Navigating the LLC Jungle, with Kevin Brodehl
We've all heard that LLCs (Limited Liability Companies) are great, but what about the lurking dangers and pitfalls? Curious about how LLCs can go wrong? In this week's episode of I Know a Lawyer, I speak with Kevin Brodehl of Patton Sullivan Brodehl LLP about these dangers and pitfalls in LLC disputes. Kevin is a litigator who specializes in litigating cases involving LLC disputes. He is our expert guide through the LLC Jungle! In this episode, we discuss:
Business partner disputes and partner compatibility. (03:17)
Importance of well-drafted operating agreements. (04:51)
Differences between member-managed and manager-managed LLCs. (07:07)
Member rights. (08:43)
Manager's fiduciary duties and potential pitfalls. (12:32)
Be careful with Co-managers! (17:43)
Dissolution of the LLC and statutory buyout. (20:23)
Thank you to Kevin for joining me on the show. I learned quite a bit about issues that can arise with LLCs, and I am sure you did as well. Be sure to follow Kevin's blogs, The LLC Jungle and Money and Dirt. Contact Kevin if you or someone you know find themselves in an LLC dispute and need help navigating the LLC Jungle!
This podcast is brought to you by McKenna Brink Signorotti LLP.
Transcript
Ryan Lockhart (00:01):
Welcome to the show, everyone. This is, I know a lawyer and I'm Ryan Lockhart, your host, as you know, I Know a Lawyer is brought to you by McKenna Brink Signorotti, LLP, a boutique law firm in Walnut Creek. Check us out at mckennabrink.com to see how we can serve you. On this week's episode. I am pleased to be joined by Kevin Brodehl of Patton Sullivan Brodehl LLP. Thanks for joining me today, Kevin, how are you?
Kevin Brodehl (00:24):
I'm good, Ryan. Thank you for having me on.
Ryan Lockhart (00:27):
Awesome. before we jump into the LLC jungle, why don't you tell the audience a little bit about yourself and where they can contact you.
Kevin Brodehl (00:34):
Sure. So my name's Kevin Brodehl and I'm a partner at Patton Sullivan Brodehl, LLP. We're are a firm in San Ramon, California, but we represent clients statewide in high stakes business and real estate disputes. I'm pretty easy to find on the internet. You can Google my name, Kevin Brodehl, or you can check out the blog, the LLC Jungle. I also run another blog called money and dirt, which is about real estate and development and investment type disputes.
Ryan Lockhart (01:06):
Awesome. Yeah. I'm excited to talk about this because I love how you call it the LLC jungle. So I'm ready to step into the LLC jungle. So LLCs, I've worked with them in the past and I generally seem to like them. So what's all the fuss about them. What do you think
Kevin Brodehl (01:20):
LLCs are all the rage these days. I kind of fell into this specialty almost when I started practicing 22 years ago. I noticed that when businesses had disputes among their stakeholders more often than not, they were LLCs. So why people are forming LLC. So first of all, I don't form the LLC is I'm a 100% litigator. That's all I do. And so that's my bias that I have to disclose here. But my understanding is, and I have a pretty clear understanding after handling disputes all this time. People like LLCs because they are flexible. They're easy to operate. They're not as cumbersome as having a corporation. And, and more than anything, they're governed by a contract. So basically whatever the stakeholders want to do, they can create their entity with the ground rules that they want. And usually that's in the form of an operating agreement, which kind of governs how the LLC is supposed to work. But because these things are so flexible and freeform, that leads to a lot of trouble. There's a lot of dangers and pitfalls within the LLC universe. And there's really a lot of blood spilled and money loss over some of these disputes. And that's kind of why I started calling my practice niche, the LLC jungle, because it really can be a jungle out there.
Ryan Lockhart (02:45):
Yeah. I've definitely heard a lot of stories about partners or business partners in LLCs with you talk about spilled blood money loss when they just get that dispute going. Cause I like LLCs because I always kind of promote as flexible, just like you said on the tax side, you know, tax is a partnership, there's a lot of flexibility that you can do there with allocations, et cetera. But let's talk about like business partner disputes you know, what kind of like red flags should we be on the lookout for, or people maybe in, in an LLC right now? What should they be on the lookout for?
