978-0077733711 Chapter 40 Lecture Note

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

CHAPTER 40

LIMITED LIABILITY COMPANIES, LIMITED PARTNERSHIPS,

AND LIMITED LIABILITY LIMITED PARTNERSHIPS

I. OBJECTIVES

There is much detail in this chapter, most of which you may expect the students to read and

understand on their own. Students should be able to relate the material in this chapter to what

they have learned in Chapters 37, 38, and 39, as the default rules of LLCs, limited partnerships,

and LLLPs share common themes with the default rules of partnerships and LLPs.

Class time should be used to cover the most important objectives of the chapter:

A. The attributes of the limited liability company (LLC), including how they differ from and are

similar to the LLP.

B. The basic requirements to form a limited partnership and the consequences of a failure to

meet those requirements.

C. The rights and liabilities of limited partners.

D. The requirements for creating a limited liability limited partnership (LLLP) and the

advantages of an LLLP.

E. How the default rules of the LLC, limited partnership, and LLLP may be modified by

members and partners to meet their needs.

II. ANSWER TO INTRODUCTORY PROBLEM

A. The LLC is a good business form for the self-service business, because it is easily adapted to

your short-run and long-run interests. If you are the only owner of the business, which you

prefer, the partnership, LLP, limited partnership, and LLLP are not possibilities, because each

requires two or more partners. A one-member LLC, by contrast, is permitted under the

RULLCA. Yet if at the beginning or several years later you wish to admit a new member,

such as the manager, that is easily accomplished, because you control the LLC and can admit

whomever you want as a member. If instead you do not want to admit the manager as a

member but to give her a share of profits, you may do that by contract without creating any

presumption, as you would under partnership law, that she is an owner of the business. The

LLC also permits you to “check the box” to opt for federal income treatment of the LLC

either as a partnership or a corporation. Since the business is expected to lose money in its

first few years, you would elect partnership treatment for that period. After the LLC becomes

profitable, you would have the option to elect corporate taxation, which would be prudent if

you want the business to retain earnings. Note that the same objectives can be accomplished

with a corporation, although the default management structure is not a perfect fit for a one-

owner business and S Corporation status must be elected to obtain tax treatment that is

similar to partnership tax treatment.

B. The LLLP is the form of choice for the family business, because both by default rule and by

the limited partnership agreement, ownership may remain in the family in perpetuity. The

LLLP may select unlimited duration. Under the default rule, no new partner may be admitted

without the consent of all partners. The default rule is that any partner who withdraws is not

entitled to the value of his partnership interest, unless the LLLP dissolves. The LLLP can

also state that no limited partner may withdraw from the LLLP. The default rule as well as

the LLLP agreement can therefore ensure that the LLLP’s assets will not be diminished by

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

the death or other withdrawal of a family member, accomplishing the objective of providing

income to the family members during their lifetimes, not to their heirs after death. This

would be more difficult to achieve, if not impossible, with a corporation, since the law of

corporations disfavors restrictions on transfers of shares. The LLLP form also extends

limited liability to all the partners, including general partners. Finally, the LLLP form

permits the partners to choose to have the LLLP taxed either as a partnership or as a

corporation. This is an advantage over the corporate form, which if there were more than 100

family members as shareholders, could not elect S Corporation status.

III. SUGGESTIONS FOR LECTURE PREPARATION

A. Limited Liability Companies

1. Compare the LLC with LLPs, limited partnerships, and corporations. You may want to

refer to Figure 1 on page 1049, which lists the characteristics of LLCs.

Example: Problem Case # 1.

2. Note the conditions that have led to the adoption of LLC statutes: The IRS has granted

favorable tax status even though members have limited liability and the number of

members is unlimited. In addition, an agreement of the members can entrust

management to a select number of members or even professional managers. The only

drawback of the LLC is the limited transferability of a member’s interest.

3. Log On (p. 1048): Direct students to the RULLCA of 2006 at the website of the National

Commissioners on Uniform State Laws. Some important sections that you may want

them to read are Section 407 (management of LLCs), Section 404 (members’ right to

distributions), and Section 409 (members’ and managers’ standards of conduct). Section

110 is a good provision to examine, for it indicates the default LLC rules that may not be

changed by the members’ operating agreement.

4. Management of LLC

a. Note that an LLC must choose to be member managed or manager managed when it

is formed. If it chooses member management, it is much like a partnership or LLP in

that respect, because each member is a general manager of the business, unless

agreed otherwise. If manager management is chosen, the members choose the

manager by their majority agreement, absent a contrary agreement.

b. LLC managers have fiduciary duties, just as partners have.

