Unincorporated Business Entities Section - Limited Liability Partnership

Unincorporated Business Entities

Section III.3:

Limited Liability Partnership

Prof. Amitai [email protected]

College of LawUniversity of Illinois

Copyright © Amitai Aviram. All Rights ReservedS07

Copyright © Amitai Aviram. All Rights Reserved 2

Statutory Foundation of LLPs LLP is a variation of general partnership (not limited partnership)

LLP option added in a 1996 amendment to RUPA (1994) RUPA §306(c): “An obligation of a partnership incurred while the

partnership is a limited liability partnership, whether arising in contract, tort, or otherwise, is solely the obligation of the partnership. A partner is not personally liable, directly or indirectly, including by way of contribution or otherwise, for such a partnership obligation solely by reason of being or so acting as a partner.” Limited liability applies only to obligations that were incurred after entity

became an LLP RUPA commentary to §401: “…Section 401(c) makes clear that a

partner's right to indemnification by the entity is not affected by a partnership becoming a limited liability partnership. Accordingly, partners continue to share partnership losses to the extent of partnership assets.”


Limited Liability PartnershipsFormation of an LLP

LLPs are not born; they’re converted (from a GP). RUPA §1001: A partnership becomes an LLP after:

1. “The terms and conditions on which a partnership becomes a limited liability partnership [are] approved by the vote necessary to amend the partnership agreement except, in the case of a partnership agreement that expressly considers contribution obligations, the vote necessary to amend those provisions.” [1001(b)]

2. A statement of qualification is filed, containing: Name of partnership Street address of chief executive office Street address of an office in the state of filing or of agent for service of

process A statement that the partnership is applying for status as an LLP A deferred effective date, if any.


Limited Liability PartnershipsForeign LLPs

RUPA §1102: An LLP must file a “statement of foreign qualification” in any state in which it transacts business (if that state adopted the RUPA amendments). Information in this statement is similar to that of the statement of

qualification. Why file a statement in each state? Why file only one “statement of qualification”, and have the rest

be “statements of foreign qualification”? I.e., why the requirement to choose one state and be a foreign LLP in all

others? Failure to file a statement of foreign qualification does not

eliminate limited liability, but prevents LLP from maintaining a legal action in the state. The state’s secretary of state becomes the agent for service of process to the LLP.


Limited Liability PartnershipsForeign LLPs

Hypo 1: Acme is a GP. Partners vote unanimously to turn it into an LLP and ask Jack (a partner) to file a statement of qualification in Florida. Jack forgets to do so. Acme later becomes insolvent and Jill, another partner, is sued. Is Jill liable?

Hypo 2: Acme is a GP. Partners vote unanimously to turn it into an LLP and ask Jack (a partner) to file a statement of qualification in Florida. Jack does so. Acme then extends its business to Georgia. Jack is told to file a statement of foreign qualification in Georgia, but forgets to do so. Acme later becomes insolvent and Jill, another partner, is sued by a Georgia creditor. Is Jill liable? From a policy perspective, is there a reason for the difference

between Hypos 1 and 2?


Limited Liability PartnershipsMisc. differences between GPs/LLPs

Name “The name of a limited liability partnership must end with ‘Registered

Limited Liability Partnership’, ‘Limited Liability Partnership’, ‘R.L.L.P.’, ‘L.L.P.’, ‘RLLP,’ or ‘LLP’.” [§1002]

Governing law In general partnerships, the law governing internal relations (between

partners and between a partner & the partnership) is that of the jurisdiction in which a partnership has its chief executive office. [§106(a)]

For LLPs, the law of the state in which a statement of qualification was filed governs internal relations and the liability of partners for an obligation of a limited liability partnership. [§106(b)]

Annual Report LLP must file an annual report in each jurisdiction in which it transacts business:

States addresses of the LLP’s office & agent for service & state under which LLP formed


History of the LLP Born in Texas, on August 26, 1991, as a response to a

surge in malpractice suits against lawyers and accountants resulting from the Savings & Loans crisis of the 1980s Lawyers and accountants were organized as GPs, and

partners feared losing their personal assets for suits unrelated to matters they were handling

Also among the potentially liable: Retired partners & partners that left the defendant law firm to join other firms

Initially greeted with suspicion Becomes known as the “help-a-lawyer bill” Due to criticism, Texas opts for a narrow non-liability statute


History of the LLP LLPs become popular with professional firms

Within a year of the Texas bill’s passage, 1,200 Texas law firms including all of the largest firms became LLPs.

