Unincorporated Business Entities Law

What happens when the practice of the members of an Unincorporated Business Entity (UBE) varies from the terms of the UBE’s constitutive documents?  In a recent opinion in Spellman v. Katz, C.A. No. 1838-VCN (Del. Ch. February 9, 2009), Vice Chancellor Noble invoked the Parole Evidence Rule to prohibit the consideration of evidence showing that the members of an LLC had disregarded a provision in the LLC Agreement. 

In Spellman, Doctors Katz, Spellman and Alfieri formed Delaware Bay Surgical Services, P.A. as the vehicle for the joint practice of medicine.  At the same time, the three also formed KSA, L.L.C.  The LLC bought a piece of property, constructed a building, Bayview Medical Center, and leased it (or a portion of it) to the PA.  At some point, Dr. Alfieri withdrew form the LLC (and, presumably, the PA), and bought one of what eventually became three "units" from the LLC.  In February, 2002, after an unsuccessful attempt to force dissolution of the PA, Dr. Spellman withdrew from the practice.  In 2002, presumably after Spellman’s departure, another unit in the building was sold.  Dr Katz continues to practice through the PA, and the PA continues to lease a unit in the building.  Slip Op., at 1-2 & nn. 1-4.

In his recent opinion, Chancellor Noble granted Dr. Spellman’s request for dissolution of the LLC and the appointment of a liquidating trustee.  Section 5.1 of the LLC Agreement provided for dissolution and winding up of the LLC

as soon as possible after the construction of the building [Bayview Medical Center] has been completed, the condominium documents have been finalized and a certificate of occupancy has been issued with respect to each condominium unit . . .

Id. at 2 (bracketed portion in the opinion’s quotation of Section 5.1).   

Although Dr Katz did not cast his argument in terms of mistake, he did argue that the members had intended the LLC to be used as the vehicle to own the facilities used by the PA in order to obtain  tax benefits.  Id. at 5.  He claimed that the members did not know of the language of Section 5.1.  Id. at 6. Chancellor Noble rejected those arguments out-of-hand:

Dr. Katz would have the Court ignore the plain language of Section 5.1 in deference to his recollection of the parties’ intention that KSA would continue as an entity long after the completion of Bayview Medical Center….

Id. at 5. 

The Chancellor also noted that Dr. Katz had not argued waiver, estoppel or acquiescence.  Id. at 6 n.20.  In retrospect, that was a mistake.  Whatever else is true, the LLC did continue doing business for over two years after the completion of the facility.  Dr. Alfieri left the practice, withdrew from the LLC, and then bought his unit (presumably, the space he had already been using).  The practice PA continued to lease the remainder of the building until Dr. Spellman left the practice, at which point the LLC sold a second unit.

How should the law handle a variance between the agreements and the practice of the parties?  Continuation of a business beyond an agreed term or undertaking, and without an express agreement to do so, was common enough that, almost a hundred years ago, the UPA addressed it (Section 23).  RUPA continues to provide for it (Section 406).  ULLCA Section 802(b) does permit the members to waive winding up, but the ULLCA does not address a continuation without a waiver.  Section 18-806 of the Delaware LLC Act does allow "revocation of dissolution," but only by "the affirmative vote or written consent of all remaining members…."

All the LLC statutes need to address the problem of "holdover" LLCs.  The R/UPA approach of falling back on the statutory default may not be the right solution.  For example, under Section 18-801(a)(1) of the Delaware LLC Act, the statutory default is perpetual existence.   One the other hand, the substance of the RUPA statutory default–an "at will" entity–may well be proper to handle holdovers.

In the absence of a legislative solution, UBE documents should address the problem.

Time to get to work.

Hat tip to the Delaware Business Litigation Report.

posted by Gary Rosin

I know that historically–before the Great Depression, perhaps even before the 20th Century–courts considered joint ventures and partnerships to be distinct business forms (for reasons that will become apparent, note my use of "forms" instead of "entities").  To be sure, the two were "similar" and courts usually applied partnership law to joint ventures.  As the Idaho Supreme Court recently put it in its opinion in Costa v. Borges, 2008 Op. No. 23, at 4, 179 P.3d 316 (Idaho February 15, 2008) (citations omitted):

Because of the similarities between partnerships and joint ventures, partnership law generally governs joint ventures.  A partnership is "an association of two (2) or more persons to carry on as co-owners a business for profit." "A joint adventure is generally a relationship analogous to but not identical with a partnership, and is often defined as an association of two or more persons to carry out a single business enterprise with the objective of realizing a profit."

