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Trusts and Estates

A Section of the Virginia State Bar.

Spring 2013 Newsletter

Newsletter - Trusts and Estates

Volume 22, No. 8

New Virginia Law Overturns State Supreme Court Ruling Limiting Transfers of LLC Membership Interests: Potential Traps for the Unwary Remain

By Arthur E. Schmalz

Introduction
The Virginia General Assembly rarely adopts legislation for the specific purpose of overturning a ruling of the Commonwealth’s highest court. And in an age of partisan conflict, it’s also unusual for a new law to pass with virtually no opposition. However, Senate Bill 779 (“SB 779”), which the General Assembly approved on April 3, 2013 with only one dissenting vote, is one of these uncommon legislative actions.

The bill’s summary explains that it “overturns the Virginia Supreme Court’s finding in Ott v. Monroe1 that current law precludes” an assignee of a membership interest in a Virginia limited liability company (“LLC”) from participating in the company’s management and affairs2 – even, seemingly, where the company’s governing documents expressly grant such rights. This aspect of Ott has been a source of concern and controversy ever since the case was decided in November 2011.

When it takes effect on July 1, 2013, SB 779 should eliminate most of the concern and uncertainty that arose after Ott, but potential traps for the unwary remain. In particular, assignees can participate in the company’s management and affairs only if they become members in accordance with the requirements of the Virginia Limited Liability Company Act (“LLC Act”).3 Additionally, the new legislation does not relax Ott’s rather strict standard for overriding the statutory presumption under the LLC Act that a member’s death results in dissociation from the company.

The Ott decision
To understand the significance of SB 779, it is first necessary to examine the Court’s decision in Ott v. Monroe. Ott involved a Virginia LLC known as L&J Holdings, LLC (the “Company”), which was formed by Admiral Dewey Monroe, Jr. (“Dewey”) and his wife, Lou Ann (“Lou Ann”). Pursuant to the Company’s operating agreement, Dewey and Lou Ann were the Company’s sole members, with 80% and 20% membership interests, respectively. Lou Ann was the managing member, and Joseph G. Monroe ("Joseph") was named as the successor managing member in the event of Lou Ann’s death, disability, removal, or resignation.

Paragraph 2 of the Company’s operating agreement stated that “[e]xcept as provided herein, no Member shall transfer his membership or ownership, or any portion or interest thereof, to any non-Member person, without the written consent of all other Members, except by death, intestacy, devise, or otherwise by operation of law.”4 Paragraph 10(C) allowed any member to transfer his or her membership interest to “[o]ther Members [or] [t]he spouse, children or other descendents of any Member.”5

Dewey died in 2004. His will left his entire estate to his daughter, Janet. Relying on this bequest, Janet claimed to be the valid assignee of Dewey’s 80% membership interest. Attempting to exercise this super majority control of the Company, Janet removed Lou Ann as the Company’s managing member and appointed herself to that position. She also removed Joseph as the successor managing member and appointed another individual in his place. Janet then (for good measure) filed a complaint seeking a declaratory judgment that all of her actions were lawful and valid. Lou Ann and Joseph filed a demurrer in response to Janet’s complaint.

In the trial court, Janet argued that her late father’s bequest left her in control of the Company because paragraph 2 of the Company’s operating agreement expressly authorized assignment of a membership interest “by death . . . [or] devise.”6 The trial court disagreed and sustained the demurrer to Janet’s complaint.