Why didn’t it become popular with other businesses? Why didn’t professional firms opt for corporations/LLCs?

In 1994, Minnesota enacts the first broad non-liability statute. Many states quickly follow. Result: LLP Partners face similar liability to LLC members or

a corporation’s SHs. In 1996, RUPA is amended to allow for the creation of

LLPs, adopting the broad non-liability model.


LLPs as Law Firms’ Entity of ChoiceGlater, New York Times (Jan. 10, 2003)

The article describes a trend of law firms converting from GPs to LLPs

A senior partner is cited saying: “Clients don’t seem to care.” Does the shift to being an LLP: Reduce the effort an attorney would devote to her work? Reduce the effort an attorney would devote to policing that

other partners aren’t negligent? Is there anything other than legal liability that gives lawyers an

incentive to police other partners?

Are clients rational in not caring about LLP status?


Chinks in the LLP Armor?

Despite the optimism of law firms reported in the NY Times article, there are situations in which LLP partners do not enjoy limited liability, including: Narrow Non-Liability Statutes Unshielded obligations Direct Liability Contribution Requirements


Losing theLimited Liability Shield

Narrow Non-Liability Statutes Unshielded obligations Direct Liability Contribution Requirements


Losing the Limited Liability ShieldNarrow Non-Liability Statutes

Texas Business Organizations Code, § 152.801(b):

“[LLC partner] is not personally liable for a debt or obligation of the partnership arising from an error, omission, negligence, incompetence, or malfeasance committed by another partner or representative of the partnership while the partnership is a limited liability partnership and in the course of the partnership business unless the first partner:” Was supervising or directing the other partner when liability was created Was directly involved in the specific activity that created the liability; or Had notice of the cause of liability and failed to take reasonable action to

prevent or cure it.


Losing the Limited Liability ShieldNarrow Non-Liability Statutes

Alex and Bridget are partners in an LLP. Partnership agreement is silent about each partner’s authority.

Alex signs an agreement with Chris under which Chris lends the LLP $1,000. Bridget does not know of this loan.

When Chris tries to collect the loan, he finds that neither the LLP nor Alex have any assets. He sues Bridget.

Bridget argues that her liability is limited since the entity is an LLP. Is she correct if: The governing law is RUPA (including the 1996 amendments)? The governing law is a narrow non-liability statute?





Losing the Limited Liability ShieldUnshielded Obligations

An LLP may have unshielded liabilities. E.g., Pre-conversion liabilities Liabilities to which personal guarantees were given

If the LLP uses its assets to pay shielded liabilities before unshielded ones it may not have enough assets to pay the unshielded liabilities.



Hypo: Acme is a GP with $50K in assets; Al and Bev are the partners. Acme borrows $100K from Charlie.

Acme then files a statement of qualification & converts into an LLP.

A month later, it borrows another$100K from Dangerous Dave. Is the liability to Dave shielded?

And the liability to Charlie?



The next day Acme loses $120K on a bad investment Dangerous Dave learns that the LLP now has only

$130K in assets and $200K in debt He has a talk with Al and Bev, after which Acme

repays Dangerous Dave’s debt. When Charlie tries to collect his $100 loan, he finds

Acme only has $30 in assets. Are Al and Bev personally liable to Charlie?



From Dave’s perspective An LLP creditor (like Dave)

may want to restrict diversion of LLP assets towards quenching unshielded obligations





Liability of an LLP PartnerDow v. Donovan [D. Mass. 2001]

Andrea Dow was an associate at Lyne, Woodworth & Evarts, LLP (“LWE”).