Kevin Brodehl (03:17):
Yeah. So the one thing that stands out to me after doing this so long is character issues. And this really has nothing to do with the law, but character issues usually can present with red flags well before the is formed. And so I can't tell you how many times I've been involved in a dispute where my client will say something to the effect of, you know my partner, I had a bad feeling about them from the get go or there was something that they said or did in the past that caused me concern, but I went ahead and got into a business relationship with them anyway. And so I think one of the simplest pieces of advice, and again, this is more in the realm of psychology than law is to just pay attention to your, your character meter. If you're, if you're having doubts about the person that you're about to do business with, listen to your gut and you know, the best way to avoid a dispute in an LLC is to never enter into that kind of relationship with a suspect character partner in the first place.
Ryan Lockhart (04:19):
I like how you said, listen to your guts. Cause that would be my part of my, you know, lawyer psychology advice too, is listen to your gut. Like you, do you have some thoughts, like kind of go down that road. I know this kind of leads back into the, you said it's LLCs are governed by contract and these are the operating agreements, right? This is what's going to lay out how this business relationship, how this LLC is going to proceed. So what should, because I know there are, you know, form operating agreements, people can find out there, but if they have an operating agreement that they don't, aren't sure what's in it. So what kind of advice would you say about operating agreements?
Kevin Brodehl (04:51):
Operating agreements are kind of the Bible for any LLC. It's possible to have an LLC without a written operating agreement. Although I haven't seen that that happened yet. Operating agreements come in all shapes and sizes. And I have to say that most of the disputes that I've handled are a direct result of you know, not enough thought being put into the operating agreement, whether it's a form that was downloaded from the internet, that just has a bunch of boiler plate that really has nothing to do with what the parties are trying to accomplish. Or, you know, sometimes they put a little more thought into some areas of the operating agreement, but there's always some gap or something that was left unexplained. So really operating agreement, it's the party's ability to customize their relationship and get everything out on the table in writing clearly.
Kevin Brodehl (05:43):
And, and one of the important things about operating agreements is if you can't understand it then chances are it's going to lead to a dispute. And I've always been a big advocate for using plain English whether it's in a legal brief or an operating agreement, it's not too common to see plain English in these things though. So the other real key thing about operating agreements is California has an LLC statute. It's called the revised uniform limited liability company act or RULLCA for short. And that act as a lot of default rules and default provisions that will govern your LLC. If you don't say otherwise in your operating agreement, but the operating agreement is your chance to customize. And there's a lot of you can pretty much override and modify almost all of those default statutory rules. And so people should take advantage of that. That's the main reason to form an LLC. So take advantage of it and customize it to really capture what you're trying to do in this business relationship.
Ryan Lockhart (06:47):
Yeah, that's good advice. Cause not, it's not a one size fits all situation. Let's, you know, it should fit what you're trying to do. And you know, this kind of leads me to my next question is I get this question quite a bit, that people have this idea they hear about manager managed versus member managed. And they only fully understand what the difference is. Can you explain a little bit about that?