The opinion in Costa v. Borges then took an unexpected turn.  Because RUPA Section 201 declares a partnership to be an entity separate from its partners, the Idaho Supreme Court concluded that partnership and joint venture law have parted company:

Although a partnership is now an entity distinct from its partners, "a joint venture is not an entity separate and apart from the parties composing it." There is no statute providing that a joint venture is an entity distinct from its members. There is no statutory provision allowing for the dissociation of a member from a joint venture and the continuation of the joint venture in business as a separate entity. That portion of RUPA providing for the continuation of a partnership as a separate legal entity after dissociation of a partner has no application to a joint venture.

Slip. Op. at 5 (citations omitted) (emphasis added).  Later, the Court indicated that, even in a three-member joint venture,

However, even if the joint venture had three members it could not continue doing business after the withdrawal of one member. Because "a joint venture is not an entity separate and apart from the parties composing it," a joint venture cannot continue in business as a separate legal entity after one joint venturer withdraws.

Id. at 4-5 (citation omitted). 

The same could have been said of mid-(20th) century partnerships.  Not only does the Costas v. Borges freeze joint-venture law, it also ignores Rights of partners under UP)A Section 38(2).  A joint venture is only a partnership for a particular purpose.  Under UPA Section 38(2), after the early withdrawal of a partner in a partnership for a particular purpose, the remaining partner(s) may

continue the business of the partnership, either by themselves or jointly with others ….

That is, the question is not whether a partnership may continue after the withdrawal of one of two partners, but whether the remaining partners may continue the business without dissolution.  That said, with its emphasis on continuation of the entity, the RUPA does not adequately address continuation of the business of two-partner partnerships after the premature withdrawal of one of the partners.

Hat tip to Marc Ward.

posted by Gary Rosin

As mentioned in my earlier post on the Casavecchia v. Mizrahi series of cases, the essence of the Casavecchia’s claims was that

1. the LLC had been formed to develop a single real estate development, Hills of the Heartland,
2. the development had been completed, and all units sold, and
3. instead of distributing profits, the Mizrahi had instead loaned the LLC’s funds to another LLC in which the Casavecchias were not participating.

I have already noted the disconnect between the Casavecchia’s understanding of the parties’ prior practice–one development at a time, and the formation of a new vehicle for new projects–and the breadth of the purpose provision of the LLC’s Operating Agreement. 

But here are other puzzling aspects of the trial court’s original order, Cassavecchia v. Mizrahi, No. 008635/2005 (N.Y. Sup. Ct. August 23, 2006) (Warshawsky, J.).  At first, it seemed as though Justice Warshawsky had ordered a defacto dissolution of the LLC.  In this connection, note that Section 701 only allows voluntary dissolution without a vote of the members only when the organizational documents provide for a time for dissolution, or dissolution on the happening of a specified event.  Section 702 of the New York Limited Liability Company Law allows for judicial dissolution at the request of a member "whenever it is not reasonably practicable to carry on the  business in conformity with the articles of  organization or operating agreement."  To the extent Warshawsky found a limited purpose, he could have found a voluntary dissolution under Section 701 or, perhaps that it was "not longer reasonably practicable" a purpose that had been completed.  But that’s not what the order said.

On closer reading, Warshawsky casts the issue as

The issue that emerges for determination is whether a reading of  ¶ 8,together with ¶¶ 4, 6 and 9 leads to the conclusion that profits of the Hills of Heartland venture should be allocated and distributed to the shareholders so that they have the right to control their use. See e.g. LLCL § 507, Interim Distributions.

Slip Op., at 3 (emphasis added).  Section 4 of the Operating Agreement set forth a broad, rather than a narrow, purpose of the LLC.  Id. at 2.  Section 6 provides for management by action of a majority in interest, which itself is consistent with the early statement that Mizrahi managed the day-to-day affairs of the LLC.  Id.  Section 9 provides for distributions "at the times and in the amounts determined by a majority in interest".  Id.  Section 507 of the New York LLC Law provides for interim distributions to members

to the extent and at the times or upon the happening of events specified in the operating agreement….

