A Law Update for Condominium Developers: Dissolution and Cancellation of Limited Liability Companies

1. A Law Update for Condominium Developers:Dissolution and Cancellation of Limited Liability Companies Presented by: Joseph P. McCarthy Douglas L. Batey Janet F. Jacobs Stoel Rives LLP October 8, 2009

2. Very Short History of Limited Liability Entities • Legal protection from business risk was not historically allowed • Sole proprietorship and partnerships = personal liability • First Business Trusts Act in late 18th century • First Corporation Act in North Carolina in 1795 • Uniform Limited Partnership Act in 1916 • First LLC Act in Wyoming in 1977, Florida in 1982, nowhere else until 1988; everywhere else by 1997 • LLCs are new

3. Legal Theories to Protect Creditors of Limited Liability Entities • Piercing the veil • Fraudulent transfer • Bankruptcy preference • Personal liability for torts • Personal liability for professionals

4. Limited Liability Companies Do Not Provide Complete Protection from Business Risk • “Except as otherwise provided by this chapter, the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations, and liabilities of the limited liability company; and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation, or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.” RCW 25.15.125.

5. Hallmarks of the Residential Real Estate Business • Unique product • Capital intensive • High risk • Short life • Project by project finance • Lender requirements for SPEs

6. The Life Cycle of an LLC • File certificate of formation (birth) • Conduct business (live life) • Dissolve (in the hospital) • File certificate of cancellation (in the ground)

7. Typical Real Estate Business Structure • Development SPEs • Developer = manager • Investors = members • Holding company

8. Typical Real Estate Business Cycle • Form it • Build it • Pay debt • Pay investors • Let it lapse

9. Legal Liability vs. Winding Up and Paying Off Investors • Dissolution: a legal status • Dissolution begins the winding up process • Winding up: pay off creditors, distribute profits • What about late-arriving warranty claims? • Warranty claimants will attempt to seek recovery from the LLC, from the managers, and from the investors

10. Response of Washington State Legislature • Ballard Square case in 2006 • Perceived unfairness to creditors (read: consumers) • LLC survival statute (RCW 25.15.303) in 2006 • Claims may be filed up to three years after dissolution of an LLC

11. Washington Supreme Court Weighs In – Chadwick Farms • Classic condo fact pattern • LLC formed for a project • LLC administratively dissolved after first unit sale • Suit by homeowners association • LLC files cross claims two months after cancellation • LLC moves to dismiss claims

12. What Should a Developer Do?

13. Formation of an LLC • State law governs • LLC begins to exist when certificate of formation is filed with Washington Secretary of State • LLC exists until a certificate of cancellation is filed

14. Normal Operations • Legal entity • Same powers as an individual • Enter into contracts • Sue and be sued • Member relations governed by operating agreement and statute • Members generally have limited liability, with exceptions

15. Dissolution • Change of status • Begins the winding up – mandatory • Trigger – written consent of all members, or: • Dissolution date in certificate of formation • An event specified in operating agreement • Five years after administrative dissolution, unlessreinstated • Unless operating agreement provides otherwise, 90 days after dissociation of last member, unless assignees have voted to admit at least one new member • Decree of judicial dissolution

16. Winding Up • Gradually settle and close the LLC’s business • Prosecute and defend suits • Dispose of and convey property • “pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional, or unmatured claims and obligations, known to the LLC.” RCW 25.15.300(2). • Distribute remaining assets to members

17. Dealing With Liabilities • LLC must pay or make reasonable provision for contingent, conditional, and unmatured claims if known to LLC, even if identity of claimant is unknown • If assets are inadequate, LLC must deal with claimants by priority and ratably within a priority

18. Who Does the Winding Up? • Manager • Persons approved by members • Person winding up has personal liability to claimants if that person does not comply with rules about dealing with liabilities

19. When Winding Up Is Completed • Certificate of cancellation must be filed • LLC no longer exists after certificate of cancellation is filed • LLC can no longer act • What about lawsuits?

20. Survival Statute • The dissolution of an LLC does not impair any remedy against the LLC, but … • Action may not be brought against LLC after three years from dissolution • What if LLC is cancelled before the three years are up? • Recent Washington Supreme Court case: Chadwick Farms

21. Chadwick Farms Owners Association v. FHC LLC –Background • Two lawsuits – condo developers • Chadwick Farms condominiums • Emily Lane condominiums • Owners associations sued alleging construction defects • Chadwick Farms – • After last unit sold, the LLC did not renew its certificate, so Secretary of State administratively dissolved the LLC • Later, after lawsuit for construction defects was started, Secretary of State cancelled the LLC in mid-lawsuit • Court of Appeals held that following cancellation, the LLC could be sued but could no longer sue in its own name (e.g., against subcontractors)

22. Chadwick Farms Owners Association v. FHC LLC – Background (cont.) • Emily Lane – members voted to dissolve after units sold, and cancelled the LLC’s certificate shortly thereafter • Later, lawsuit was filed against the LLC • Court of Appeals allowed lawsuit against LLC to proceed after cancellation • Appeals consolidated

23. Chadwick Holdings in Supreme Court • Cancellation ends everything – even in mid-suit • An LLC may not be sued after cancellation • existing lawsuits abate • An LLC may not sue after cancellation • Why not? Non-existence • Cancellation trumps the three-year survival statute • Dissolution triggers mandatory duty to wind up • Failure to properly wind up = personal liability • Cancel at your peril

24. What, Me Worry? • Doesn’t having a Limited Liability Company limit the liability of members and managers? • How could they have personal liability?