Kevin Brodehl (07:07):
Yeah. So this is probably the most important area of any operating agreement. It's probably the most important decision to make within any LLC. And that is who's running the show in a member managed LLC. It basically means all of the members have equal voting and management rights. They get to make the decisions together. That's not too common, at least in my universe. That's, it's done often I'm sure, but in my typical clients are, you know, say like real estate investment groups or, you know, cannabis entities these days are very popular. Just about any industry, it's very cumbersome to have every LLC member involved in running the show in most of those industries where LLCs are super popular, it's just going to be too. It's going to be too cumbersome to have everyone involved. So most of the time there is either one manager appointed or maybe, you know, a small committee of maybe three managers, managers are the ones who get to do the day to day decision making for the entity. And so it's of course critical to lay out those ground rules in the operating agreement to
Ryan Lockhart (08:21):
Good. Going back to the operating agreement a little bit is again, is let's talk about the rights that these members have. Cause you just said there's a manager managed LLC. We have the person in charge of basically running the show is other members obviously have rights. So how, how do these rights kind of play out for those not silent partners, but let's just, you know, say they're not managing the day to day operations,
Kevin Brodehl (08:43):
Right? So what I think of as kind of the passive members, and like I said, I think most of the rest of our discussion here, we'll assume it's a manager managed LLC. So they are kind of two there's the manager or managers. And then there are what we kind of regard as the more passive investor members. So it's yeah, member rights is a huge issue and this is one big, big area of litigation. So member membership interest in an LLC basically break down into two species. One is the economic interests and every member unless it says, otherwise we'll have a right to things like distributions when they are made and their capital accounts and things like that, then there's a whole nother set of non-economic rights. And mostly that means voting. And the operating agreement can specify what do the members get to vote on?
Kevin Brodehl (09:37):
And what kind of vote is required? Is it a majority or a super majority or a unanimous vote for things like, for instance selling the LLCs principal asset, if it's a real estate investment LLC who gets to decide if the asset can be leased out or sold or improved with capital expenditures, those are the kinds of things that should be set out in the operating agreement, but it's a key, basic core membership, right? And another big one is accessing the books and records of the LLC. This is something that cannot be modified by the operating agreement. This is a statutory, right? Every member has the right to access books and records. And a lot of managers get into trouble by not complying with those rights. They might sense that well, that member's really up to no good. I'm not going to give them the books. Well, they should, because as I said, it's a statutory, right? And there's an attorney fee hook there too. So if a member has to Sue just to get their access to the books and records, they will be entitled to their attorney fees too.
Ryan Lockhart (10:41):
Wow. I can imagine that a lot of your disputes that you're working with are members taking on the manager, they're not happy with the manager, right? So
Kevin Brodehl (10:51):
That is, that is the the portrait of an LLC jungle dispute it's members versus managers. And, and here's another membership, right? That is kind of misconstrued cause it's actually not a right to a lot of LLC members think or feel that the LLC assets are their assets too, because they have an equitable claim to them. Right? So let's say again, using a real estate investment LLC, as an example if something happens to the property, if the manager lets you know, maybe rents out the property below market rate or something like that, the, a lot of LLC members will want to sue in their own name versus the LLC or the manager saying, that's my, I have an interest in that property and I'm suing to enforce those interests. But then we get into the whole direct versus derivative lawsuit conundrum.
Kevin Brodehl (11:45):
And basically what the courts have held is that, no, it's not your property. It's the LLCs property. And if there's harm to the property, it's harm to the LLC first, yet it causes indirect harm to the members. And so what a member there would have to do is instead of suing in their own name, they'd have to bring a derivative lawsuit. And that's a whole, that could be a whole nother podcast, but essentially they're required to ask the LLC to take care of the problem first and only if the LLC refuses to then they can sue, but they have to sue in the name of, or on behalf of the LLC. So that's one thing that consistently gets overlooked by not just LLC members, but their attorneys.
Ryan Lockhart (12:26):
Wow. So these managers obviously taking on a big job, what kind of duty is imposed on them?
Kevin Brodehl (12:32):
All right. So managerial fiduciary duties is probably the number one hot button for LLC litigation. And so the way courts have described manager's fiduciary duties is one of utmost loyalty and highest good faith. So that's, that's really no joke. It's nothing to be taken lightly. A lot of LLC operating agreements will have what's called sole discretion provisions basically saying, look, you know, manager gets to call all the shots here. And that's the way it is. And a lot of managers will kind of try to hide behind those types of provisions saying, look, I can't be challenged. The operating agreement itself, the Bible of our LLC says I have sole discretion, but the courts not just in California, but elsewhere Delaware and New York, almost every jurisdiction that's addressed this issue. The courts are concluding that sole discretion is not a license for bad faith conduct. And if what the manager does breaches some of his fiduciary duties of good faith they will be liable.
