The Creditor's Remedy Against A Debtor's Interest In An LLC Or Partnership
Garcia v. Garcia, 2018 WL 2316522 (Cal.App. Distr. 5, Unpublished, May 22, 2018).
California Rules of Court, rule 8.1115, restricts citation of unpublished opinions in California courts.
NOT TO BE PUBLISHED IN THE OFFICIAL REPORTS
Court of Appeal, Fifth District, California.
MORRIS GARCIA et al., etc., Plaintiffs and Appellants,
JOHN GARCIA etc., et al., Defendants and Respondents.
MORRIS GARCIA et al., Plaintiffs and Appellants;
JOHN GARCIA etc., et al., Defendants and Respondents
(Super. Ct. No. 15CECG02784)
(Super. Ct. Nos. 12CECG03902, 13CECG00135 & 15CECG01410)
APPEAL from judgments of the Superior Court of Fresno County. Kristi Culver Kapetan, Judge.
Attorneys and Law Firms
Wendel, Rosen, Black & Dean and Kevin R. Brodehl for Plaintiffs and Appellants.
Gilmore Magness Leifer, David M. Gilmore and Katherine M. Rigby for Defendants and Respondents.
*1 Plaintiffs borrowed money and guaranteed other loans in connection with a real estate development. The development failed, the loans went into default, and in April 2010 the bank obtained a $2.4 million judgment against plaintiffs. To collect its judgment, the bank foreclosed on real property collateral worth about $1.1 million and obtained a charging order against plaintiffs' one-half economic interest in two California limited liability companies. (Former Corp. Code, sec. 17302 [charging orders].)1 When the limited liability companies made no payments subject to the charging order, the bank foreclosed on the "economic interests" plaintiffs held in the companies.2 At the foreclosure auction, the bank credit bid and purchased the economic interests for $1.5 million. After the foreclosure, the limited liability companies sold their real estate, ceased their farming operations, and distributed over $5 million to the bank as the holder of 50 percent of the economic interests in the companies. The limited liability companies then dissolved.
All unlabeled statutory references are to the Corporations Code.
The term "[e]conomic interest" was defined in the operating agreements of the limited liability companies and also by former section 17001, subdivision. (n).
Plaintiffs sued the manager of the limited liability companies who, along with his wife, owned the other half of the companies. Plaintiffs alleged a breach of fiduciary duty, arguing that, despite the foreclosure, they retained an interest in their original capital contributions and accumulated capital of the companies, which should have been returned to them instead of being included in the $5 million transferred to the bank. The manager and his wife filed a demurrer, contending plaintiffs had no right to a return of capital and, instead, the bank had a rightful claim to the funds as the holder of one-half of the "economic interests" in the limited liability companies. The trial court agreed, concluding plaintiffs retained no rights to a return of capital and, thus, were not damaged by the allegedly wrongful conduct. The court sustained the demurrer without leave to amend. Plaintiffs appealed.
Based on statutory definitions that cannot be altered by the terms of a limited liability company agreement, we conclude the trial court correctly determined plaintiffs retained no rights to the return of capital, whether characterized as a capital interest or capital account. However, we also conclude plaintiffs have alleged a breach of fiduciary duty based on the manager's failure to make distributions that would have been paid to the bank pursuant to its charging order. Plaintiffs alleged the failure to make distributions caused the bank to foreclose, which caused the companies to cease farming operations, liquidate their land and go out of existence. These allegations, which are accepted as true for purposes of the demurrer, are sufficient to allege the manager did not act in the best interests of the companies or the plaintiffs, which constitutes a breach of the manager's fiduciary duty in matters committed to the manager's discretion.
*2 We therefore reverse the order dismissing plaintiffs' lawsuit and the order imposing sanctions.
Appellants Morris Garcia and Sharon Garcia, husband and wife, were plaintiffs below. Respondents John Garcia and Janie Garcia were defendants. Respondents Vista Del Sol Farms, LLC and Vista Del Sol Farms I, LLC were nominal defendants.3
We refer to the individuals by their first name because they share the same surname. Morris and Sharon are referred to collectively as plaintiffs. John and Janie are referred to collectively as defendants. Vista Del Sol Farms, LLC and Vista Del Sol Farms I, LLC are referred to collectively as the LLC's.
In 1979, Morris and his nephew John formed a partnership named G2 Farms, which grew cotton and related crops. Later the partnership expanded into almonds. Sometime after its formation, Sharon and Janie acquired interests in G2 Farms and, as a result, each partner owned a 25 percent interest.
In 2004, Morris formed a real estate development company named Wasco Rose, LLC (Wasco Rose). A corporation owned by Morris and Sharon, Western Ag Realty, Inc. (Western Ag), held a majority interest in Wasco Rose. As part of Wasco Rose's operations, Morris purchased land in Wasco, California, which he planned to develop by building single-family housing. Morris, Sharon and Western Ag took out loans from the Bank of Stockton (Bank) to finance the project. In addition, Wasco Rose obtained loans from the Bank, which were partially secured by real property located in Wasco. Morris and Western Ag personally guaranteed the loans made to Wasco Rose.
In August 2009, after the loans went into default, the Bank filed a lawsuit against plaintiffs and Western Ag seeking repayment of the loans. The action was filed in San Joaquin County Superior Court.
While the Bank's lawsuit was pending, plaintiffs and defendants decided to convert the G2 Farms partnership into the two LLC's. The LLC's were capitalized by each partner of G2 Farms contributing their 25 percent interest in the partnership, which established each member's capital account. In return, Morris, Sharon, John and Janie became members of the LLC's, with each member owning a 25 percent interest in each company. On January 1, 2010, the reorganization was formalized by filing articles of organization for both LLC's with the California Secretary of State. The articles identified G2 Farms as the converting entity.
John was appointed as the manager of each of the LLC's and handled the day-to-day farming operations. Morris handled nonfarming activities such as financing, leasing and water district issues. The operating agreements of the LLC's stated that their primary purpose was to engage in farming and related activities. Sections 5.7 of the operating agreements stated: "Standard of Care. The fiduciary duties a Manager owes to the Company and the other Members are those of a director of a California corporation to the corporation and its shareholders."