Hecht v. Andover Assoc. Mgmt. Co. (p. 1050): This case is another example of the

fallout from the massive fraud practiced by Bernie Madoff, who made off with lots of

money of his clients. As is common when something bad happens, victims look for

someone from whom to recover, in this case, an investment manager and an

investment consultant who invested or recommended investing the LLC’s funds in or

by Bernie Madoff’s company. In this case, the investment manager, Andover

Management, moved to dismiss the action on the grounds that the manager had not

breached its duty to the LLC because it complied with the business judgment rule.

The court refused to grant the motion to dismiss on the grounds that there was

sufficient evidence that may prove on remand that Andover Management was grossly

negligent.

Points for Discussion: What facts may prove, upon remand to the trial court, that

Andover Management was grossly negligent? First, Andover Management did not

properly review trade tickets that confirmed trades Madoff supposedly made for the

LLC. Had Andover Management reviewed the tickets and compared the trading

information on the tickets with actual prices of securities on those dates, Andover

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

Management would have detected inconsistencies that would have suggested the

need for further inquiries that would have uncovered the fictitious trades. Second,

Andover Management trusted Madoff without making any investigation into his

operations. Although not discussed in the case, many investors and investment

advisors invested with Madoff because his firm provided returns that were

consistently higher, sometimes significantly so, than those of other investment firms.

Some professional investors thought that was a red flag, that Madoff’s high returns

were not possible unless something shady was going on. Others happily invested

with Madoff, blinded by greed and, therefore, oblivious to the improbability of such

high returns.

Additional Example: Problem Cases ## 2 and 4.

c. Note that LLC members, even if they manage the business and make contracts on

behalf of the LLC, have no personal liability on those contracts, unless they agree to

be liable on those contracts. This is one of the chief advantages of the LLC, even a

one-person LLC: member liability is limited to the assets of the LLC.

Examples: Problem Cases # 1 and 5.

5. Compensation of members

a. Members are compensated in the same way as partners in a partnership—that is,

sharing profits equally absent a contrary agreement. Many LLC agreements,

however, provide that the managers of the LLC will receive salaries.

6. Member’s Ownership Interest

a. A member’s interest in the LLC is the member’s personal property. Note that a

member cannot, however, transfer freely all his rights in the LLC. To allow free

transferability would disrupt the expectations of other members of the LLC, who

have chosen those persons with whom they want to be members. In this respect

again, the LLC is a close and personal relationship, just as a partnership is. The

members may, however, in the LLC agreement make the LLC interests freely

transferable.

b. Example: Problem Case # 6

7. Member’s Dissociations and LLC Dissolution

a. The RULLCA has changed the some of the rules regarding dissociations of members

and dissolutions of LLCs, making the law quite a bit different from the RUPA’s rules

on dissociations of partners and dissolution of partnerships. The biggest change is

the RULLCA not requiring the buyout of a withdrawn member until the end of the

LLC term. This means LLC member had better consider the issue and make sure

their operating agreement provides for early withdrawal and payment, if they want

early payment. As with a partnership, a carefully crafted LLC agreement should state

how a member’s LLC interest will be valued when she is bought out.

b. Example: Problem Case # 3.

8. As you go through the default rules of the RULLCA, ask students what may be good and

bad about the default rules. You may want to propose a business context to students.

Example: Chapter Introductory Problem (p. 1047): The first part of this problem is a

good LLC scenario. The LLC will be a good form whether or not the manager will also

be a member. If the manager is also a member of the LLC, ask students what is bad

about the default rules. The rules regarding shared management may not work for an

LLC in which the manager is expected to do most day-to-day matters and the investor

probably wants to control major decisions, because he has invested the most capital. The

default profit sharing rule may also be inappropriate, since the manager will want some

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

guaranteed compensation when the business is unprofitable, and the major investor will

want to receive the bulk of the profits, not share equally with the manager. They will

almost certainly also want to change the rules regarding dissociations, especially the buy-

outs of members. The major investor may, for example, want to be able to force the

manager out as a member if the investor is not satisfied with the performance of the

manager.

Additional Example: Log On (p. 1048): Finding examples of LLC operating agreements

may provide guidance to students. At the least they will find a list of what they should

consider for inclusion in the operating agreement.

Additional Example: Problem Case # 3.