Ryan Lockhart (13:37):
So what you just said, breaches, what are some examples of what a breach would be by the manager?
Kevin Brodehl (13:42):
So probably the most common garden variety breach of fiduciary duty by an LLC manager involves dipping into the pot of LLC assets in one form or another. So you can call it misappropriation and maybe diversion taking what maybe it's cash that they're taking out of the LLC account and using to fund, you know, their personal expenses or maybe their side projects that are unrelated to the LLC. Another variety is just taking opportunities that should be presented to the LLC taking those opportunities for themselves or their side projects. So that's another big area and then those are the common ones, but there are so many subtle flavors and variations of fiduciary duty breaches. I mean just a few recent examples that I've seen in the case law. One involved, a manager soliciting a bunch of member contributions, capital contributions to acquire another entity that was basically insolvent, but the manager had a relationship with that other entities owner.
Kevin Brodehl (14:49):
So it was a sweetheart rescue, which didn't benefit the members at all. A couple of others you know, selling the LLC for less than fair market value in a sweetheart deal to an affiliated buyer withholding distributions when there's really no reason to, you know, just letting the money pile up and kind of starving the members of distributions when they are available. And there's no liabilities that would support holding them back. And then another one I've seen is kind of trying to break the members with excessive capital calls. You know, a lot of operating agreements will say, look, you make your capital contribution once and then you're done, but others will say no, there might be an ongoing need for capital. And if the manager puts out a capital call, you better, you better pay up or you're going to be thrown into default. And so those are just some samples of manager misconduct that I've seen.
Ryan Lockhart (15:45):
Yeah. There's a lot of pitfalls there. I know we talked offline before you mentioned this idea that even there could be like criminal liability for a manager who really does something bad. I mean, is that actual thing?
Kevin Brodehl (15:56):
Yes. so penal code section, I think it's 496. I don't have it in front of me, but there have been conflicting court of appeal, opinions about whether the remedies in the penal code can apply to manage misconduct. And so we're not talking about locking people up. Maybe that would be interested in that if it's true, you know, if it's truly a, a crime, but what 496 says is that there can be civil repercussions for misappropriation. It's basically the receiving stolen property statute. And so the hook in that statute basically says that there are civil remedies too. And they involve things like treble, which is tripled damages and attorney fees. And so we had a conflict of authority. There was a case called Switzer that came out about a year ago saying, Oh, managers can be a liable for their misconduct under the penal code.
Kevin Brodehl (16:55):
And that, you know, they can be held liable for attorney fees and triple damages. And then just recently we had a different court of appeal in California taking the opposite side, saying, no, hold up. You know, there's already tort remedies for this stuff. Attorney fees should be decided based on contract. Not based on the penal code, basically that court said business disputes should not incur penal code remedies. And so the California Supreme court just granted review of that second case called Siry. And so it's just getting started in the Supreme court. So we should have some guidance on that soon fascinating case though.
Ryan Lockhart (17:35):
So you managers out there stay tuned, see how the Siry case comes out.
Kevin Brodehl (17:39):
Right. And I will be blogging about that update when it comes.
Ryan Lockhart (17:43):
Yeah. It sounds like that's pretty interesting one there. So in, in my estate planning context I had this about whether we should have more than one trustee of trust, right. There's potential issues with having co-trustees I'm assuming it's the same for co managers, correct?
Kevin Brodehl (17:58):
Yeah. So this is a really pretty wild issue that I have seen, I think in four recent cases of mine the LLC operating agreement sets up a co-manager system which, you know, again, I've seen plenty of operating agreements that have three managers or, or whatnot, but these particular ones that I've seen recently, they just say, no there's two managers and they have equal power with everything. And the problem is they did not include any kind of tie breaking mechanism and the operating agreement, none at all. And so what happens was probably very predictable. Eventually the managers come into a conflict about a situation and there's absolutely no way to solve the conflict other than involving the courts. And so the way this has come out imagine for example, managers with equal authority to do just about anything, including encumbering or selling the LLCs principal asset, I've had cases where one of the managers says, well, I think it's a good idea to encumber the property or to sell the property. And they just do it when they know that the other manager doesn't agree. And then the other manager will come back and do something else with maybe another one of the LLC assets. So setting up a co-manager system is really a recipe for disaster.