In April 2010, the Bank obtained a judgment against Morris, Sharon and Western Ag in the amount of $358,920.56, plus interest and attorney fees and a separate judgment against Morris and Western Ag in the amount of $2,190,246.99, plus interest and attorney fees. To enforce its judgment, Bank filed a motion and application of a charging order.4
Another way the Bank attempted to collect the money owed was by conducting a nonjudicial foreclosure sale of real property that partially secured the Wasco Rose loans. The sale occurred in August 2010 and approximately $1,147,725 in proceeds were applied to reduce the judgment held by the Bank.
*3 On July 2, 2010, the court granted Bank's motion and issued a charging order against plaintiffs Morris and Sharon's economic interest in the LLC's. Under the charging order, the plaintiffs' 25 percent interests in the LLC's were "charged as assets of [the plaintiffs,] the proceeds of which shall be applied to pay the unsatisfied portion of the Judgment entered in the pending action ... until such Judgment is satisfied in full." The charging order refused to appoint a receiver and stated a writ of execution (which was not issued) was the proper means to levy the retirement plan and IRA account.
Plaintiffs allege they attempted to access their capital accounts in the LLC's to repay the amounts owed to the Bank. John, in his capacity as manager, and John and Janie, in their capacities as members, denied plaintiffs access to their capital in the LLC's. Plaintiffs allege they had no alternative except bankruptcy protection.
On March 31, 2011, plaintiffs filed a chapter 7 bankruptcy petition in the federal bankruptcy court. Plaintiffs claimed approximately $18,500 of the value of their membership interest in one of the LLC's was exempt from execution. Their bankruptcy schedule of property claimed as exempt estimated the value of the membership interest in the LLC at over $2.2 million.5 On July 5, 2011, the bankruptcy court entered an order stating plaintiffs were "granted a discharge under section 727 of title 11, United States Code."
On June 23, 2011, the Bank objected to plaintiffs' claim of exemption. About nine months later, on March 15, 2012, the bankruptcy court overruled the Bank's objection to the claim of exemption.
2012 Foreclosure on Economic Interests
John, as manager of the LLC's, did not make any distribution to the Bank pursuant to the July 2010 charging order. Eventually, the Bank moved to foreclose on the economic interests of plaintiffs in the LLC's based on the April 2010 judgments.
On May 4, 2012, the foreclosure sale was held. The Bank made an opening credit bid of $1.5 million and no one else submitted a competing bid. The bid specified that (1) $500,000 would be credited against the joint and several liability of Western Ag, Morris and Sharon and (2) $1 million would be credited against the joint and several liability of Western Ag and Morris.
On August 9, 2012, the court entered an order of foreclosure and sale to the Bank. The order stated: "The respective 25% 'economic interests' of MORRIS F. GARCIA and SHARON A. GARCIA in [ ] each of the respective LLCs as defined in Cal. Corp. Code sec. 17001(n) is hereby foreclosed so that [Morris and Sharon] shall thereafter have no further 'economic interest' in either of the LLCs." The order stated the economic interests were sold to the Bank, which "shall thereafter have the rights of an assignee of said economic interests." The order also directed the Bank to file a partial satisfaction of judgment.
Sale of Assets of LLC's and Dissolution
In November 2013, plaintiffs learned that defendants, acting for the LLC's, had sold all of the real property owned by the LLC's to Samara Ranches, LLC. The real property consisted of seven parcels totaling approximately 400 acres. Defendants signed a grant deed covering the seven parcel and delivered it to the buyer. The grant deed was recorded on November 26, 2013. Plaintiffs were not given an opportunity to vote on the sale of the real property. Plaintiffs allege they would have not agreed to the sale if they had been given an opportunity to vote.
In December 2013, John filed statements of information for each LLC with the California Secretary of State. The statements listed John as chief executive officer and Janie and the Bank as the managers of the LLC's.
*4 An undated "AGREEMENT FOR DISSOLUTION OF VISTA DEL SOL" was entered into by the Bank, John and Janie with reference to "Vista Del Sol, a California limited liability company." The agreement stated "Vista Del Sol shall be dissolved as of June 30, 2014 and thereafter shall no longer engage in any business or operations."
On July 16, 2014, the Bank received a payment of $2.5 million from the LLC's. On November 5, 2014, the Bank received payments totaling $2,526,933.15 from the LLC's. The general ledger of one of the LLC's shows these transfers as withdrawals by the Bank from a capital account.
In April 2015, John filed a "Certificate of Dissolution of a Limited Liability Company" for each of the LLC's. Each certificate stated the dissolution of the LLC was caused by the vote of a majority of the members of the LLC.
On June 3, 2015, John filed a "Certificate of Cancellation of a Limited Liability Company" for each of the LLC's, which cancelled their articles of organization. The certificates stated that (1) the "dissolution was made by the vote of all of the members" and (2) all tax returns required under California statute had or would be filed with the California Franchise Tax Board.
Fiduciary Duty Lawsuit
In May 2015, plaintiffs filed their complaint for breach of fiduciary duty, conversion, unjust enrichment, accounting, imposition of constructive trust and declaratory relief against John and Janie (super. ct. case No. 15CECG01410).6 The complaint also listed the LLC's as nominal defendants. A series of demurrers and amended pleadings followed.
The lawsuit was assigned superior court case No. 15CECG01410 and was consolidated with (1) an earlier lawsuit filed by the Bank against John, Janie, Morris, Sharon and the LLC's, superior court case No. 12CECG03902 (lead case); and (2) a lawsuit filed by another of plaintiffs' creditors against the Bank, superior court case No. 13CECG00135. This appeal does not challenge rulings made in these two earlier lawsuits.