On appeal, the Supreme Court of Virginia affirmed. It concluded that Dewey’s death caused his “dissociation” from the Company pursuant to Code § 13.1-1040.1(7)(a), notwithstanding the language in paragraph 2 of the operating agreement. According to the Court, “Paragraph 2 . . . does not address statutory dissociation and does not state an intent to supersede Code § 13.1-1040.1(7)(a). Consequently, it lacks specific language that would constitute an exception to the rule of dissociation set forth in Code § 13.1-1040.1.”7

Under the LLC Act, a dissociated member of an LLC or his successor is reduced to the status of an “assignee,” as defined in Code § 13.1-1039(A).8 Prior to enactment of SB 779, Code § 13.1-1039(A) stated that an “assignee” was not entitled to participate in the management or affairs of the company and could only receive the share of profits, losses, and distributions corresponding to the assignor’s membership interest. 9 Accordingly, under that version of the statute, by becoming an assignee, a dissociated member (or his or her assignee) would lose all voting and control rights that he or she had prior to dissociation and would retain only the right to receive distributions and allocations of profits and losses. Because the Court ruled that Dewey’s death had dissociated him from the Company, and thereby transformed his interest into that of an “assignee,” it held that Janet succeeded only to her late father’s economic interests in the Company; Lou Ann, therefore, retained managerial control, even though she held only a 20% membership interest in the Company.10

Having determined that the operating agreement was not specific enough to override Dewey’s statutory dissociation under Code § 13.1-1040.1(7)(a), the Court’s analysis seemingly could have ended there. But the Court went further, observing that, “even if Paragraph 2 had superseded dissociation under Code § 13.1-1040.1, it is not possible for a member unilaterally to alienate his personal control interest in a limited liability company. Code § 13.1-1039(A).”11 Indeed, the Court continued, “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 on him.”12

In reaching these conclusions, the Court focused entirely upon Code § 13.1-1039(A), the section of the LLC Act that addresses assignments of membership interests. The third sentence of that statute states, “[a]n assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member.”13 Unlike the first sentence of the statute, however, the Court observed that the third sentence lacks the proviso, “unless otherwise provided in the articles of organization or an operating agreement….” 14 The Court reasoned that the absence of the proviso from the third sentence evidenced the General Assembly’s intent to prohibit members from overriding the statutory limitations on assignees’ rights by providing “otherwise” in the company’s operating agreement or articles of organization.15

Concerns over Ott
The concerns over Ott are primarily twofold. First, it imposes a fairly rigorous standard for LLC members to contract around the statutory default rule that a member is dissociated from the company upon death. An operating agreement or the articles of organization must “address statutory dissociation” sufficiently to “state an intent to supersede Code § 13.1-1040.1(7) (a).”16 According to the Court, less explicit language, such as that in Ott which authorized transfer of a membership interest “by death . . . or devise,” is insufficient to “constitute an exception to the rule of dissociation set forth in Code § 13.1-1040.1.”17

It is debatable whether this rather strict requirement is fully consonant with Code § 13.1-1001.1(C), which provides that the LLC Act “shall be construed in furtherance of the policies of giving maximum effect to the principle of freedom of contract and of enforcing operating agreements.” 18 Ott makes no mention of this statutory rule of construction.

Of far greater concern, however, is Ott’s broad language stating that LLC members are prohibited from alienating their personal control interests in the company, even if such action as authorized by the company’s operating agreement or articles of organization. This could, among other things, make it virtually impossible for a controlling member to implement a succession plan designed to have a spouse or child assume managerial control upon the member’s death.

Apart from such practical concerns, the Court’s statement that Dewey could not unilaterally transfer to “Janet his control interest and make her a member of the Company upon his death because the Agreement could not confer that power on him19 arguably conflicts with Code § 13.1-1040(A). That statute expressly allows an operating agreement or articles of organization to confer full membership status upon assignees automatically, without the consent of the other members:

Except as otherwise provided in writing in the articles of organization or an operating agreement, an assignee of an interest in a limited liability company may become a member only by the consent of a majority of the membermanagers (other than the assignor member) of a manager-managed limited liability company of which one or more members is a manager, or by a majority vote of the members (other than the assignor member) of any other limited liability company.20

And when an assignee becomes a member in accordance with these provisions, the assignee obtains the very same “rights and powers” that the assignor member had.21 Thus, even prior to the adoption of SB 779, under Code § 13.1-1040(A), an operating agreement could automatically make an assignee a member with full voting and control rights. To the extent Ott suggests that this is prohibited by Code § 13.1-1039(A), the Court has created a conflict with the express language of Code § 13.1-1040(A).