Ryan Lockhart (19:24):
Yeah. It sounds like it, I mean, it sounds like one of them just going to do it, that's going to work out well. I'm sure. Yeah. Right. So whenever you have a bad manager what can the LLC do?
Kevin Brodehl (19:34):
Well at that point like I said, that's when the courts come in and you end up needing to hire an LLC litigator like me if a manager has gone rogue, whether it's a, just a sole manager or a co-manager th that's when you need to file file lawsuit. And if, if there are things going on like that in the interim, that's when receivership can come into play you can ask the court to appoint a re a general equity receivership, not just over the entities property, but over the entity itself. So the receiver will actually be making decisions about, can we sell this property? Should we rent it? And it can we encumber it and that, that can get expensive, but that's really the only, the only remedy.
Ryan Lockhart (20:16):
Wow. And I'm pretty sure they don't want to do that. Right. The members, they don't want the receiver in charge of the whole,
Kevin Brodehl (20:21):
Unless they have no choice. Yeah.
Ryan Lockhart (20:23):
Yeah. So what if you had this entity that's LLC and it's just gone bad all the way across the board. This is where dissolution comes in. Can you talk a little bit about these kind of like dissolution events and how these people really kind of go their separate ways?
Kevin Brodehl (20:38):
Yeah. Dissolution is kind of the end game of a bad business relationship. It is business divorce and many attorneys who are in field call themselves business divorce attorneys. I just came up with another nickname with the LLC jungle. But yeah, the business divorce and dissolution is, is what happens when you have deadlock within the LLC and no way to solve it. So again, a lot of it can be headed off in the operating agreement. If there was a simple tiebreaker mechanism, then a court will say, well, there's no deadlock. It's just, you know, you solve it based on the way you have it in your operating agreement. If it's majority vote, it's majority vote. But in those instances where there's either no tie-breaking mechanism or where there really is some sort of abandonment of the, of the purpose of the entity, or if there's ongoing breaches that make, you know, even if there is a tie breaking mechanism, if the manager's pocketing assets and, or diverting them to his own personal side projects, there's no way for the entity to go on.
Kevin Brodehl (21:38):
And, and with this dissolution it's becoming a pretty big industry for a lot of third parties in that we mentioned receivers already, and that there's a big need for receivers in this field. And again, we're talking general equity receivers, not just, you know, a deed of trust, receiver, or foreclosure receiver. This is, this can be a pretty involved job when our receivers in there running the show and making management decisions, but other people too courts will appoint a provisional managers, which is sort of like a receiver forensic accountants have a huge role in this. And I I've been telling a lot of the CPA folks in my network. Look, if if you're looking for a niche, there's a need in this space, because invariably when when an entity goes down the tubes like this, there's always going to be questions about, wait a minute, how was the money spent? And second guessing things that happened in the past. And that's a perfect role for a forensic accountant.
Ryan Lockhart (22:36):
No, it's good. I'm glad you mentioned that because I deal with some forensic accounting on the trust and estate side, when we're trying to go back 20 years to see what happened on a trust when there are disputes that are arising there that's pretty interesting.
Kevin Brodehl (22:48):
That would translate very well to the LLC world. Same idea, right? Yup.
Ryan Lockhart (22:53):
New niche area for you CPAs out there. That's right. One of the things I've heard about, but I don't know that much about is this idea of a statutory buyout. Can you explain a little bit more about that.