In May 2016, plaintiffs filed a third amended complaint, which is one of the operative pleadings for purposes of this appeal. By that point, plaintiffs' claims against the Bank had been combined with their claims against John and Janie. The claims stated were for breach of fiduciary duty, conversion, money had and received, unjust enrichment, accounting, imposition of constructive trust and declaratory relief. Plaintiffs alleged an economic interest in a limited liability company was a "profits interest" that entitled the holder to share in the income, gains, losses, deductions and credits and to receive distributions from the stream of income produced in the ordinary course of business. Plaintiffs also alleged a membership interest in a limited liability company was a "capital interest" that entitled the holder to the capital account attributable to that member and to vote and otherwise participate in the management of the company. Plaintiffs further alleged that they owned 50 percent of the membership (i.e., capital) interests in the LLC's and, as a result, were entitled to possession of the value of their capital accounts despite the Bank's acquisition of their economic (i.e., profit) interests in the LLC's. Consequently, in plaintiffs' view, the payments of over $5 million made to Bank in 2014 should have been made to them because the payments consisted of the value of plaintiffs' capital accounts in the LLC's.
*5 The Bank challenged the third amended complaint by filing a demurrer, one of the subjects of this appeal. On June 14, 2016, the trial court sustained the Bank's demurrer without leave to amend. The court concluded the Bank held the economic interests in the LLC's, which entitled the Bank to receive funds paid from the capital accounts. As a result, the court concluded plaintiffs had failed to state causes of action against the Bank for money had and received, unjust enrichment, restitution or imposition of a constructive trust.
On June 20, 2016, defendants filed a demurrer to the third amended complaint, contending none of the claims alleged facts sufficient to constitute a cause of action. Defendants argued the Bank, as a result of its foreclosure, had become the owner of all economic interests in the LLC's and plaintiffs had no right to any value in the capital accounts of the LLC's or to any distributions from the LLC's. Based on this theory, which was the same theory the Bank presented in its earlier demurrer, defendants argued plaintiffs failed to state how they were damaged.
On July 22, 2016, the trial court issued an order sustaining the demurrer to the entire third amended complaint without leave to amend. The court rejected plaintiffs' theory that they were entitled to a refund of their capital contributions and concluded any money in the capital accounts would go only to the holder of the economic interests in the LLC's, which was the Bank. The court determined all of plaintiffs' claims failed to state a cause of action because the allegations did not support the existence of any money damages as to plaintiffs.
In August 2016, the court signed a request for dismissal that ordered the dismissal of the plaintiffs' third amended complaint with prejudice.7 Later that month, plaintiffs filed a notice of appeal relating the dismissal of their claims against the defendants. The notice of appeal did not extend to the dismissal obtained by the Bank.
An order sustaining a demurrer is not appealable, while an order dismissing the complaint is. (Munoz v. Davis (1983) 141 Cal.App.3d 420, 431; see Code Civ. Proc., sec. 904.1.)
Elder Abuse Lawsuit
In December 2015, plaintiffs filed a first amended complaint for damages for financial elder abuse, superior court case No. 15CECG02784 (elder abuse action). Plaintiffs acknowledge that the factual allegations in the elder abuse action largely mirrored the allegations in their third amended complaint in the fiduciary duty lawsuit. Plaintiffs asserted the facts alleged constituted "financial abuse" within the meaning of Welfare and Institutions Code section 15610.30, subdivision (a). They also asserted they qualified as "elders" because they were over 65 years of age. Plaintiffs alleged defendants represented they would comply with the charging order obtained by the Bank by continuing to made regular distributions until the judgment was satisfied in full, but failed to make such distributions. Plaintiffs supported this allegation by attaching a copy of a March 12, 2012, letter from defendants' attorney stating the LLC's "will simply proceed with paying off the judgment creditors through payment of distributions which otherwise would have been paid to Morris and Sharon pursuant to their economic interests." This letter was sent shortly before the May 4, 2012, foreclosure sale.
In February 2016, defendants filed a motion for sanctions, contending the elder abuse action was frivolous and lacked legal and factual merit. Defendants requested attorney fees in the about of $13,037.90.
*6 In April 2016, the trial court granted the motion and imposed sanctions in the amount of $5,940 against plaintiffs and their attorney. The court determined the elder abuse action lacked merit under an objective standard and constituted a frivolous filing under Code of Civil Procedure section 128.7. Plaintiffs filed a timely notice of appeal of the order imposing sanctions.
I. STANDARD OF REVIEW FOR GENERAL DEMURRERS
Appellate courts independently review an order sustaining a general demurrer and make a de novo determination of whether the pleading "alleges facts sufficient to state a cause of action under any legal theory." (McCall v. PacifiCare of Cal., Inc. (2001) 25 Cal.4th 412, 415.) Generally, appellate courts "give the complaint a reasonable interpretation, reading it as a whole and its parts in their context." (City of Dinuba v. County of Tulare (2007) 41 Cal.4th 859, 865.) The demurrer is treated as admitting all material facts properly pleaded, but does not admit the truth of contentions, deductions or conclusions of law. (Ibid.)
The pleader's contentions or conclusions of law are not controlling because appellate courts must independently decide questions of law without deference to the legal conclusions of the pleader or the trial court. (Villery v. Department of Corrections & Rehabilitation (2016) 246 Cal.App.4th 407, 413.) Legal questions include the interpretation of a statute and the application of a statutory provision to facts assumed to be true for purposes of the demurrer. (Ibid.)
II. BREACH OF FIDUCIARY DUTY: RETURN OF CAPITAL
A. Elements of a Breach of Fiduciary Duty Claim
The elements of a cause of action for breach of fiduciary duty are (1) the existence of a fiduciary relationship, (2) the breach of a fiduciary duty arising from that relationship, and (3) damages proximately caused by that breach. (Knox v. Dean (2012) 205 Cal.App.4th 417, 432; see Oasis West Realty, LLC v. Goldman (2011) 51 Cal.4th 811, 820.) Generally, whether a particular fiduciary duty exists is a question of law and whether the duty was breached is a question of fact. (Green Valley Landowners Assn. v. City of Vallejo (2015) 241 Cal.App.4th 425, 441.)
