Virginia Supreme Court Limits Transfers of LLC Membership Interest

Virginia Supreme Court Limits Transfers of LLC Membership Interest

Jan 1, 2012

In Virginia, the elements of ownership of a limited liability company include “control interest,” which is the right to participate in the LLC’s administration, and “financial interest,” which is the right to share in the LLC’s profits and losses. A decision handed down by the Virginia Supreme Court on November 4, 2011, highlighted the legal distinctions between the two elements, before digressing into an analysis of transferability of control, which now calls into question the ability to provide in operating agreements for unrestricted transfers of control interest.

Ott v. Monroe arose from the formation of L&J Holdings by Dewey Monroe and his wife Lou Ann. As originally structured, Dewey owned 80 percent of the entity, Lou Ann 20 percent and Lou Ann was the managing member. Paragraph 2 of the operating agreement stated that except as otherwise provided in the agreement, “no Member shall transfer his membership … to any non-Member… without the written consent of all other members, except by death, intestacy, devise or otherwise by operation of law.”

Dewey died in 2004 and his will bequeathed his entire estate to his daughter Janet. Janet, asserting the authority to control the LLC through the bequest of her father’s 80 percent interest, terminated Lou Ann as managing member and elected herself in Lou Ann’s place. Lou Ann contested Janet’s actions, arguing that Janet had inherited only her father’s financial interest. Janet filed suit for a judicial declaration that she inherited both the financial and control interest.

The Circuit Court of Stafford County concluded that under the Virginia Limited Liability Act, all of Dewey’s right and authority to control the company terminated by operation of law upon his death (a “dissociation” under the LLC Act), leaving only his financial interest to be transferred by will. Therefore Janet did not become a member of the LLC, did not have authority to exercise control over the LLC, and could not remove Lou Ann as managing member.

Janet appealed, arguing that paragraph 2 of the operating agreement (cited above) superseded the default dissociation provisions of Section 13.1-1040.1(7)(a) of the LLC Act, by virtue of the statute containing the qualification language “except as otherwise provided in the articles of organization or an operating agreement.” The Supreme Court disagreed and affirmed the trial court’s decision.

In disagreeing with Janet, the high court found that all paragraph 2 of the operating agreement did was prohibit a member from transferring any part of his interest except “upon death” (among the other enumerated events), and did not specifically state an intention to supersede the statutory dissociation provision. Therefore the statutory qualification language was not applicable (i.e., paragraph 2 did not otherwise provide for a transfer of interest that differed from the statutory terms), and only the financial interest passed to Janet under Dewey’s will in accordance with the operating agreement.

That might have been the end of the opinion and the case, as this reasoning fully decided the legal issues presented. Instead, the court embarked on a review of the statutory and tax regulatory history underlying restrictions on partnership (and LLC) ownership transfers (since made obsolete by the 1997 “check the box” regulations), leading it to an additional conclusion which was not only unnecessary to the determination of the case, but likely to cause controversy and future uncertainty in the Virginia business community, announcing that “[u]nder the statute, only the financial interest in an LLC is alienable” and the control interest cannot be bestowed on another by the transferor’s unilateral act.

The court observed that even if the L&J Holdings operating agreement was construed to supersede the statutory consequences of dissociation under Section 13.1-1040.1 of the LLC Act, “it is not possible for a member unilaterally to alienate his personal control interest in a limited liability company.” And then the Court summed up: “Thus it was not within Dewey’s power under the Agreement unilaterally to convey to Janet his control interest and make her a member of the Company upon his death because the Agreement could not confer that power upon him.” (emphasis added).

What was the problem with the court’s gratuitous observations? Section 13.1-1038.1 of the LLC Act provides that an assignee of interest may become a member as provided in Section 13.1-1040, which in turn states that “[e]xcept as otherwise provided in … an operating agreement,” an assignee may become a member only as provided in the statute, and that “[a]n assignee who has become a member has … the rights and powers … of a member …”

The court acknowledged Section 13.1-1040 as providing the means by which the assignee of a financial interest could become a member, but failed to recognize that the operating agreement could provide that an assignee of interest might become a member automatically, or by a process far less restrictive than that set out in the statute.

Unless the court is taking the position that an operating agreement cannot permit admission of an assignee as a member in a manner that is unrestricted or less restrictive than as provided in Section 13.1-1040, its bald pronouncement that control interest cannot be alienated by a member unilaterally simply fails to account for the right to provide in an operating agreement for the free transferability of control interest. While the L&J Holdings operating agreement may not have provided for an assignor’s right to have its assignee admitted as a member without any consent or approval of other members or managers, under the contract flexibility afforded by Section 13.1-1040, it could have. The court’s statements indicate otherwise, however.

In suggesting that the transfer of control interest cannot be accomplished by admission of an assignee as a member except by the means specifically prescribed in Section 13.1-1040 (or on more restrictive terms), the court lost sight of the overarching rule of construction for the LLC Act set forth in Section 13.1-1001.1: “This chapter shall be construed in furtherance of the policies of giving maximum effect to the principle of freedom of contract and of enforcing operating agreements.”

On this issue, the Ott decision seems destined to unsettle far more LLC operating agreement drafting issues than it resolved, an unnecessary and unfortunate consequence.