9. In re Garrison-Ashburn, LC (p. 1053): This case is good example of members of an LLC

not planning well, failing to anticipate the effects of the default rules and the rules in their

LLC operating agreement, and as a result ending up in litigation.

Points for Discussion: Where did Comer and Chapman, or at least Chapman, err? Did

they provide for both members’ agreement for certain actions, such as the sale of real

property, which was the subject matter here? Well, kind of. They required the signature

of both the operating manager and the assistant operating manager, which ostensibly were

to be Comer and Chapman. The problem was that they didn’t consider the effect of the

LLC act’s default dissociation rules (which resulted in the termination of Chapman’s

rights as a member, except to receive distributions), and they didn’t ensure that even if

Chapman dissociated he would still have management rights. Consequently, the right to

appoint a new assistant operating manager fell to the sole remaining member, Comer.

Additional Point for Discussion: Ask students how they would want the agreement

written if they were Comer. They probably would want something preserving Comer’s

rights despite the filing of the bankruptcy petition. They might want dissociation not to

occur purely due to the bankruptcy filing. Then ask them how they would want the

operating agreement written if they were Chapman. The responses may vary from

before.

Additional Point for Discussion: In conclusion make this point: when one enters an LLC

(or any business for that matter), one must understand the default rules that apply to the

LLC and the rules that have been included in the operating agreement. Those rules have

both good and bad consequences. A member may benefit or suffer from a rule depending

on what the future holds. A member must be willing to accept the risks created by the

default rules and the operating agreement. If not, the agreement should include different

rules that produce consequences that are acceptable to the members.

10. The Global Business Environment (p. 1054): Business forms like the LLC exist

throughout the world.

B. Limited Partnerships and LLLPs

1. Cover the characteristics of limited partnerships and LLLPs listed on page 1056.

Compare the limited partnership to the partnership, LLP, LLC, and the corporation. Note

especially that an LLLP is a type of limited partnership. Make sure students understand

that an LLP is an entirely different business form than a limited partnership or LLLP.

2. As a way of making this material more relevant to students, mention that most hedge

funds and venture capital firms that they have read about in current news are limited

partnerships. Some are LLCs, like the one is Problem Case # 3.

3. Log On (p. 1055): Refer students to the Uniform Limited Partnership Act of 2001. We

have chosen to focus on the new ULPA. Although the Act has been adopted in only 18

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

states as of January 2012, its rationality will ensure its quick adoption in a majority of

states. It is the law that our students will mostly be affected by during their business and

professional careers. Note that the old RULPA is not even posted at the website of the

National Conference of Commissioners on Uniform State Laws. That clearly shows

where the law is headed.

4. Note the two reasons why a limited partnership is used usually: as an ownership vehicle

for tax shelter investments and for family business to ensure perpetual ownership.

Example: Chapter Introductory Problem (p. 1047): The second part of this problem is a

good example of using a limited partnership or LLLP to meet the needs of a family

business. Note especially that the concern of the business is to provide income to family

members during their lifetimes only. Therefore, the intent is that a deceased family

member’s estate will have no rights in the LLLP after death and will not receive

payments from the LLLP for the value of the deceased member’s partnership interest.

This ensures that the assets of the LLLP are not liquidated to buy out deceased partners.

C. Creation of Limited Partnership

1. Review the formalities for creating a limited partnership or LLLP. Stress the need for

business people to consult a lawyer when they decide to create a limited partnership or

LLLP. Not only will a lawyer help ensure compliance with the statute, but also she will

help draft a limited partnership agreement that satisfies the interests of all the partners.

Example: Problem Case # 7.

2. Note the liability placed upon purported limited partners when there is a defective

attempt to create a limited partnership or a defective amendment to a certificate. Indicate

that a limited partner should read the limited partnership agreement and certificate to

ensure that he is not listed as a general partner. Cover the actions a limited partner must

take after discovering a defective creation attempt in order to avoid liability as a general

partner.

Moser v. Moser (p. 1057). This case is a fairly common example of parents who engage

in an estate plan in order to reduce their taxes, but fail to execute the plan fully in

compliance with the law. It is no surprise that the court found the estate plan to be a

sham and ruled that no valid gift had been made to the children.

It is also an example of how testy and petty matters get in family businesses. The bottom

line was the wife ended up with more assets after her divorce from the husband, but the

way she did that was to show that the children’s limited partnership had never received

the gift of property. That is, she got more at the expense of her children.