Under California law, a fiduciary relationship exists between the manager of a California limited liability company and its members. (Former sec. 17153.)8 The fiduciary duties a manager owes to the members are those a partner owes to the other partners of the partnership. (Ibid.) Partners are bound to act in the highest good faith to their copartners. (Page v. Page (1961) 55 Cal.2d 192, 197.) Thus, a manager "is obligated to act with the utmost loyalty and in the highest good faith when dealing with any member of the LLC." (Feresi v. The Livery, LLC (2014) 232 Cal.App.4th 419, 425.)
Currently, section 17704.09 defines the fiduciary duties of the members and managers of a limited liability company.
B. Contentions of the Parties
1. Plaintiffs' Claims of Error
Plaintiffs alleged defendants breached their fiduciary duties in a number of ways. One such claim was based on defendants' failure to return plaintiffs' capital interest and, instead, transferring the money to the Bank.
Plaintiffs argue the trial court erred in sustaining the demurrer because (1) the operating agreements of the LLC's are ambiguous as to plaintiffs' rights to the return of their capital contributions; (2) the ambiguities should not be resolved on demurrer; and (3) their interpretation of the ambiguities is consistent with both the statutory scheme governing limited liability companies and the language of the operating agreements. Plaintiffs' argument as to ambiguity is based on (1) the definition of "economic interest" in the operating agreements and what that definition contains and does not contain, (2) provisions of the operating agreements that define "capital account," and (3) sections 3.4 of the operating agreements, which state that a separate capital account shall be maintained for each member and interest holder. Plaintiffs contend these provisions can be interpreted to mean that a separate capital account was required to be maintained for them in their capacity as members and that account includes their original capital contribution. Plaintiffs contend extrinsic evidence must be considered to resolve the ambiguity as to their rights to their capital contribution and, thus, the demurrer should have been overruled.
2. Defendants' Contentions
*7 Defendants contend there are no ambiguities in the operating agreement and the question of ambiguity is subject to de novo review. Defendants further contend plaintiffs' interpretation of the operating agreements is wrong because the membership interest plaintiffs retained after the Bank's 2012 foreclosure did not contain an economic component in the form of rights to the "capital accounts" of the LLC's or any rights to a capital interest. Defendants assert there is no legal authority supporting the argument that plaintiffs' retained membership interest included a "capital interest" or rights to the "capital accounts."
C. Contractual Ambiguity
1. General Principles
As the foundation for our discussion of rules of law governing the proper pleading of a contractual ambiguity, we make four general points about contractual ambiguity. First, the term "ambiguous" means "reasonably susceptible to more than one interpretation." (Adams v. MHC Colony Park, L.P. (2014) 224 Cal.App.4th 601, 619 (Adams).)
Second, courts are concerned with the application of contractual language to material facts and not with abstract uncertainties in the language. (Dore v. Arnold Worldwide, Inc. (2006) 39 Cal.4th 384, 391 (Dore).) Thus, a legally relevant contractual " 'ambiguity arises when language is reasonably susceptible of more than one application to material facts.' " (Ibid.)
Third, an ambiguity can be classified as either "patent or latent." (Dore, supra, 39 Cal.4th at p. 393.) A contract is patently ambiguous if it is ambiguous " 'on its face.' " (Id. at p. 391; Fremont Indemnity Co. v. Fremont General Corp. (2007) 148 Cal.App.4th 97, 114 ["ambiguity may appear on the face of a contract"].) In contrast, " 'a latent ambiguity may be exposed by extrinsic evidence which reveals more than one possible meaning to which the language of the contract is yet reasonably susceptible.' " (Dore, supra, at p. 391; Fremont, supra, at p. 114 ["extrinsic evidence may reveal a latent ambiguity"].) Thus, while a written contract may appear to a court to be plain and unambiguous on its face, a latent ambiguity may be established through extrinsic evidence showing a meaning to which the language is reasonably susceptible. (Dore, supra, at p. 391; see Pacific Gas & E. Co. v. G. W. Thomas Drayage etc. Co. (1968) 69 Cal.2d 33, 37 (Pacific Gas).) It follows that "[t]he analysis of whether an ambiguity exists is not limited to the words of the contract." (Adams, supra, 224 Cal.App.4th at p. 620.)
Fourth, whether a contractual ambiguity exists is a question of law. (Adams, supra, 224 Cal.App.4th at p. 619; Winet v. Price (1992) 4 Cal.App.4th 1159, 1165.) Accordingly, whether an ambiguity exists is subject to independent review on appeal. (Ibid.)
2. Proper Pleading of Contractual Ambiguity
In the landmark decision of Pacific Gas, the Supreme Court addressed when extrinsic evidence was admissible to explain the meaning of a written contract and rejected the exclusion of such evidence where the court determined the contract was plain and unambiguous on its face. (Pacific Gas, supra, 69 Cal.2d at p. 37.) The court stated: "A rule that would limit the determination of the meaning of a written instrument to its four-corners merely because it seems to the court to be clear and unambiguous, would either deny the relevance of the intention of the parties or presuppose a degree of verbal precision and stability our language has not attained."9 (Ibid.)
Twenty years after Pacific Gas was issued, the Ninth Circuit stated: "Pacific Gas casts a long shadow of uncertainty over all transactions negotiated and executed under the law of California." (Trident Center v. Connecticut General Life Ins. Co. (9th Cir. 1988) 847 F.2d 564, 569; see Dore, supra, 39 Cal.4th at p. 396, conc. opn. of Baxter, J. [criticizing the use of extrinsic evidence to create a latent ambiguity when the contractual language appears clear in the context of the parties' dispute].) We are bound by Pacific Gas and the majority opinion in Dore.
*8 Since Pacific Gas, the question of how to properly plead a contractual ambiguity has been addressed many times by the Court of Appeal. Two decisions of the Fifth District on this issue are Southern Pacific Land Co. v. Westlake Farms, Inc. (1987) 188 Cal.App.3d 807 (Southern Pacific) and Hayter Trucking, Inc. v. Shell Western E&P, Inc. (1993) 18 Cal.App.4th 1 (Hayter Trucking).) Three decisions of the Second District are Marina Tenants Assn. v. Deauville Marina Development Co. (1986) 181 Cal.App.3d 122; Aragon-Haas v. Family Security Ins. Services, Inc. (1991) 231 Cal.App.3d 232; and George v. Automobile Club of Southern California (2011) 201 Cal.App.4th 1112.