‘Making partner’ in a law firm is no different from admitting a new partner to any other existing partnership. The default rule: admitting an new partner requires the consent of

all existing partners. LWE followed the default rule. After Dow spent eight years as an associate, the LWE partners

met to discuss her candidacy for partnership. “Not a single partner spoke in favor of making Dow a partner, and

several spoke against that action.”


Liability of an LLP PartnerDow v. Donovan

Dow was informed that she was declined partnership, and her associate position will be terminated. She was given three months to seek other employment.

Dow sued LLP and each of the partners, alleging gender-based employment discrimination. Suppose that the law firm is found to have violated

employment anti-discrimination laws. Are the individual partners vicariously liable? Could they be liable on other grounds?


Megadyne Information Systems v. Rosner, Owens and Nunziato [Cal. CA 2002]

Megadyne wins a bid and enters a contract with the Orange County Transportation Authority (OCTA).

By Nov. 1995 it learns that its bid was based on misinformation furnished by OCTA in March 1995.

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Liability of an LLP PartnerMegadyne Information Systems

Dec. 1995: Megadyne referrs this matter to Irell & Manella (“I&M”). I&M handled various matters for Megadyne in the

past 20 years.

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I&M never files a formal claim against OCTA. Nov. 1996: The one-year statute of

limitations for this claim expires.

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May 1997: I&M suggested to Megadyne to refer the case to another law firm – Rosner, Owens & Nunziato (“RON”).

I&M referred ~15 cased to RON in a five-year period.

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Nov. 1997: RON serves OCTA a statutory claim Owens handles the matter. Nunziato’s name also appears in the caption

page of the claim.

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Jan. 1998: OCTA returns the claim because the statutory time limit had lapsed. After the rejection, RON does nothing, but reassures

Megadyne that they are “zealously protecting [Megadyne’s] interests.”

Owens testifies that during this time “there might have been discussions” between him and the other two partners that Megadyne had a viable legal malpractice claim against I&A.

Why didn’t RON advise Megadyne to sue I&A?

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Aug. 1998: Megadyne fires RON. Sept. 1998: Megadyne hires another firm, but

the claim is again rejected for failing to abide by the 1 year limit.

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~ Nov. 1998: Megadyne sues RON. Why didn’t they also sue I&A?

Suppose that RON and Owen are liable. Are Rosner and Nunziato also liable?

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Losing the Limited Liability ShieldContribution Requirements

Converting a GP into an LLP can conflict with contribution requirements in the partnership agreement.

Hypo: Alan, Becky and Cheryl form a general partnership. To ensure that the partnership has sufficient funds, the partnership agreement allows the partnership (through a majority vote of partners) to impose a mandatory contribution from the partners. This contribution is capped at $10,000 per year. What are the advantages of this method of raising capital?

Why is the contribution capped?



The partners vote unanimously to convert the GP into an LLP. Later that year Alan and Becky want to expand business,

financing the expansion with a $300,000 loan for 20 years @10% interest (i.e., interest payment of $30,000/year).

Cheryl does not want to pay $10,000 a year for the next 20 years and objects, but is outvoted 2-1.

Nonetheless, she refuses to pay her contribution, claiming that the mandatory contribution is a form of unlimited liability, from which she is shielded as a partner in an LLP. Is she correct? Note the last sentence in RUPA §306(c). Is there any reason that the LLP might want both a limited liability

shield and a mandatory contribution requirement?



The partners reach a compromise – they will take the loan and require the mandatory contribution, but they will not force Cheryl to pay her share. Alan and Becky calculate that partnership profits would suffice to replace

the $10,000 Cheryl would have contributed. Cheryl trusts her partners not to renege on their promise, and knows that

she can veto the admission of other partners who might insist that she contribute, so she goes along with the compromise.

The LLP applies to a bank for the $300,000 loan. The bank insists that the partners vote to ratify the contribution section.