Points for Discussion: Ask students what was done wrong here? Was the limited

partnership improperly formed? No. There was no problem on that count. Instead,

Terrance used the limited partnerships assets as if they were his own, listing its assets as

his own and transferring assets freely between the limited partnership and businesses he

owned. In corporation law terminology, we would call the limited partnership his alter

ego and pierce the veil of the limited partnership. See Chapter 41, page 1080. The same

rationale applies here to invalidate the gift. There is no gift, because Terrance has not

given up control of the assets.

D. Foreign Limited Partnerships

Although we have cut the material on foreign limited partnerships, you may refer to the

material in Chapter 40 on foreign corporations should you choose to cover the concepts that

apply in this context. The laws that cover foreign corporations is almost identical to the law

of foreign LLCs and foreign limited partnerships.

Example: Problem Case # 8.

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

E. Rights and Liabilities of Partners in Limited Partnerships

1. List separately the rights of general partners, the rights of limited partners, the liabilities

of general partners, and the liabilities of limited partners. One of the most fundamental

obligations of limited partners is to contribute the amount of capital they agree to

contribute.

Example: Problem Case # 9.

2. General partner’s fiduciary duty. All the fiduciary duties of general partnership law are

owed by general partners of a limited partnership. For a more detailed explanation, refer

students to Chapter 38. Note that limited partners, while not owing fiduciary duties, do

owe the duty to act in good faith and to deal fairly with the limited partnership.

3. Transfer of Partnership Interests. Note that partners’ transfers of their interests in a

limited partnership are treated by the ULPA much the same as the RUPA does.

4. Partner’s right to withdraw. Note that the ULPA erects barriers to a partner’s withdrawal

from a limited partnership or LLLP. While partners have the power to withdraw, they

have no right to do so. Therefore, the limited partnership need not pay the withdrawing

partner her share of the value of the business until it dissolves and liquidates.

Note that a limited partnership or LLLP may prohibit a limited partner’s withdrawal (but

not a general partner’s). See the dissociation discussion on pages 1061-1063. The rules

in the ULPA are what make the limited partnership or LLLP the best business form for a

family business that wants to ensure perpetual ownership by the family.

5. Partner’s right to sue. Note that any partner may sue in her own name to enforce her

individual rights, such as a limited partner suing to force general partners to comply with

the limited partnership agreement or to give the limited partner her share of distributions

made to partners. Any partner may sue derivatively also: in the name of the limited

partnership to remedy a wrong done to the limited partnership. The RULPA makes it

clear that a limited partner may bring a derivative action.

6. Limited partner’s liability for participating in management

a. This was a most interesting subject under the RULPA, but it has been made simpler

by the ULPA of 2001. Under the ULPA, limited partners do not lose their limited

liability, regardless of the amount of management in which the engage. This rule is

essential to maintain consistency: it extends to limited partners who manage the

same privileges extended to a member-manager in an LLC and a partner-manager in

an LLP, both of whom have limited liability. It made no sense to impose greater

liability on a limited partner who manages.

Nonetheless, a limited partner who commits torts while acting for the limited

partnership or LLLP will have liability for that tort, and will be liable on contracts for

which she agrees to accept liability, such as her signing in her own name a loan

agreement with a bank.

b. RULPA Section 303: Since most states have enacted the RULPA, you may want to

cover the rule of Section 303. That section can be found on the Internet, and the 11th

edition of this textbook covers it completely. If you do cover Section 303, explain

the rationale for imposing liability upon limited partners who manage: limited

liability is intended to be granted only to passive investors. Of course, we know that

is that a ridiculous rationale when we have LLPs and LLCs that protect their

managers.

c. Examples:

1) Problem Case # 10.

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

2) Len wants to work for the general partner. He will calculate the return on

investment for various proposed purchases. Len retains limited liability, because

he is merely acting as an employee of a general partner.

3) The limited partnership hires Len as a financial consultant to advise it on the

wisdom of making several real estate investments. Len retains limited liability,

because he is merely acting as an adviser.

4) The limited partnership hires Len as a financial adviser. Len will find

prospective purchases and negotiate contracts to purchase the property. Len may

lose his limited liability, because he not merely an adviser despite his title. He is

engaging in control.

d. Using a corporation as the sole general partner.