We summarize the principles from these cases insofar as they address pleading an ambiguity in a written contract attached to the complaint. First, an ambiguity is adequately pleaded if (1) the contract attached to the complaint is facially ambiguous and (2) the complaint alleges the meaning the pleader ascribes to the contract. (Southern Pacific, supra, 188 Cal.App.3d at p. 817; Hayter Trucking, supra, 18 Cal.App.4th at p. 18.) When the ambiguity appears on the face of the document, it is not necessary to plead the extrinsic evidence that will be offered to support the pleader's interpretation. Second, when the written contract attached to the complaint lacks a facial ambiguity and the cause of action depends upon the existence of a latent ambiguity, the complaint must allege (1) the meaning the pleader ascribes to the contract and (2) at least some of the extrinsic evidence that renders the proffered interpretation reasonable.
D. Statutory Provisions
Plaintiffs contend the operating agreements entitled them to the return of their capital. This contract based theory requires us to consider the California statutes governing the existence and operation of limited liability companies. Certain statutory provisions are mandatory and may not be varied by of the operating agreement. Consequently, plaintiffs' theory that they retained to the right to the return of their capital might be precluded by statute.
1. Applicable Legislation
In 1994, the Legislature enacted the Beverly-Killea Limited Liability Company Act (Beverly-Killea Act; former sec. 17000 et seq.) which authorized the formation of limited liability companies. (Stats. 1994, ch. 1200, sec. 27, p. 625.) In 2012, the Legislature adopted the California Revised Uniform Limited Liability Company Act (Revised Act; sec. 17701.01 et seq.) to replace the Beverly-Killea Act. (Stats. 2012, ch. 419, secs. 19, 20.) The Revised Act became operative on January 1, 2014. (sec. 17713.13.)
The Bank foreclosed on plaintiffs' economic interests in 2012, before the Revised Act became effective. In contrast, the payment of approximately $5 million to the Bank was made in 2014, after the Revised Act went into effect. During the course of this litigation, the parties have not been in complete agreement as to which act applies to particular events.
Plaintiffs' current position is stated in their opening brief, where they assert the Revised Act became effective "after the foreclosure and other allegedly wrongful conduct occurred here." Similarly, defendants' appellate brief asserts the Beverly-Killea Act applies. Consistent with this assertion, defendants refer to one provision from the Revised Act, section 17705.02, and contend it does not apply to the question of whether a membership interest includes the member's capital account. Based on the arguments presented on appeal and the facts alleged in the complaint, we conclude the 1994 Beverly-Killea Act applies to the disputes raised by the parties. (sec. 17713.04 [Revised Act applies to all actions taken by managers and members after January 1, 2014, subject to stated exceptions].) In short, the scope or extent of the rights the Bank obtained at the 2012 foreclosure sale and the rights plaintiffs retained as part of their membership interests are determined by the statute in effect at the time of the foreclosure sale.
2. Interests Defined by the Beverly-Killea Act
*9 Former section 17001 defined over 40 terms used in the Beverly-Killea Act. These statutory definitions are important because a limited liability company's articles of organization and operating agreement may not "[v]ary the definitions in Section 17001, except as specifically provided therein." (Former sec. 17005, subd. (b)(1).) As relevant here, subdivisions (n) and (z) of former section 17001 defined "economic interest" and "membership interest" and did not specifically allow those definitions to be varied. Another "interest" mentioned in former section 17001 was "capital interest"—a term that was not defined but appeared in the definition of "capital account." (Former sec. 17001, subd. (d).)
" 'Membership interest' "—the broadest of the interests defined by statute—meant "a member's rights in the limited liability company, collectively, including the member's economic interest, any right to vote or participate in management, and any right to information concerning the business and affairs of the limited liability company provided by this title." (Former sec. 17001, subd. (z), italics added.) Three aspects of this definition are noteworthy for purposes of this appeal. First, the use of the word "including" in the definition does not limit the term "membership interest" to the things listed in the definition. (In re Marriage of Angoco & San Nicolas (1994) 27 Cal.App.4th 1527, 1534 ["including" is a word of enlargement, not limitation].) Second, the definition makes no reference to a capital interest or capital contributions. Third, the definition clearly identifies "economic interest" as a subset of the broader "membership interest."
" 'Economic interest' " was defined by the Beverly-Killea Act as "a person's right to share in the income, gains, losses, deductions, credit, or similar items of, and to receive distributions from, the limited liability company." (Former sec. 17001, subd. (n).) The definition explicitly excluded "any other rights of a member, including, without limitation, the right to vote or to participate in management, or, except as provided in Section 17106, any right to information concerning the business and affairs of the limited liability company." (Former sec. 17001, subd. (n).) This definition, like the definition of membership interest, made no direct reference to a capital interest or capital contributions.
The foregoing definitions demonstrate that the Beverly-Killea Act divided membership interests into two categories. The first category was economic interests—a term defined by the statute. (Former sec. 17001, subd. (n).) The second category was the membership interests excluded from the definition of economic interests, which the statute referred to as "any other rights of a member." The other rights of a member included the right to vote, the right to participate in management, any right to information concerning the company's business and affairs, and any other right or interest that is not an economic interest. (See former sec. 17001, subds. (n), (z).)
3. Capital Interest
Plaintiffs' proffered interpretation of the operating agreements is tied to the concept of a "capital interest," which was not defined by the Beverly-Killea Act. However, the term was used in the statutory definition of "capital account," which meant "the amount of the capital interest of a member in the limited liability company consisting of that member's original contribution, as (1) increased by any additional contributions and by that member's share of the limited liability company's profits, and (2) decreased by any distribution to that member and by that member's share of the limited liability company's losses." (Former sec. 17001, subd. (d), italics added.) The statutory definition of "capital account" applied to a particular limited liability company "unless otherwise provided in the operating agreement." (Ibid.)
