It’s commonly said there are three things that matter with real estate: location, location, location. Likewise, three things matter when choosing a lawyer to set up a limited liability company: experience, experience, experience.
Tom Rutledge’s terrific blog, Kentucky Business Entity Law, last week highlighted a case in which the admitted inexperience of the lawyer who organized an LLC ultimately proved fatal to its existence and to a farming operation owned by the same family for four generations over 100 years. It’s a sobering lesson for anyone contemplating forming a new LLC for a start-up business or to serve as the ownership vehicle for an existing business.
Felt v Felt, No. 18-0710, 2019 WL 2372321 [Iowa Ct App June 5, 2019], involved a dissolution lawsuit among the three children of Richard Felt, the third-generation owner of an Iowa farm. One of the children, David, worked and lived on the family farm for decades when his father was diagnosed with cancer in 2013 and died in 2015. Richard’s will left his property equally to David and his two siblings, Susan and Daniel.
Richard Puts the Farm in an LLC
Some months before Richard died, he placed the farm into an LLC with the idea it would help preserve it as a family farm and provide tax benefits. Here’s how the court’s opinion describes what happened:
In early 2015, Richard began discussing the creation of a limited liability company (LLC) with his attorney, Sam Braland. Richard was interested in potential tax benefits and wanted to keep the farms in the family. Braland had not previously formed a LLC, so he studied the Iowa LLC statutes and obtained a template of a farm LLC from the Iowa State Bar Association. He did not consult with an attorney with more LLC experience. Braland drew up a certificate of organization and an operating agreement. On August 28, Richard signed the organizational documents and operating agreement for a manager-managed LLC named Felt Farms LLC. Richard transferred all his real property to the LLC in exchange for ownership of 100 Class A Units (income units) and 900 Class B Units (ownership and voting units). Richard and David were appointed and signed the agreement as managers of the LLC, and Richard signed separately as its only member. Richard did not change his will, which continued to leave his property in equal shares to his children. Richard did not tell Daniel or Susan anything about the LLC.
After their father’s death, in December 2015, David told his siblings that the farm properties were in an LLC. That same month the lawyer, Braland, wrote them a letter advising “the three of you have succeeded in equal shares to all ownership units of the company” and proposing to meet “for the purpose of issuing certificates of ownership to each of you, and to briefly discuss the operation of the company, and to answer questions you might have.”
The meeting never happened. In May 2016, David obtained liability insurance for the LLC naming all three siblings as “members.” Later that year, David issued equal interests to himself, Susan, and Daniel. In late 2016, David acting as manager paid what he termed “distributions” to himself and his siblings. Each of the siblings received K-1s identifying them as “members.”
The court’s opinion tells us little about the dissension that preceded the litigation. The only clues it gives is that, in 2016, David rebuffed a proposal by Daniel and Susan to change the LLC from manager-managed to member-managed or to partition the land, and that subsequently David as sole manager unilaterally procured a letter of credit for the LLC. We can only guess that Daniel and Susan foresaw little economic benefit in remaining passive owners indefinitely of a farm operation controlled by David.
The Operating Agreement’s Ticking Time Bomb
As mentioned in the opinion’s above-quoted passage, the LLC’s operating agreement created Class A “income” (non-member) units and Class B “ownership and voting” (member) units. The agreement required the manager’s written consent for the transfer of Class A units and unanimous approval of the Class B members for the transfer of Class B units.
The father, Richard, owned all Class A and Class B units. The agreement contained no provision designating his children as members upon Richard’s death.
The agreement automatically dissociated a member upon the member’s death and required “any person admitted as an additional or substitute Member [to] execute a Joinder Agreement and thereby become a party to this Agreement.”
Critically, the operating agreement did not alter the Iowa LLC Act’s tandem default provisions concerning LLC membership and dissolution following the death of the sole member of a single-member LLC. One section of the Act provides a person can become a member if
within ninety consecutive days after the company ceases to have any members, all of the following occur: (1) The last person to have been a member, or the legal representative of that person, designates a person to become a member. (2) The designated person consents to become a member.
Another section provides:
A limited liability company is dissolved, and its activities must be wound up, upon the occurrence of the following: Once the company has at least one member, the passage of ninety consecutive days during which the company has no members.