25. Limited Liability • Limited liability is predicated on one simple principle: • The LLC is a distinct and separate legal entity from its members

26. RCW 25.15.125 • “Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company; and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation, or liability of the limited liability company solely by reason of being a member or acting as a manager of a limited liability company.”

27. What Does “Limited Liability” Mean? • LLC is responsible for debts and liabilities • Member’s capital contribution is at risk • Member’s assets outside the LLC are not at risk

28. Loss of Limited Liability Protection • Liability to LLC or other members • Improper interim distributions • Use of LLC’s property or business opportunity • Liability to third parties • Piercing leads to loss of limited liability protection

29. Wrongful Non-Liquidating Distributions • RCW 25.25.235: no distributions if • LLC wouldn’t be able to pay debts OR • Amount of liabilities exceeds value of remaining assets • No liability to LLC for unknowing receipt • No liability to LLC after three years for knowing receipt • NOTE: liability is to LLC, not to other members or third-party creditors

30. Exceptions to Limited Liability – Third Parties • Contracts • Personal torts • LLC torts: “piercing the veil” • Improper wind-up

31. Exception: Torts • Personal liability for a wrongful act not connected with LLC business • Even if acting in the course of the LLC’s business • Example: drunk driving while delivering LLC’s product • Piercing analysis is used to hold members responsible for wrongful act connected with LLC business

32. Breach of Fiduciary Duty • Under the Condominium Act, the Board of Directors owes fiduciary duties to condo owners • Developer as board member • Duties of loyalty, good faith, and high standard of care • Prioritize interests of condo owners, not LLC members

33. Fraudulent Concealment • Five elements: • A residential dwelling with a concealed defect • Developer knows about the defect • Defect is a danger to the property, health, life of purchaser • Purchaser doesn’t know about the defect • Purchaser wouldn’t discover defect even on careful inspection

34. Fraudulent Concealment (cont.) • Fraudulent concealment finding  Economic Loss Rule • Damages limited to contract remedies • Contrast actual fraud…

35. Fraudulent Transfer Elements • Elements: • Antecedent debt • Transfer of assets out of the LLC • to an insider • No “reasonably equivalent value” for the transfer • LLC is unable to pay the debt after the transfer or is functionally insolvent • Intent to prevent or delay payment of debt

36. Fraud • Elements: • Representation of an existing fact • Which is material • And false • The person making the statement knows it’s false or doesn’t know if it’s true • The speaker wants the listener to rely on the statement • The listener doesn’t know it’s false • And relies on the truth of the statement to reach a decision • And is entitled to rely on it • And suffers damages as a result

37. Consumer Protection Act • Elements: • An unfair or deceptive act • In the conduct of trade or commerce • That has an impact on the public interest • And injures plaintiff’s property • And there’s a causal link between the unfair/deceptive act and the harm done

38. Improper Winding Up • RCW 25.15.300 • Proper winding up  no personal liability to LLC claimants • Proper winding up • Reasonable provision for known claims and obligations • Court-blessed plan of winding up? • Chadwick Farms: personal liability for improper wind-up

39. Practical Advice for Real Estate Developers

40. Heads Up – Proposed Legislation • Once the LLC is dissolved, the LLC may optionally file a certificate of dissolution • Certificate of dissolution may be revoked for 120 days • If a certificate of dissolution is filed, LLC may give written notice to holders of known claims, who must respond within 120 days • If LLC rejects the claim, claimant must file suit within 90 days • Claims against LLC must be brought within three years of filing of certificate of dissolution, regardless of when certificate of cancellation is filed • Certificate of cancellation does not terminate LLC’s existence

41. Issue: What Is a Known Claim Or Obligation? • The Act requires provision for “claims” and “obligations” • Does “known” require actual or constructive knowledge? • Statutory language suggests “actual” knowledge – some cases have found constructive knowledge is enough

42. Strategy: Dissolve, Wind Up, Cancel, Defend • Triggers three-year claim period • May be shorter than the statutory warranty period • Document the dissolution, so it’s not private

43. Suggestions for Wind-Up • Prepare a wind-up plan • Adopt resolutions • Document assets • Analyze and document potential claims • Document actions • Buy insurance for winder upper?

44. Guard Against Piercing the Corporate Veil • Financially troubled LLC: third party focus • Under-capitalized for intended business • Failure to follow formalities • No bona fide commercial purpose • Violation of governing documents • Dissolution issues • Lack of LLC formalities alone is not grounds for loss of limited liability

45. Piercing the Veil (cont.) • Best practices: • Adequate capitalization • Strong LLC agreement • Meetings • Diligent record keeping • Separation of assets • Arms-length member/LLC transactions • Document distributions (+ salary)

46. How to Make Provision for Claims and Obligations • Keep reserves • Establish a trust • Buy insurance (sigh) • Go to court?

47. Strategy: Don’t Dissolve • Avoids duty to wind up • Avoids personal liability for improper wind-up • Allows LLC to conduct business as usual

48. If Administratively Dissolved, Reinstate (If You Can) • Now, five year window • Simple filing • Return to active status

49. Strategy: Adopt Robust structure • Use robust warranty disclaimers, as allowed by Condominium Act • Avoid member-managed LLCs • Use an entity as manager • Consider a separate entity to wind up

50. Corporation as Manager • Manager-managed LLC • Use a corporation as the manager • Analogous to using a corporation as the general partner in a limited partnership • Possibly use a separate, corporate manager to manage only the winding up • Observe all the corporate formalities, put some capital into the corporation • When the LLC is dissolved, the corporate manager conducts the winding up • Claims of improper winding up would be made againstthe corporation, not the members or other managers