*10 Plaintiffs argue a "capital interest" was a type of membership interest and, as such, their capital interests were not part of the economic interests acquired by the Bank at the foreclosure auction. The Beverly-Killea Act did not explicitly state, one way or the other, whether a "capital interest" was an economic interest. Similarly, it did not state a "capital interest" was only a membership interest.
4. Foreclosure under the Beverly-Killea Act
The Bank acquired plaintiffs' economic interests by purchasing those interests at the foreclosure sale. Consequently, the statutory provisions that addressed foreclosure provide information about the economic interests acquired by the Bank. Former section 17302 addressed charging orders and foreclosures, which were remedies a judgment creditor could obtain against a judgment debtor's interest in a limited liability company. "A charging order constitutes a lien on the judgment debtor's assignable membership interest. The court may order a foreclosure on the membership interest subject to the charging order at any time. The purchaser at the foreclosure sale has the rights of an assignee." (Former sec. 17302, subd. (b).)10
In contrast, statutes in some states explicitly preclude foreclosure as a remedy, while statutes in other states provide that the charging order is the exclusive remedy. (See Pomeroy, Think Twice: Charging Orders and Creditor Property Rights (2014) 102 Ky. L.J. 705, 721; Arkow, The New LLC (Jan. 2014) 36 Los Angeles Lawyer 25, 28 [Delaware law squarely rejected allowing judgment creditors to foreclose on debtor's interests in limited liability companies].) The purpose of limiting the judgment creditor's remedy to a charging order is to protect the nondebtor members from being forced into what would amount to an involuntary partnership with the creditor. (Adkisson, Charging Orders: The Peculiar Mechanism (2016) 61 S.D. L.Rev. 440, 451.)
Here, the August 9, 2012, order of foreclosure and sale stated the 25 percent economic interests of Morris and Sharon in each of the LLC's was "foreclosed so that [Morris and Sharon] shall thereafter have no further 'economic interest' in either of the LLCs." The order also stated the economic interests were sold to the Bank, which "shall thereafter have the rights of an assignee of said economic interests." Based on the last sentence of subdivision (b) of former section 17302 and the terms of the order, the Bank had "the rights of an assignee" to the plaintiffs' economic interests in the LLC's. (Former sec. 17302, subd. (b).) The provisions of the Beverly-Killea Act governing assignments are described next.
5. Assignments under the Beverly-Killea Act
Former sections 17300 through 17304 addressed assignments of membership and economic interests. Former section 17301, subdivision (a)(1) provided that, except as provided in the operating agreement, a membership interest or an economic interest was assignable in whole or in part. Based on the wording of the order of foreclosure and sale, all of the economic interests of the plaintiffs were assigned to the Bank. In other words, this case does not involve a partial assignment of the economic interests.
Former section 17301, subdivision (a)(3) provided in full: "An assignment of an economic interest merely entitle[d] the assignee to receive, to the extent assigned, the distributions and the allocations of income, gains, losses, deductions, credit, or similar items to which the assignor would be entitled." (Italics added.) The statutory phrase "to the extent assigned" is not relevant in this appeal because the all of the plaintiffs' economic interests were assigned to the Bank. In contrast, the phrase "distributions ... to which the assignor would be entitled" is central to the parties' dispute. (Ibid.) In particular, defendants contend the economic interests obtained by the Bank entitled the Bank to receive "the distributions ... to which the [plaintiffs] would be entitled" and those distributions included payments that, from an accounting perspective, would reduce plaintiffs' capital account. (Former sec. 17301, subd. (a)(3).)
*11 Both subdivision (a)(3) of former section 17301 and the statutory definition of "economic interest" refer to distributions. " 'Distribution' " was defined broadly as "the transfer of money or property by a limited liability company to its members without consideration." (Former sec. 17001, subd. (j).) Plaintiffs' third amended complaint quoted the statutory definition of "distribution" and noted it was one of the definitions that could not be varied by the operating agreement. Plaintiffs argued the definition mentioned only transfers to "members," which supports their interpretation that holders of economic interests could not receive distributions. We reject this statutory interpretation and conclude the failure to mention holders of an economic interest in the statutory definition of "distribution" did not mean that holders of an economic interest could not acquire a member's right to receive distributions. The phrase "the distributions ... to which the assignor would be entitled" used in former section 17301, subdivision (a)(3) clearly showed that an assignee of an economic interest, such as the Bank, could obtain the assignor's entitlement to distributions from the limited liability company.
Based on the foregoing statutory provisions, a key issue of statutory construction is whether the statutory term "distributions" encompassed the return of capital contributions.11 This specific question is not answered explicitly by the definition of "distribution," although the general reference to "the transfer of money or property" is broad enough to encompass a return of capital.
"Contribution" referred to any assets (e.g., money, property or services rendered) that a member contributed to a limited liability company as capital in the member's capacity as a member pursuant to an agreement among the members. (Former sec. 17001, subd. (g).) Thus, a contribution referred to a specific type of transfer of an asset from a member to the company.
We conclude another of the Beverly-Killea Act's definitions provided the basis for the proper interpretation of the statutory term "distribution." Former section 17001, subdivision (aj) provided: " 'Return of capital,' unless otherwise provided in the operating agreement, means any distribution to a member to the extent that the member's capital account, immediately after the distribution, is less than the amount of that member's contributions to the limited liability company as reduced by prior distributions that were a return of capital." This definition plainly established that the term "distribution" extended to money or property classified as capital.
The statutory definitions of "economic interest," "membership interest" and "distribution" could not be varied by the operating agreements. (See former sec. 17005, subd. (b)(1).) Consequently, we conclude the interpretation of "economic interest" to include the right to "distributions" and the interpretation of "distribution" to include the transfer of money or property classified by the limited liability company as capital or part of a capital account was binding on the parties and their operating agreements.
