Six Degrees of Depredation

Retrieved from Voice Mail, 12-30-08, 6 a.m. Arizona Time:

Mike, where are you, buddy? It’s Moe in Miami—howzit goin’? Listen, Manuela and I are headed down to the Keys this morning to see our nephew, Earnest. There’s some weak cell coverage down here, so I’ll talk fast. Hey, remember you set up that LandHammerhead LLC for me a few years ago when I bought that 10 acre piece outside Mayer, up there in Yavapai County? Well, I got a good offer from a guy named Straw, Jack Straw, on the piece; him and some investors he’s talking to want to buy it-- and, listen, I got some losses on some condos down here to cover. I was thinking about doing a 1031 with the proceeds at first, but Jack’s got a great idea: he wants to buy the LLC. It’s sweet, Mike—check this! There’s no worries about buying title insurance, or that goofy disclosure statement you guys in Arizona want to make owners record with those questions nobody knows the answers to when the property’s out in the boonies like this lot. Jack saves the cost of setting up a new company—he thinks he’ll just keep the company and buy the member interests, and he won’t even have to get a new tax number. I told him I’ve got a $25,000 equity line lien on the title, but he says we’ll just deduct that from the sales price, and nobody’s the wiser—he’ll just get a new company checking account at his bank, and keep making the monthly home equity payments. This is great—this way, we can close right away, maybe tomorrow! So, listen, can you gin up some kind of assignment of member interest—just leave the new member’s names blank for now—oh yeah, and a letter for me to resign as Manager, and email it to [inevitable static message interruption here] at that Prescott title company? I bet her email’s on their Website. Oh, yeah, last thing—Jack may be a little light on cash at the closing if this one guy isn’t in the deal. So, we’re talking about selling half the membership interest this year and the other half next year, so I can keep their feet to the fire. Hey, call me if you think of anything I need to know or if there’s a question. Thanks!

The pit of my stomach calls to me—take today off! Someone—the odds favor me--is about to regret my picking up the telephone. But I need to at least communicate that he’s going to have to give up a lot more data if he’s to get my help. Google gets me to his home phone, so I leave this message: “Moe, I’ve got three and a half questions: When can I see the company operating agreement and the minutes of meetings or company resolutions and, if there are any of such, can I rely on what they say? Next, when do I get to speak directly to your wife? And, give me some names, Moe, so I can run a conflict check on the proposed investors in buyer group? Call me today if you want my help figuring this out, because until we speak, there’s no chance I can help on this deal!”

If you see the whole checkerboard at once, there are a few items in Moe, Manuela and Jack’s membership sale proposal that are going to require thought, and here are a half dozen or so:

Ethics Considerations:

Well, for starters, who’s your client? Is it the company, or the existing members? Did you know Moe was married to Manuela—and were they married before or after the company began? (Moe told me when the company was formed that he was the sole member and so there didn’t need to be a manager. Hasn’t something changed.) Do the spouses own their interest in the company in some joint form of ownership? Or are there, today, two separate members? In either case, has Manuela consented to this sale of member interest[s]—or is she just wedged beneath the steaming roller of Moe’s excitement? Ethics Opinion 02-06 of the State Bar of Arizona should be consulted on the representation of entities or their members in formation of a new business. Of course, this is an issue of the transfer of member interests, not initial formation; but some of the issues are analogous. What, for example, if Manuela doesn’t want to sell the company’s assets—or any of her separate member’s interest in the company (or the member interest, if she and Moe are joint owners in some manner)? What does the operating agreement say about consent of members to a disposition of assets or member interests, and is there any text on who votes when an interest is jointly owned? (I’m assuming, of course, that this company had an operating agreement; Arizona law does not make that document a condition of existence of an LLC.) Someone has to sign, more than likely, a waiver of conflict letter even if Moe and Manuela are on the same page with respect to the transaction pending.

Real Property Considerations:

a. Lien on the title and assumption of the obligation: The lien of the equity line of credit is documented probably by a deed of trust that very likely contains a due-on-conveyance clause. Those clauses, about 85% of the time, say that the change in identity of owners of more than a certain percentage of the equity interests (and frequently a very small percentage, at that) is deemed to be a sale of the collateral by agreement of the parties. An unhappy lender whose security instrument contains this language can declare the sale of LandHammerhead to be a conveyance, call the note, and commence its remedies if the note isn’t promptly paid. That could be a problem for Straw’s group—so will likely come back to haunt Moe, especially in his starring role [probably] as personal guarantor of the line.

b. Title Insurance and Fairway issue: Moe’s title insurance on the 10 acres won’t be any good as soon as the new members take over a majority interest in the company. So, landowners setting up LLCs to be absolutely safe, anticipating that over time a new person may be acquiring, or "buying into" the company, replacing one or more departing partners, should consider purchasing a Fairway Endorsement to the policy [an endorsement that got its name from a specific court case, Fairway Development Co. v Title Insurance Co. of Minn., 621 F. Supp. 120 (N.D. Ohio 1985)] when the company first acquires the property. Later, the title company will not be able to deny coverage if the title owned by the prior membership comes under attack. The company will not be able to say that coverage ended because the new entity does not have the same internal composition as the old partnership. But that approach won’t do Moe any good; you cannot purchase a Fairway Endorsement several years after the original policy is purchased. Instead, Moe’s successors will have to acquire, if one is available (and affordable), a so-called “additional insured” endorsement.

c. Affidavit of Disclosure: Moe’s reference is to A.R.S. §33-422, which identifies required written disclosures in connection with transfers of fewer than 5 lots in unincorporated areas of Arizona unless the subject lots have been subdivided. Moe believes that the disclosure isn’t required because fee title to the land isn’t changing owners—but that seems an unsupportable interpretation of the statute’s purpose, since a brand-new company member[s] is in no better position to be familiar with the circumstances of the property than any third party purchaser is. There are several cases pending before the Arizona Court of Appeals that may afford some insight on this issue (Verma v. Stuhr, Verma v. Dougherty, Vig v. Nix Project II); so stayed tuned for those opinions, in case they say anything pertinent to this issue.