A Transferee is Not the Same as a Member
In early 2017, Daniel and Susan brought suit against David asserting a variety of claims including for judicial dissolution under the statute requiring dissolution of an LLC that has no member for 90 days.
The trial court rejected the claim, finding that David became a Class A member within 90 days of Richard’s death; that Daniel and Susan were deemed to have assented to the operating agreement and membership pursuant to statute; and that the siblings’ membership in the LLC was consistent “with the goal of honoring [Richard’s] intent when he created the LLC.”
Daniel and Susan appealed. The Iowa Court of Appeals reversed the lower court’s decision and granted dissolution.
The appellate court began its analysis with the broad pronouncement that “[b]oth the operating agreement and the statutes make clear membership is not the same as possession of a transferable interest.” While there was no dispute that, under Richard’s will, the LLC’s units “transferred equally to David, Daniel, and Susan upon Richard’s death,” that did not resolve the critical question
whether the LLC had a member in compliance with the operating agreement within the ninety days following Richard’s death . . .. Once the ninety days passed, if the LLC had no member it dissolved as a matter of law.
The court found that the LLC did not have a member within 90 days based on the following, undisputed facts:
- When he died Richard was the LLC’s sole member.
- David did not make himself a Class A member prior to Richard’s death, despite his managerial authority to do so under the operating agreement.
- The operating agreement contained no provision designating the children members upon Richard’s death.
- The lawyer’s December 2015 letter to the siblings did not mention membership or address steps needed to confer membership on them.
- The lawyer was not Richard’s estate’s legal representative and lacked authority to invite membership.
- None of the children signed joinder agreements as required by the operating agreement.
- David’s action listing the three siblings as “members” for insurance purposes did not override “the contractual deficiency of the missing joinder agreement.”
- There was no documentation of David’s admission as a member.
The court’s opinion concludes:
On our review, we are constrained to construe the contract according to its terms and the statutory law. We determine the intent of the parties forming the company from the language of the contract. The operating agreement only provides one way for a potential member to show agreement to become a member: the joinder agreement. We find none of the unit holders of Felt Farms LLC complied with the contractual requirements for membership by signing a joinder agreement prior to the expiration of the ninety-day statutory period. Therefore, the LLC dissolved as of February 3, 2016. [Citation omitted.]
The court’s opinion recites that the attorney Richard used had never before organized an LLC, did not consult with an attorney with LLC experience, and used an off-the-shelf form for the LLC’s operating agreement. The attorney delayed around 10 months after Richard’s death before consulting with an experienced attorney, which is when he first learned of the distinction between transferees and members. Further commenting on the attorney’s shortcomings, the court wrote:
The district court noted Braland could have advised David of the steps to admit and document the admission of members, including the preparation of a joinder agreement within the ninety-day period if he had understood the law and the operating agreement he drafted, and that Braland failed to do so.
I’m in no position to comment on the unknown factual circumstances or ethical considerations surrounding Richard’s engagement of an attorney who’d never before organized an LLC or prepared an operating agreement. Obviously it turned out very badly, at least for David who’d worked the family farm for decades and for Richard’s goal of keeping the farm for future generations of the Felt family. Perhaps the court’s decision will lead to a partition of the farmland, leaving David with less acreage while giving his siblings the ability to sell off the rest.
Forming any kind of business entity and drafting its organizational documents requires thorough knowledge not only of the governing statutes but also of the construction and application of the statutes by the jurisdictionally appropriate courts. An argument could be made that such knowledge is even more essential when forming LLCs due to the relative newness of the LLC business form and the highly nuanced interplay between the operating agreement and the default provisions of the LLC statutes.
It was inevitable that a lawyer with no LLC experience would resort to, and use in unadulterated form, an off-the-shelf template for the operating agreement. The Felt case is a poster child for the dangers of using form operating agreements for LLCs — a danger I’ve warned about before.
So I say to anyone contemplating forming an LLC and/or entering into an operating agreement, make the investment in hiring competent, experienced counsel. Think of it as an insurance policy that will pay big, long-term benefits by creating a business structure that sensibly allocates ownership, economic, and managerial rights and, just as importantly, provides a workable blueprint for future contingencies and inevitabilities such as owner retirement, disability, and death.