Section 8 of the operating agreement provides for the allocation of profits and losses to the members.  Slip Op., at 3.  Warshawsky then noted the dispute as to the purpose of the LLC, and concluded

While it is conceivable that [LLC] could build homes and lend money out of profits so generated, that plan of operating would have to be approved by all the investors in the venture as they are the lawful beneficiaries of the success of any LLC.

Slip Op., at 4. (emphasis added).

It is clear that, while Warshawsky contemplates interim distributions, the basis for his order of "an inquest … to determine the profits available for distribution" is not entirely clear.  Does he deem that the Cassavecchias’ own a majority of interest, so can decide to make distributions?  Does he instead believe (wrongly) that allocations under Section 8 give the members the right to distributions?  Why else would he suggest that the diversion of profits into a loan would require the approval of all investors?

posted by Gary Rosin

The still on-going litigation arising out of Hills of Heartland LLC can help illuminate the role of a transactional lawyer.  The latest installments are two opinions out of the NY Appellate Court, 2nd department, Casavecchia v. Mizrahi, 2008 NY Slip Op 00938 & 2008 NY Slip Op. 00939 (NY AD [2nd] December 16, 2008).  The appellate opinions grow out of orders by Judge Warshawsky (N.Y. Sup. Ct., Nassau County) on August 23, 2006 and on September 11, 2007.  The point here is not to parse the opinion, but to note the inconsistency between the LLC’s operating agreement and the practice of the parties.

Casavecchia and Mizrahi were serial real estate developers who

were in business together for many years constructing and marketing residential housing of which Hills of Heartland is just one. Allegedly, as a development was completed , the profits were used to finance the building of a new development. There came a time when plaintiff was no longer associated with the business.

Order, September 11, 2007, at 2.  One of the key disputes between Casavecchia and Mizrahi related to the role (and purpose) of Hills of Heartland LLC.  In the Order of August 26, 2006, Judge Warshawsky found that the purpose of Hills of Heartland LLC was solely to develop Hills of Heartland: 

Defendant bootstraps section 202(f) & (c) of the LLC on to the Hills of Heartland Operating Agreement to support the claim that the purpose of the Company was to build and to lend money. He unfolds a rather convoluted claim that plaintiff was interested in the Company lending money rather than distributing it when the Company acquired a parcel of land on which it has now completed development….   * * *  His profound ending is that the process of lending retained money rather making a distribution to investors is a sage and efficacious way of doing new business with old money.

* * *  The only dispute in the arguments of the parties … is whether the Company was formed to lend money. 

Despite thoroughly and carefully searching the record the court can find no evidence that it was.  Defendant’s assertion is unsupported by evidentiary proof in admissable form …. He testified that the Company had not made any loan. He admitted in the answer that it was formed to build homes.

Id. at 4. 

Mizrahi’s attorney appears to have focused on Section 202(f) of the New York Limited Liability Company Law, which includes in the laundry list of general powers of an LLC the power to "lend  money for any lawful purpose, invest or reinvest its funds…."  Earlier in the opinion, Judge Warshawsky had quoted paragraph 4 of the LLC’s Operating Agreement, which included an omnibus purpose clause:

4.  PURPOSE. The Company is formed for the purpose of acquiring, owning, operating, developing, constructing buildings of all kinds or nature and selling real estate and engaging in any lawful act or activity for which limited liability companies may be formed under the LLCL and engaging in any and all activities necessary or incidental to the foregoing.

Order of August 26, 2006, at 2 (emphasis added). 

The point here is not to assess Judge Warshawsky’s conclusion, could well have been influenced by the fact that he loaned the LLC’s funds to a company in which the Casavecchia’s had no ownership interest:

that defendant Mizrahi is the only investor in the Company who is actively involved in Casa Mason, the proposal of being an unsecured, unguaranteed, interest free lender to a Mizrahi entity appears to be a bountiful bonanza to only defendant.

Id. at 5.

Instead, assuming that the parties’ prior practice had been to invest in particular development projects via project-related unincorporated business entities (UBEs), why did the purpose clause not only refer to investment in real estate generally, but also include an omnibus purpose clause?  Surely, some transactional dropped the ball here, probably by trying to save drafting time by pulling out a form. 

There is more that I could say, but I’ll stop here.

posted by Gary Rosin