Kevin Brodehl (23:05):
Yeah. So this can be a real booby trap for the, for those who are unaware. And so let's say you have a, an LLC where there's some sort of internal strife and deadlock and a member sues for dissolution thinking, okay, we're just going to sink the whole ship here and be done with this. Well, what happens under California law? And again, this only applies to California LLC. So if people have gotten really cute and fancy and thought that forming a Delaware, LLC, even though everyone's in California, is the solution. This remedy will not apply, but in California, under California law, if a member sues for dissolution, the statute allows the LLC, the remaining members to buy that member out. And there's a whole process that set out in the statute where appraisers determine the fair market value for that buyout. But a lot of members who are plaintiffs, and a lot of honestly, plaintiff's attorneys don't realize that there is the statutory buyout.
Kevin Brodehl (24:04):
So when they go in thinking we're sinking the whole ship and we're going to get our, you know, get the whole thing wrapped up all of a sudden they filed their, their case. And if the other side elects to do the buyout, I mean, maybe it's not the end of the world, but they will get bought out and the LLC will go on and live its life without them. And whether the buyout is fair or not, I mean, that's, you have to have a lot of faith in the appraisal process, but one real gray area. And that is what, how our tort claims sorted out in that context. And there really isn't any clear guidance on that. Appraisers are not equipped to try to put a value on a breach fiduciary duty case. So it's a really gray area of the law, but I've seen a lot of plaintiff. I've seen a lot of members and plaintiff's attorneys representing members rush in with the idea that they're going to sink the ship. And that's just not the way it works under the statutory buyout procedures.
Ryan Lockhart (24:59):
Hmm. I can imagine there's some valuation disputes and those types of a statutory buyout situations for sure. Awesome. I think you've given us a lot about the LLC jungle and it really is a jungle. There's, I've, I've dealt with LLCs, not so much on the conflict litigation side, just more about the formation and operations, but it is, it's a jungle out there, especially for managers. I think that's a big one that people take on this managerial duty. I've done them with families where we're putting managers in on a manager managed LLC, and it's a lengthy conversation to really tell them and explain their duty. So I'm glad you explained it the way you did, and just kind of broke that down a little bit further and just some pitfalls and traps, and especially going back to the character red flags, like if you're getting in business and you have this gut feeling, explore that, explore that at least at a minimum, just so you know, a little bit more about what you're getting involved in. So I appreciate all the comments you made today. Kevin any final thoughts?
Kevin Brodehl (25:53):
I think that's about it, Ryan, you know, there's a, it, it really, I think it comes back to what you just said more than anything else, LLC managers just need to understand that they have fiduciary duties. If there's one takeaway, you probably summarize it perfectly right there. Cause that's the one, the one thing that I've seen consistently, whether, you know, I'm on the member side in a case or the manager side of the case, managers will often say, you know, I, I really didn't look at the operating agreement and I really didn't understand that I had any duties here other than to just do what I thought was best. And oftentimes that's just not enough.
Ryan Lockhart (26:28):
Yeah. They're just used to doing business, right. So they're just like, yeah, I'm doing business, but didn't really realize I had to, you know, provide all this accounting or something like that to the members. But once you hit up, I know you said you have the LLC jungle blog and money and dirt blogs. So it working folks find that out to read up on what you're doing. Right?
Kevin Brodehl (26:46):
And so the two blogs I run, the first one that we've been talking about today is just called the LLC jungle, the LLC jungle.com. And that's where I write about all of this LLC stuff. The second blog is called money and dirt.com. And that's more on the real estate disputes and a deed of trust related disputes. We're at a firm's website, his Patton Sullivan Brodehl. We have another blog actually on that website. That's run by my partners. So it's pretty easy to find me.
Ryan Lockhart (27:17):
Awesome. Thank you, Kevin, for joining me today, I thought that was a great episode. And you gave a lot of good information. So that is Kevin Brodehl of Patton Sullivan Brodehl LLP. I'm Ryan Lockhart. This is, I Know a Lawyer. Thank you everybody. And enjoy the end of summer. And hopefully fall will be better for us as in his Covid environment. All right. Take care. Bye bye.