The bank then lends the money. Ultimately the LLP defaults on the loan. The bank tries to force Cheryl to make the mandatory contributions. Cheryl claims immunity to liability, pointing out to RUPA §306(c). Will she defeat the bank’s claim?



Same fact pattern as before, except that Cheryl first checks the LLPs financial condition and finds that it will be able to repay the loan. Indeed, the LLP does not default on the loan.

However, Alan defaults on a personal credit card debt. The credit card company seizes Alan’s transferable interest in the LLP. It then learns that Cheryl had not contributed the mandatory payments, and sues to enforce her contribution duties. Cheryl responds that her liability is limited and that the credit card

company is not a partner and therefore lacks standing to enforce the partnership agreement. Is she right? Note RUPA §807(f).


Raising Additional Capital


Raising Additional CapitalHypo

The Project Dave, a real estate

developer, plans to construct an apartment building at a cost of $10 million.



Debt Capital Dave decides to borrow as

much of the $10M as he can. A bank is willing to lend Dave

$9 million, if he has equity capital of at least $1 million.



Equity Capital To raise the $1 million in equity,

Dave forms Acme Corp. 40 investors invest $25,000

each in Acme 40 x $25,000 = $1 million

Each investor receives one share for each $1,000 he/she invests (so, each investor receives 25 shares).



Difficulties Unfortunately, after the $10 million are

spent, the building is not yet complete. The incomplete building can’t generate

rents, but can be sold for $9 million. If the unfinished building is sold, Acme

will have $9 million in cash. After paying out the $9 million debt to the bank, Acme will have no assets left. Investors lose all of their investment



Salvaging the Project Dave estimates that if Acme spent another $500,000, the

building can be completed. Such a building will be worth $10 million.

If the building is completed and sold, and the debt is repaid, Acme will have a $1 million surplus. In other words, if the investors can raise another $500,000,

they will likely create a surplus of $1 million – a good deal. But how to get the $500,000?


Raising Additional Capital1. Shareholders’ Voluntary Loan

Each of the 40 investors to lend $12,500, charging zero interest If all investors lend the money, the corporation will have a $10

million building, and $9.5 million in debt. This leaves a surplus of $500,000, or $12,500 per investor. Is there a cost to the investors in lending the money?

If one investor doesn’t lend the money, while all other investors do, the corporation may lend the remaining money, but it will have to pay interest, which will reduce the surplus. Suppose the interest amounts to $400. How much of that cost will be borne by the shirking investor?

Result: Investors are likely to decline to lend the money.


Raising Additional Capital2. Issuing Shares at Original Price

Instead of raising debt capital from the investors, Acme can offer each investor to buy 12.5 additional shares, at the same price as the original shares cost ($1,000/share). This will raise: 40 (investors) x 12.5 (shares) x $1,000 (price) = $500,000

The problem is that the value of Acme dropped. Even if it gets the additional capital, it will cost $10.5 million to build a $10

million building. Therefore, the value of an Acme share dropped below the original value

of $1,000. A share is now worth $500 (I won’t bother you with the math of

calculating this). A rational investor would not pay $1,000 to buy a share worth

$500, so this attempt to raise capital will fail.


Raising Additional Capital3. Issuing Shares at Reduced Price

If Acme offered shares at their actual value ($500), it would need to issue 1,000 shares to raise $500,000. With this money it will complete the building, sell it for $10 million, pay off

the $9 million debt, and divide the surplus between the 2,000 shares (1,000 original shares and 1,000 new shares), distributing $500 ($1,000,000/2,000) per share.

This may be too close a margin for some investors – if there are any additional costs, the value of a share will drop below $500, so why buy additional shares?

To attract investors to buy the shares, a corporation may offer the new shares at a discount from their expected value. E.g., offer 2,000 new shares for $250 each. Since the expected value

of a share is $500, this is a good deal for each investor.