Considering the Beverly-Killea Act as a whole, we construe its provisions to mean that an "economic interest" includes the right to receive "distributions" and "distributions" include the transfer of money or property that was regarded (i.e., accounted for) as capital by the limited liability company. As these definitions could not be varied, it follows that the Bank, as the holder of plaintiffs' economic interests in the LLC's, was entitled to receive distributions of capital. (See former sec. 17005, subd. (b)(1).) In other words, plaintiffs' retained membership interests did not include the right to receive their capital contributions or the capital accumulated in the capital account they held before the foreclosure sale.
Based on our statutory construction, it is unnecessary to review in detail the provisions of the operating agreements to determine if those provisions are ambiguous as to whether plaintiffs retained a right to the return of capital. Even if the operating agreements were facially or latently ambiguous on that question, the provisions of the Beverly-Killea Act would override the ambiguity and lead to the conclusion that the membership interests retained by plaintiffs did not include any right to the return of capital. Therefore, we conclude the trial court correctly determined plaintiffs had failed to state a cause of action for breach of fiduciary duty based on defendants' failure to return plaintiffs' original and accumulated capital interest. Stated in the language of subsections 1.8.3 of the operating agreements, the Bank succeeded to the capital accounts of the plaintiffs because the entire capital accounts were "attributable to the transferred [economic] interest[s]."
III. BREACH OF FIDUCIARY DUTY: FAILURE TO MAKE DISTRIBUTIONS
*12 Plaintiffs also contend defendants breached their fiduciary duties by failing to make distributions pursuant to the 2010 charging order, which precipitated the Bank's eventual foreclosure and the liquidation of the LLC's. Plaintiffs contend this breach caused them damage because they would not have lost their economic interests in the LLC's pursuant to a foreclosure if distributions had been made under the charging order. The trial court rejected the theory on the ground "it does not appear that John was under any legal obligation to make distributions to anyone" and "he had discretion as manager for the LLC's as to whether to make any distributions at all."
B. Fiduciary Duties
The relevant fiduciary duties are based on statute and contract. Under former section 17153, the fiduciary duties a manager owed to the members of a California limited liability company are those a partner owed to the other partners of the partnership. Thus, a manager is obligated to act with the utmost loyalty and in the highest good faith. (Feresi v. The Livery, LLC, supra, 232 Cal.App.4th at p. 425.) In addition to the statutory duties, the operating agreements provided that the manager owed the same fiduciary duties to the companies and the other members as a director owed to a California corporation and its shareholders. The duties of a corporate director are set forth in section 309, subdivision (a): "A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances." This duty, which is described in general language, applies to specific transactions. For example, when considering a proposed merger or change of control transaction, the directors are obligated to determine whether the offer is in the best interests of the corporation and its shareholders. (Central Laborers' Pension Fund v. McAfee, Inc. (2017) 17 Cal.App.5th 292, 314.)
C. Sufficient Allegations of a Breach
First, a fiduciary duty can be breached without the breach of a specific legal obligation, such as an obligation imposed by the operating agreements. (See Palm Springs Villas II Homeowners Assn., Inc. v. Parth (2016) 248 Cal.App.4th 268 [affirmed ruling sustaining demurrer to claim for breach of entity's governing documents; reversed order granting summary judgment on breach of fiduciary duty claim].) Therefore, plaintiffs may plead a breach of fiduciary duty without pleading a breach of the operating agreements or a specific statutory provision.
Second, we reject the idea that the exercise of discretionary authority can never breach the fiduciary duty to make decisions in good faith and in the best interests of the company. (See generally, Scheenstra v. California Dairies, Inc. (2013) 213 Cal.App.4th 370, 388 [business judgment rule applies to board's discretionary authority]; Berg & Berg Enterprises, LLC v. Boyle (2009) 178 Cal.App.4th 1020, 1045 (Berg LLC).) When managers, directors or partners exercise discretionary authority, they are subject to a fiduciary duty of good faith and to act in the best interests of the entity and its members, shareholders or partners.
We further conclude that plaintiffs have alleged sufficient facts to show that John's discretionary decision to make no distributions to the Bank under the charging order was not made in good faith and did not serve the best interests of the LLC's or plaintiffs in their capacity as members. Plaintiffs' allegations, which are accepted as true for purposes of the demurrer, show that John's decision not to make distributions to the Bank under the charging order caused the Bank to foreclosure on the economic interests of the plaintiffs in the LLC's.12 In turn, the foreclosure caused the LLC's to cease business operations, liquidate their real property, and go out of existence. It is reasonable to infer that going out of business and ceasing to exist was not in the best interest of the LLC's and, therefore, John's acts and omissions that caused this result also were not in the best interest of the LLC's. As to whether John's decision, which deviated from previous practice, was in plaintiffs' best interest, plaintiffs have alleged they were subject to (1) foreclosure and lost their economic interests in the LLC's and (2) adverse tax consequences. These allegations are sufficient to support the inference that the decision was not in their best interest. In sum, we conclude the allegations set forth sufficient facts to survive the demurrer. (Cf. Berg LLC, supra, 178 Cal.App.4th at p. 1046 [listing cases affirming demurrers on ground the pleadings failed to allege facts rebutting business judgment rule].)
This theory of causation presents a question of fact, which is not within the scope of a demurrer. (Alejo v. City of Alhambra (1999) 75 Cal.App.4th 1180, 1190; see Del E. Webb Corp. v. Structural Materials Co. (1981) 123 Cal.App.3d 593, 604 [for purposes of a demurrer, "facts alleged in the pleading are deemed to be true, however improbable they may be"].)
*13 Defendants have interpreted plaintiffs' allegations to mean John, as manager, had a duty to cause the LLC's to pay off the judgment "without regard to the consequences to the entities or John and Janie and thus to ensure that the Bank never foreclosed." This interpretation about disregarding consequences, which is favorable to defendants, is not warranted at the pleading stage. (Mendoza v. Continental Sales Co. (2006) 140 Cal.App.4th 1395, 1401-1402 [when construing a complaint, court assumes the truth of facts that (i) can be inferred reasonably from the allegations and exhibits and (ii) are favorable to the plaintiff]; see Code Civ. Proc., sec. 452 [construction of pleadings].) The consequences to the entities have been put at issue by plaintiffs' allegations, and we must accept as true that (1) the consequences were going out of business and ceasing to exist and (2) those consequences were negative outcomes for the LLC's and plaintiffs. In short, the dispute about the consequences of the choices available to John as manager cannot be resolved at the pleading stage in favor of defendants.