1) Prior to the creation of LLLPs, nearly every limited partnership that was

organized with competent legal advice had a corporation as the sole general

partner. Many of these corporations were created only to be general partners. As

a result, no natural person had unlimited liability. To avoid holding the

shareholders of the corporation liable for the limited partnership’s obligations, the

corporation must be adequately capitalized. Thin capitalization of corporations is

covered in Chapter 41. Today, it is more common to have an LLC be the sole

general partner of an LLLP.

2) As state’s recognition of LLLPs becomes more widespread, the need for

corporate or LLC general partners for liability reasons is eliminated. Corporate

and LLC general partners may nonetheless be preferred, because unlike a human,

a corporate or LLC general partner may have a perpetual life, eliminating many

dissociation and dissolution problems.

Example: Problem Case # 11.

F. Dissociation, Dissolution, and Winding Up

1. Note the different dissociation rules that apply to limited partners and general partners.

2. Cover carefully how the partners in a limited partnership of LLLP may change the default

rules of the ULPA. Note especially, that a family LLLP may want to prohibit a limited

partner from withdrawing and from receiving the value of his interest until the LLLP is

dissolved. Other limited partnerships, however, such as an LLLP that owns a baseball

team or motion picture, may want to provide a procedure by which a limited partner may

leave the LLLP and receive the value of her interest. Such a buyout provision should be

consider the issues we studied in partnership law, such as how to value the interest and

over what time period to pay the dissociating partner.

G. Mergers and Conversions

1. The easy merger and conversion rules for LLCs and limited partnerships are consistent

with modern business organization law, which makes changes easier than earlier law

permitted, especially corporation law.

2. Lach v. Man O’War, LLC (p. 1063): This case is an example of the kind of manipulations

that have been used in corporation law for years and now is trickling into the law of other

business forms, such as the limited partnership and LLC as those forms become more

commonly used by smaller business. There is nothing new here in the behavior of the

general partners. For decades, this kind of partial or oppressive behavior has been

engaged in by unethical majority shareholders and managers of closely held corporations.

Corporation law has developed a distinct area that covers these cases. We address those

issues in Chapters 43 and 44.

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Chapter 40 – Limited Liability Companies, Limited Partnerships, and Limited Liability Limited Partnerships

Points for Discussion: Why did the court conclude that the general partners had not

complied with the Kentucky statute’s requirement for conversion of the limited

partnership to an LLC? It was because a conversion involves only an entity which

changes its business form. That is what makes conversion convenient. There is no need

to create a new, second business. Here the general partners did not take advantage of that

convenience, instead forming a new LLC to merge with the limited partnership.

Additional Point for Discussion: Why did Lach win the case? She proved that the

general partners breached their fiduciary duty by acting with partiality to their own

interests. Where was the partiality if Lach owned the same rights in the LLC that she

owned in the limited partnership? One change was made requiring Lach and the other

members to give up their right to vote on LLC matters unless they agreed to the

restructuring that gave management control to those who owned less of the LLC than did

Lach. Of course, Lach objected, just as she had the right to object when the business was

a limited partnership.

H. Global Business Environment (p. 1065): As with other business forms, the limited

partnership is recognized in most modern societies throughout the world. In other countries,

limited partnership law more closely tracks the ULPA of 1919 or the RULPA, but one should

expect the ULPA of 2001 to have an impact on the law in other countries over the next 20

years.

I. Ethics in Action (p. 1066): A profit maximizer would probably have no qualms about

granting limited liability only to those who take advantage of the law’s extension of limited

liability to managers. That’s the way the law is written, and there should be some advantage

given to those who are diligent enough to know it and take advantage of it. A rights theorist

may come to the same conclusion, arguing that a third party who deals with an LLC or LLLP

knows that there is limited liability of all the owners, but expects general partners to be liable

in a limited partnership. That could be stretching the limits, however, of what the ordinary

person knows about these forms. A utilitarian would consider the costs and benefits of

limited liability or lack thereof, and consider whether someone protected by limited liability

may make imprudent contracts because of a lack of fear of liability. A profit maximizer

would probably dispute that likelihood, arguing that it is in the best interest of a general

partner, who is an owner of the business, to make prudent decisions that increase profitability.

That rationale, however, is weaker if the general partner receives a salary that dwarfs his

profit share. Yet even then, a profit maximizer would argue that such a general partner would

be interested in keeping his job by keeping limited partners happy by keeping profits high. A

believer in justice theory would investigate whether the managers are more in need of limited

liability protection that those who deal with the business are in need of a remedy against the

managers.

IV. RECOMMENDED REFERENCES

See the references in Instructor’s Manual Chapter 37.

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