practitioners who use targeted capital accounts believe that method allocates items in accordance with the partners’ interest in the partnership under Treasury Regulation § 1.704-1(b)(3), or in accordance with the economic equivalence test under Treasury Regulation § 1.704-1(b)(2)(ii)(i). The Internal Revenue Service is not yet convinced, publicly anyway. The Service has, however, added guidance for the targeted capital account method in its 2016-2017 Priority Guidance Plan.

Employing the targeted capital account method seems simple on the surface. Compute for each partner the difference between the amount that would be distributed to that partner on a liquidation as of the end of the allocation year minus that partner’s actual capital account balance as of the beginning of that year (adjusted for distributions and contributions during that year). Target allocations can be a lot more complex than they seem, even where the partnership has a relatively simple economic arrangement.

Practitioners use target capital accounts especially where some partners enjoy a preference on distributions. For example, assume A and B form a partnership AB on January 1, 2016. A contributes $1,800 cash and B contributes $200. Under the deal, cash is distributed as follows:

1. All to A until A is returned $1,600 of A’s contributed capital
2. 50% to A and 50% to B until they are both returned all contributed capital,
3. the balance, 60% to A and 40% to B.

AB uses its $2,000 to buy land. It then enters into a land lease under which it realizes $200 of net income.

In 2016, AB had $200 of taxable income and realized $200 of cash. AB did not distribute cash to A or B during 2016. In that case, income would be allocated 60% to A and 40% to B. However, all $200 would be returned to A. So, B is allocated $80 of income, but receives no cash. In that case, B must use B’s own cash to pay income taxes on that $80 of income.

Enter tax distributions. The ideal tax distribution covers the spread between a partner’s tax on its distributive share of income for a given year and the cash distributed to it in that year under the economic deal.

The decision to pay tax distributions is well-intentioned. However, if the partnership is using targeted capital accounts, the person drafting the partnership agreement must exercise some care. At a minimum, the draftsperson should consider how the distributions change the economic deal and add provisions to correct the change – to restore the economics as much as possible. One remedy is to treat the tax distributions as a loan. In the example above, tax distributions to B can be treated as a loan to B that B is obligated to repay, regardless of the performance of the partnership.

In the alternative, the agreement can provide that B’s tax distribution is an advance on future distributions. However, if the partnership adopts that approach, it must consider how those distributions affect income allocations. If the partners do not want those distributions to affect income allocations, the agreement should include language such that the target capital account balances used to calculate income for income tax purposes will not be adjusted for these distributions.

The alternative approach is far less appealing to A. If things go really badly, the economics between A and B are irrevocably affected by the tax distribution. For example, assume that the land AB acquired becomes a superfund site. That tax distribution that B received is likely money to which A is entitled under the deal. A would have no recourse against B to get that money back, unless B had a personal obligation to repay it.

The targeted capital account allocation looks like a nice way to avoid drafting complicated allocation provisions. They can be. However, they do not relieve us from understanding how allocations and distributions – including, and especially, tax distributions – work together.

“Choice of entity” may be the most mercilessly beaten dead horse of all. There are many varieties of the presentation. All of them have merit. Some emphasize one set of criteria, others emphasize slightly different sets of criteria. No matter which criteria folks emphasize, all agree that there is a choice to be made. No business entity is clearly superior in all cases.

While different circumstances call for different entity choices, there is at least one constant in business. Business is conducted by human beings. Human beings have weaknesses, vulnerabilities, varying degrees of emotional management, and differing ethical codes. These human qualities (or failings) can produce disputes, sometimes ugly disputes.

Most business attorneys representing a closely-held business will attempt to anticipate these disputes. They’ll attempt deal with these disputes by advising the business owners to establish a contractual business divorce process. In the corporate world, these provisions are contained in the Shareholders Agreement. In the partnership/LLC world, the provisions are in the Partnership Agreement or Limited Liability Company Agreement (an LLC Agreement).

The business divorce provisions in a Shareholders Agreement will in many ways be a good template for similar provisions in a Partnership Agreement or LLC Agreement. While a wise business law practitioner might begin to draft business divorce provisions for an LLC Agreement using a Shareholders Agreement template, she will not simply cut and paste. Rather, she’ll modify the Shareholder Agreement provisions, sensitive to the business, economic, and tax differences between corporations and partnerships/LLCs.