Enterprise Considerations:

a. Securities Laws: Are there outstanding liabilities of the company besides the land-secured credit line? What if there are, and Moe neglects to disclose that fact? For that matter, what if Moe does, but Straw fails to disclose that fact to his investor group before the deal closes? Is there liability under any securities laws attaching to Moe and Manuela in connection with the sale of the membership interests by Jack to his investors, under a theory of aiding and abetting in the sale of a security? There’s a pretty fine summary on the Internet reviewing case law about the sale of LLC interests being subject to securities laws by Robert J. McGaughey, Esq., entitled “When LLC Interests are Securities” (2008); McGaughey’s Web site is www.law7555.com. Arizona’s law is that the sale of a member’s interest may be a sale of a security, depending on the facts and circumstances, see Nutek Information Systems v. Arizona Corporation Commission, 194 Ariz. 104, 977 P.2d 826 (App. 1998); watch out for the expectation of profits arising from third-party, “essential managerial efforts.” Jack Straw is the fellow in the direct line of security-liability fire, but what happens if Moe and Manuela don’t make sufficient disclosures about what happened in the company on his/their watch and liabilities or obligations survive the transfer of member interests—like the equity line of credit—and the new members are not aware of these constraints when they purchase their interests?

b. Status of substitute equity holders: What does the operating agreement for the company say about the admission of new members? If it says that the remaining members must approve their admission, and Moe (and maybe also Manuela) resign as members of LandHammerhead before the new investors are approved for admission, well, what then? (Under Arizona law, they may enjoy the status of distributees and nothing else.) And what happens if there is no replacement manager appointed by Moe (and maybe also Manuela) before the company’s member[s] resign? For more discussion of the anomalies caused when there is not a proper transition of LLC membership under Arizona Title 29, see my article in PDF format called Beware the Single Member, Member-Managed, Arizona LLC, available at www.bffb.com under my attorney profile.

c. Perfecting a security interest in the sold interest portion, if there is a default in purchasing the balance of Moe’s member interest: Unless Moe wants to be tied up with persons who may default under their agreement to buy the rest of his interest with the deferred portion of the purchase price, Moe had best remember to take a security interest in the member interest he has sold at the time the deal is consummated, so that if necessary, Moe can take back the equity interests in the company altogether. And he needs to remember to file a financing statement against the membership interest sold (since it is a “general intangible” under Article 9 of the Uniform Commercial Code) in the records of the Secretary of State of Arizona, I suppose, assuming that Straw will continue to use the state as the company’s principal place of business.

Taxation Considerations:

a. Deemed dissolution of the company: Was LandHammerhead, LLC originally taxed as a disregarded entity or a partnership? (I didn’t prepare the tax election.) There’s a loss of tax treatment of distributions from a partnership (such that revenue will receive treatment as ordinary income, with a higher tax rate) when there’s a technical termination in the year that the company sells 50% or more of the equity interests in the company. Section 751 of the Internal Revenue Code can cause all or a portion of the gain on the sale of a partnership interest to be treated as ordinary income despite Section 741, which provides that a partnership interest generally is a capital asset. So, two questions for Moe are fundamental—one, which box did you check for your tax election, and two, did you discuss this disposition program with your accountant before you bought into Straw’s transfer concept? If there’s no offsetting advantage to the possible increase in Moe and Manuela’s tax burden upon the conveyance of the company, why do the deal this way? If there is a need to proceed Straw’s way, and the company was being taxed as a partnership, then even the form and text of the transfer documents may become material in determining whether Section 751 will control the tax treatment of the disposition.

b. Use of the existing EIN: Since you don’t represent Jack Straw’s group, the only advice you need to give Moe and/or Manuela here is not to suggest how the buyer should proceed with LandHammerhead’s EIN; the rules are complicated enough--forget you don’t even know whether Straw will be the only new member, ultimately. There’s a helpful treatise available through Google Books, Cartaro, David J., Federal and State Taxation of Limited liability Companies (2008)(CCH, 2007); take a look at the discussion of use of EIN identifiers depending on whether there is one or more than one company member after reorganization, found at paragraphs 1117.04 and 1118.04.

Common sense issues:

If Straw’s group cannot come up with the closing price, why would Moe think the new company will timely make the payments on the equity line? And what is Moe thinking about issues such as his personal guaranty of the equity line note—and whether the lender will waive its security (not wishing to own land out in the boondocks in its REO portfolio) and sue Moe instead? Is Moe about to get pillaged by the lender and his buyer? And why am I letting myself be knitted into the fabric of this debacle?

-MNW