The Ott decision does not appear to recognize this conflict, however. Early in its analysis, the Court observed that an assignee “has no control interest in a limited liability company without becoming a member,” and added that Code §13.1-1040(A) “provides the means by which the assignee of a financial interest may become a member.”22 But the Court doesn’t acknowledge the “[e]xcept as otherwise provided” language, or otherwise address the statute any further. Thus, Ott rendered uncertain the legality of operating agreement provisions that automatically make assignees members with full voting and control rights.

The adoption of SB 779
Senator John C. Watkins, of Senate District 10, introduced SB 779 at the start of the 2013 legislative session specifically for the purpose of overturning Ott’s ostensible limitations on assignee rights. The measure proposed to add to the third and fourth sentences of Code § 13.1-1039(A) the missing “magic words” that the Ott Court indicated were necessary in order for an LLC’s operating agreement or articles of organization to opt out of the statutory limitations on assignees’ rights: “Unless otherwise provided in the articles of organization or an operating agreement . . . .”23 The bill received the endorsement of the Virginia Bar Association and unanimously passed both houses of the Generally Assembly.24

In late March, the Governor recommended that, instead of adding the “magic words” to the beginning of the third sentence of Code § 13.1-1039(A), the General Assembly should replace them with the following phrase: “Except as provided in subsection A of 13.1-1040.”25 By linking Code §§ 13.1-1039(A) and -1040(A), this change harmonizes the potential inconsistency between the two statutes that became apparent after Ott.

On April 3, 2013, both houses concurred in the Governor’s recommendation, 40-0 in the Senate and 92-1 in the House.26 The approved amendment to Code § 13.1-1039, which takes effect on July 1, 2013 as Chapter 772 of the 2013 Acts of Assembly, states:

A. Unless otherwise provided in the articles of organization or an operating agreement, a membership interest in a limited liability company is assignable in whole or in part. An assignment of an interest in a limited liability company does not of itself dissolve the limited liability company. Except as provided in subsection A of § 13.1-1040, an assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member. Unless otherwise provided in the articles of organization or an operating agreement, such an assignment entitles the assignee to receive, to the extent assigned, only any share of profits and losses and distributions to which the assignor would be entitled. (emphasis added). B. Unless otherwise provided in the articles of organization or an operating agreement, a membership interest in a limited liability company may be evidenced by a certificate of interest issued by the limited liability company. The articles of organization or an operating agreement may provide for the assignment or transfer of any interest represented by such a certificate and make other provisions with respect to such certificates.27

Potential pitfalls remain even after enactment of SB 779
When it takes effect in July 2013, the newly adopted amendment to Code § 13.1-1039(A) should eliminate arguments based upon Ott that an assignee is statutorily prohibited from participating in the management and affairs of the company, regardless of whether the company’s governing documents provide to the contrary. But under the new law, if certain assignees are to have such participatory rights, LLC members must do more than simply say so in the company’s operating agreement or articles of organization. The assignee must also become a member pursuant to Code § 13.1-1040(A), which can happen in one of two ways. One way is to obtain the consent of a majority of the other member-managers (or members in an LLC managed by a non-member). The other way is to include language in the company’s governing documents that makes particular kinds of assignees members automatically, without approval of the other members. The latter approach is highly recommended whenever LLC members want to be able to transfer their voting and control rights to a chosen successor (again, usually a surviving spouse or child), without the risk of having their succession plans thwarted by other members who might otherwise refuse consent in the future.