A relatively recent Delaware case highlights the perils of failing to clearly and unambiguously address these differences where a partner’s interest is “redeemed”. In Hampton v. Turner, C.A. No. 8369-VCN (Del Ch. April 29, 2016) the Delaware Chancery Court addressed a dispute between members of a tech company. One set of members were responsible for creating the intellectual property of the Company. Let’s call these folks the IP Members. The other set was a group of members providing capital led by Mr. Turner. We’ll call these folks the Investor Members.

We don’t know what precipitated the dispute between the IP Members and Mr. Turner, but, you can imagine what might have happened, based on the differing interests and backgrounds of the groups involved. In any case, the IP Members sought to have the LLC dissolved under judicial dissolution. That act triggered a provision in the LLC Agreement granting the LLC the right to buy out the IP Members’ interests in the LLC (their Units). The buyout provision in the LLC Agreement stated that amount to be paid for their Units (in this case) is the Fair Market Value of their Units.

That provision begs the question:  what is the Fair Market Value of the Units?  The Investor Members argued that the LLC Agreement provides that the Fair Market Value of a person’s Units is determined with reference to liquidating distribution provisions.  In other words, for each Unit, a departing Member receives the net amount that person would receive as to that Unit if the Company sold all of its assets for fair market value in liquidation. Under this approach, the IP Members were entitled to about $197,000 each.

The IP Members argued that the Fair Market Value of their Units was the product of the enterprise gross value multiplied by their share of profits. Under this approach, the brainy folks were entitled to about $444,000 each.

Vice Chancellor Noble disagreed with the Investor Members, denying their motion for Summary Judgment. He correctly stated that if the Members wanted Fair Market Value to be determined with respect the liquidating distribution waterfall, they could have said so. They did not.

Vice Chancellor Noble also said that a payment from the Company to a person for Units is not necessarily a distribution. And even if it were a distribution, it could be a distribution that is made differently than distributions under the LLC Agreement’s liquidating distributions provisions.

Vice Chancellor Noble’s statements on distributions seem suspect to me. It seems to me that a payment from a partnership to a partner to liquidate a partnership interest must be treated as a distribution. And if it is a distribution, it seems that payment should be governed by distribution provisions in the partnership agreement.

Regardless of whether Vice Chancellor is correct about distributions, he is absolutely correct that the Members could have made that result inevitable had they drafted the agreement more precisely and clearly, in keeping with their business deal. Under the Chancery Court’s ruling, the business deal seems to have been undone, as the Investor Members’ capital will shift from them to the IP Members.

Or not. If the parties had accurately accounted for the value of the intellectual property contributed by the IP Members, the IP Members would have been entitled to book capital accounts equal to that value and perhaps a priority return of that value. In that case, perhaps the ruling gives the IP Members their due, or something close to it.

Regardless of whether the IP Members received true value for the interests, something more, or something less, the parties each took a chance. They signed an Agreement with a buyout provision that was suitable for a corporate deal, but inadequate for a partnership deal. Partnerships, unlike corporations, are not distinct from its equity holders. The partnership is an aggregate of the equity holders. Their shares of that partnership are determined by their shares of equity as determined by the partnership agreement. Those shares are likely at odd with shares of Units.

When drafting partnership buyout provisions, or partnership drag-along and tag-along provisions, bear in mind that each partner’s interest is not necessarily measured by shares of Units. In other words, if you simply use a corporate model, you are taking a risk. If, however, you draft referencing interests as measured according to the partnership deal (usually distribution provisions or capital account balances), you will probably get the result you hope to get.

“Choice of entity” may be the most mercilessly beaten dead horse of all. There are many varieties of the presentation. All of them have merit. Some emphasize one set of criteria, others emphasize slightly different sets of criteria. No matter which criteria folks emphasize, all agree that there is a choice to be made. No business entity is clearly superior in all cases.

While different circumstances call for different entity choices, there is at least one constant in business. Business is conducted by human beings. Human beings have weaknesses, vulnerabilities, varying degrees of emotional management, and differing ethical codes. These human qualities (or failings) can produce disputes, sometimes ugly disputes.