D. Other Legal Theories
In Genesis Environmental Services v. San Joaquin Valley Unified Air Pollution Control Dist. (2003) 113 Cal.App.4th 597, we stated that when reviewing an order sustaining a general demurrer, "our inquiry ends and reversal is required once we determine a complaint has stated a cause of action under any legal theory." (Id. at p. 603.) Based on this principle and our determination that the complaint states a cause of action for breach of fiduciary duty, we end our inquiry without considering the additional legal theories advanced by plaintiffs on appeal.
A. Basic Principles
A request for sanctions under Code of Civil Procedure section 128.7 may be brought by a party to the litigation as a separate motion or by the court on its own motion. (Code Civ. Proc., sec. 128.7, subd. (c).) The statute authorizes sanctions if the court determines a pleading or motion was filed for an improper purpose or was indisputably without merit, either legally or factually (i.e., was frivolous). (Guillemin v. Stein (2002) 104 Cal.App.4th 156, 168.) Under Code of Civil Procedure section 128.7, frivolity is determined using an objective standard. (Burkle v. Burkle (2006) 144 Cal.App.4th 387, 401.) "A claim is objectively unreasonable if 'any reasonable attorney would agree that [it] is totally and completely without merit.' " (Peake v. Underwood (2014) 227 Cal.App.4th 428, 440.)
The standard of review for the award of sanctions under Code of Civil Procedure section 128.7 is abuse of discretion. (Guillemin v. Stein, supra, 104 Cal.App.4th at p. 167.)
B. Plaintiffs' Claim Was Not Frivolous
Based on our conclusion that plaintiffs stated a cause of action for breach of a fiduciary duty, we conclude there was an objectively reasonable basis for plaintiffs' elder abuse action. Accordingly, the order awarding sanctions under Code of Civil Procedure section 128.7 shall be reversed.
The order dismissing the third amended complaint with prejudice is reversed. The trial court is directed to vacate its order sustaining the demurrer without leave to amend and to enter a new order overruling the demurrer.
The order imposing sanctions is reversed.
Plaintiffs shall recover their costs on appeal.
DETJEN, Acting P.J.
by Jay Adkisson
2020.06.20 ... Payment Of Distributions Directly To Creditor Holding A Charging Order Deemed Appropriate In BMO Case
2020.04.30 ... Charging Order Denied For Lack Of Proof Of The Debtor's Interest In Dhillon
2020.02.29 ... Florida Charging Order Requires Distributions To Be Re-Directed To The Creditor In Kostoglou
More Articles On Charging Orders click here
LAW REVIEW ARTICLES
by Jay Adkisson
For more on the historical background of Charging Orders and contemporary issues involving the same, see Jay Adkisson's article, Charging Orders: The Peculiar Mechanism, 61 South Dakota Law Review 440 (2016). Available at SSRN: https://ssrn.com/abstract=2928487
Analysis of Uniform Limited Liability Company Act Sections re Charging Orders
The Uniform Acts re Charging Orders and Transferable Interests (without Jay's comments):
Effect of Bankruptcy On The Debtor-Member's LLC Interest here
Collected Court Opinions On Charging Orders here and below
NATURE OF REMEDY
Distributions/Economic Rights - Creditors rights to distributional interests/economic rights
Prejudgment Relief - Freezing the interest and distributions pending judgment
Procedure - The procedure for obtaining a charging order and ancillary provisions
Unknown Interest - Where the debtor's interest, if any, has not been ascertained
Order Form Generally - Most issues to the form of the charging order
Order Form Future Interests - How the charging order affects subsequently-acquired interests
Exemptions - Available state and federal protections that may apply to charging orders
Conflicts-Of-Law - Determining which state's laws apply to a charging order dispute
Jurisdiction - Issues relating to the court's authority over out-of-state debtors and LLCs
Foreign Entities - Charging orders against out-of-state entities
Creditor Rights Restrictions - Limitations on creditors' management and informational rights
Information Rights - Creditors' ability to access information about the LLC
Management & Voting Rights - Rights of creditor after charging order issued
LIEN EFFECT AND PRIORITY
Lien - The lien effect of a charging order and priority issues
Compliance - Issues for the LLC and non-debtor members in complying with a charging order
Receiver - The role of the receiver in charging order proceedings
SINGLE MEMBER LLC
Single-Member LLCs - Enforcing the judgment against an LLC with a sole member
Foreclosure - Liquidation by judicial sale of the debtor's right to distributions
REPURCHASE AND REDEMPTION RIGHTS
Repurchase/Redemption Rights - Third-parties' ability to purchase the charged interest
Appeal - Issues relating to the appeal of a charging order
RELATION TO OTHER REMEDIES
Exclusivity - The charging order as the sole remedy available to creditors and exceptions
Voidable Transactions/Fraudulent Transfers - Issues relating to avoidable transfers of interests
Bankruptcy - Treatment of the debtor/member's interest in bankruptcy
Intra-Member Disputes - Where one member obtains a charging order against another
Taxes - Tax issues relating to charging orders for all involved parties
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Additional Court Opinions About charging orders (unsorted)
THE CHARGING ORDERS PRACTICE GUIDE
The Charging Order Practice Guide: Understanding Judgment Creditor Rights Against LLC Members, by Jay D. Adkisson (2018), published by the LLCs, Partnerships and Unincorporated Entities Committee of the Business Law Section of the American Bar Association, click here for more
Available for purchase directly from the ABA at https://goo.gl/faZzY6
Also available from Amazon at https://www.amazon.com/Charging-Orders-Practice-Guide-Understanding/dp/1641052643
OTHER INFORMATIONAL WEBSITES
by Jay Adkisson
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