The new legislation also does nothing to assuage the Court’s somewhat demanding requirements for overriding statutory dissociation under Code § 13.1- 1040.1(7)(a). If members of an LLC want to avoid dissociation upon their death (which converts their interest to that of a mere assignee), then the company’s operating agreement or articles of organization must include language that clearly expresses “an intent to supersede Code § 13.1-1040.1(7)(a).”28

Conclusion
When it takes effect on July 1, 2013, the General Assembly’s new amendment to Code § 13.1-1039(A) will alleviate most of the concerns resulting from the Ott decision. Nonetheless, potential traps for the unwary remain. In order for assignees to participate in the management and affairs of an LLC, they must be made members of the company. Additionally, Ott’s strict requirements for overriding statutory dissociation remain even after enactment of the new law.

Members of Virginia LLCs who wish to opt out of the statutory default provisions governing assignments of membership interests and dissociation are well advised to have knowledgeable legal counsel examine their company’s governing documents to determine whether the documents contain language sufficient to meet the applicable requirements.

Arthur E. Schmalz is a partner in the McLean office of Hunton & Williams LLP. He has extensive commercial litigation experience and substantial trial and appellate experience in Virginia’s state and federal courts. His practice focuses on litigation, with a primary emphasis in commercial contract, business and land use/real estate disputes, as well as constitutional, education, information technology and appellate issues. He received his B.A. from the College of William & Mary and his J.D. with distinction from the George Mason University School of Law.

(Endnotes)

1. 282 Va. 403, 719 S.E.2d 309 (2011).

2. See legislative summary of SB 779, available at http://lis.virginia.gov/cgi-bin/legp604.exe?131+sum+SB779.

3. The LLC Act is codified at Va. Code Ann. §§ 13.1-1000 through 13.1-1080 (2011 Rep. Vol. & 2012 Supp.).

4. Ott, 282 Va. at 406, 719 S.E.2d at 310 (emphasis added).

5. Id.

6. Id.

7. Id. at 410, 719 S.E.2d at 312.

8. Va. Code Ann. § 13.1-1040.2(A) (2011 Repl. Vol.).

9. Id. § 13.1-1039(A).

10. Ott, 282 Va. at 411, 719 S.E.2d at 313.

11. Id. at 410, 719 S.E.2d at 312 (emphasis added).

12. Id. at 411, 719 S.E.2d at 313 (emphasis added). To the extent that these conclusions are, in fact, unnecessary to the Court’s holding, they would constitute dicta. See. e.g., Lofton Ridge, LLC v. Norfolk S. Ry., 268 Va. 377, 383, 601 S.E.2d 648, 651 (2004) (observing that a court’s justification for a ruling that is “unnecessary to the holding . . . is dicta”).

13. Va. Code Ann. § 13.1-1039(A) (2011 Repl. Vol.).

14. Ott, 282 Va. at 410, 719 S.E.2d at 312-13 (quoting Va. Code Ann. § 13.1-1039(A)).

15. Id.

16. Id. at 410, 719 S.E.2d at 312.

17. Id. at 410

18. Va. Code Ann. § 13.1-1001.1(C) (2011 Repl. Vol.).

19. Ott, 282 Va. at 411, 719 S.E.2d at 313 (emphases added).

20. Va. Code Ann. § 13.1-1040(A) (2011 Repl. Vol.) (emphasis added).

21. Id. § 13.1-1040(B).

22. Ott, 282 Va. at 409, 719 S.E.2d at 312.

23. See SB 779’s text as originally introduced and passed by the Senate and House, available at http://lis.virginia.gov/cgi-bin/legp604.exe?131+ful+SB779ER

24. See voting history on SB 779’s original text, http://lis.virginia.gov/cgi-bin/legp604.exe?131+sum+SB779

25. See SB 779’s text as modified per Governor’s recommendation , available at http://lis.virginia.gov/cgi-bin/legp604.exe?131+ful+SB779ER2

26. See voting history adopting Governor’s recommendation to modify SB 779’s text, http://lis.virginia.gov/cgi-bin/legp604.exe?131+sum+SB779

27. 2013 Va. Acts. Ch. 772, available at http://lis.virginia.gov/cgi-bin/legp604.exe?131+ful+CHAP0772

28. Ott, 282 Va. at 410, 719 S.E.2d at 312.