Most business attorneys representing a closely-held business will attempt to anticipate these disputes. They’ll attempt deal with these disputes by advising the business owners to establish a contractual business divorce process. In the corporate world, these provisions are contained in the Shareholders Agreement. In the partnership/LLC world, the provisions are in the Partnership Agreement or Limited Liability Company Agreement (an LLC Agreement).

The business divorce provisions in a Shareholders Agreement will in many ways be a good template for similar provisions in a Partnership Agreement or LLC Agreement. While a wise business law practitioner might begin to draft business divorce provisions for an LLC Agreement using a Shareholders Agreement template, she will not simply cut and paste. Rather, she’ll modify the Shareholder Agreement provisions, sensitive to the business, economic, and tax differences between corporations and partnerships/LLCs.

A relatively recent Delaware case highlights the perils of failing to clearly and unambiguously addressing these differences where a partner’s interest is “redeemed”. In Hampton v. Turner, C.A. No. 8369-VCN (Del Ch. April 29, 2016) the Delaware Chancery Court addressed a dispute between members of a tech company. One set of members were responsible for creating the intellectual property of the Company. Let’s call these folks the IP Members. The other set was a group of members providing capital led by Mr. Turner. We’ll call these folks the Investor Members.

We don’t know what precipitated the dispute between the IP Members and Mr. Turner, but, you can imagine what might have happened, based on the differing interests and backgrounds of the groups involved. In any case, the IP Members sought to have the LLC dissolved under judicial dissolution. That act triggered a provision in the LLC Agreement granting the LLC the right to buy out the IP Members’ interests in the LLC (their Units). The buyout provision in the LLC Agreement stated that amount to be paid for their Units (in this case) is the Fair Market Value of their Units.

That provision begs the question:  what is the Fair Market Value of the Units?  The Investor Members argued that the LLC Agreement provides that the Fair Market Value of a person’s Units is determined with reference to liquidating distribution provisions.  In other words, for each Unit, a departing Member receives the net amount that person would receive as to that Unit if the Company sold all of its assets for fair market value in liquidation. Under this approach, the IP Members were entitled to about $197,000 each.

The IP Members argued that the Fair Market Value of their Units was the product of the enterprise gross value multiplied by their share of profits. Under this approach, the brainy folks were entitled to about $444,000 each.

Vice Chancellor Noble disagreed with the Investor Members, denying their motion for Summary Judgment. He correctly stated that if the Members wanted Fair Market Value to be determined with respect the liquidating distribution waterfall, they could have said so. They did not.

Vice Chancellor Noble also said that a payment from the Company to a person for Units is not necessarily a distribution. And even if it were a distribution, it could be a distribution that is made differently than distributions under the LLC Agreement’s liquidating distributions provisions.

Vice Chancellor Noble’s statements on distributions seem suspect to me. It seems to me that a payment from a partnership to a partner to liquidate a partnership interest must be treated as a distribution. And if it is a distribution, it seems that payment should be governed by distribution provisions in the partnership agreement.

Regardless of whether Vice Chancellor’s is correct about distributions, he is absolutely correct that the Members could have made that result inevitable had they drafted the agreement more precisely and clearly, in keeping with their business deal. Under the Chancery Court’s ruling, the business deal seems to have been undone, as the Investor Members’ capital will shift from them to the IP Members.

Or not. If the parties had accurately accounted for the value of the intellectual property contributed by the IP Members, the IP Members would have been entitled to book capital accounts equal to that value and perhaps a priority return of that value. In that case, perhaps the ruling gives the IP Members their due, or something close to it.

Regardless of whether the IP Members received true value for the interests, something more, or something less, the parties each took a chance. They signed an Agreement with a buyout provision that was suitable for a corporate deal, but inadequate for a partnership deal. Partnerships, unlike corporations, are not distinct from its equity holders. The partnership is an aggregate of the equity holders. Their shares of that partnership are determined by their shares of equity as determined by the partnership agreement. Those shares are likely at odd with shares of Units.

When drafting partnership buyout provisions, or partnership drag-along and tag-along provisions, bear in mind that each partner’s interest is not necessarily measured by shares of Units. In other words, if you simply use a corporate model, you are taking a risk. If, however, you draft referencing interests as measured according to the partnership deal (usually distribution provisions or capital account balances), you will probably get the result you hope to get.