Raising Additional Capital3. Issuing Shares at Reduced Price

This is sometimes called a “penalty dilution”, because an investor who does not buy the reduced price shares will lose some of the value of her existing investment. An equity interest is like a slice of the corporation pie (the pie

is the total assets of the corporation) Issuing a new share reduces the size of each slice But the money for which the share was purchased increases

the corporation’s assets, so it makes the pie larger


Raising Additional Capital“Penalty Dilution” – Intuitive Explanation

Suppose a corporation issued 4 shares when it was formed. Each share represents an equal slice of the corporation’s assets.

Size of each slice (i.e., value of a share) = size of pie/number of slices (i.e., corporation’s total assets/number of shares).

Now the corporation has issued another share. Another slice was added to the pie, making the relative size of each slice smaller. But the money received for selling the fifth share was added to the corporation’s assets, making the pie larger.

Is each slice in the lower pie larger or smaller than a slice in the higher pie?

What does that depend on?

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Raising Additional Capital“Penalty Dilution” – Intuitive Explanation

When a point is bought for exactly its value, the size of each slice doesn’t change – the increase to the size of the pie (money paid for the share) is equal to the size of the new “slice”.

If a point is sold below its value, the increase to the size of the pie was less than the size of the new slice. Therefore, the other slices become smaller.

Purchasing a share below its value results in a transfer of wealth from the owners of the existing shares to the owner of the new share. This is called “dilution” of the existing shareholders.


Raising Additional Capital “Penalty Dilution” – Numerical Example

Alice owns 1 of 3 shares in Acme. Brian owns the other 2 shares. Acme is worth $90K ($30K/share)

Acme offers its SHs 3 new shares, pro rata, for $10K/share Alice does not have $10,000 in cash & has to decline Brian purchases the 2 shares offered to him, paying $20,000

Acme is now worth $110K, and has 5 shares Each share is worth $22K (110,000/5)

Alice lost $8,000 (30K-22K) Brian gained $8,000

Before: 2x$30K= $60K After: 4x$22K= $88K Gain: $88K-60K-20K = $8K


Raising Additional CapitalNo Dilution if Everyone Participates

If the existing shareholders buy the all of the newly issued shares pro rata (i.e., at the same proportions as their current ownership), then the wealth will be transferred from them (as the owners of the existing shares) to… them (as the owners of the newly issued shares).

In other words, they will not be diluted – they will neither gain nor lose from buying the new shares. Meanwhile, the corporation will raise more capital.


Raising Additional CapitalProblems with “Penalty Dilution”

1. SHs who don’t have money to invest will lose value Potential for opportunistic behavior when minority SHs are

low on cash

2. SH who doesn’t want to invest more in the corporation will lose some of the investment value

Harms SHs who have a greater need to diversify


Raising Additional Capital4. Shareholder Loans at Above-Market Interest Rate

Another option is to raise the money as a loan (as in Option 1), but pay an above-market interest rate. If all SHs lend, interest rate does not matter – interest comes out

of one pocket (SHs as owners of the firm’s assets) into their other pocket (SHs as creditors of the firm).

But if some SHs refuse to lend, they pay high interest payments (i.e., the value of their shares shrinks), but don’t receive interest payments (since they did not lend).

This is another type of penalty dilution; same pros & cons


Raising Additional Capital5. Mandatory Capital Contributions

Options 1 & 2 for raising capital from the existing shareholders were completely voluntary

Options 3 & 4 were voluntary, but refusal resulted in a dilution of the refusing party

Alternative: Mandatory contribution BoD given the right to require each SH

to contribute more capital to the firm

Pros & cons of this option? Contribution caps mitigate the

disadvantages


Raising Additional Capital6. Turning to Outsiders

Options 1-5 raised capital from existing SHs. Another source: Third parties Authorize (in the AoI or the bylaws) BoD to:

Issue shares to third parties; or Lend money/sell bonds to third parties

What are the pros & cons of this option?

Unincorporated Business Entities Section - Limited Liability Partnership

Economy & Finance