Bulletin: CA000019

Dear Associates:

On September 30, 1994, emergency legislation was signed into law by Governor Wilson. This legislation is known as the Beverly-Killea Limited Liability Company Act. Because the legislative bill was passed and signed on an ?emergency? basis, it was effective immediately, rather than on January 1, 1995. In recent years, many states have passed similar legislation. In fact, California was the forty-sixth state to pass a limited liability company act. Currently, only Hawaii, Massachusetts, Pennsylvania and Vermont have not adopted limited liability company legislation.

The purpose of this bulletin is to familiarize you with the legislation and prepare you for the questions you will encounter over the next few months regarding this new form of business entity. With that in mind, let's begin with some background information and progress through the underwriting issues which the title insurance industry must resolve when dealing with a limited liability company (?LLC?).

The first LLC legislation was passed in Wyoming in 1977. It was not very popular at first, primarily because of uncertainty regarding how the income and profits of the entity would be taxed by the Internal Revenue Service. In the mid-1980's, a determination was made by the IRS that an LLC would, as a general rule, be taxed like a partnership as opposed to a corporation. After this determination, the popularity of limited liability companies soared. Partnerships pay no federal income tax. The income of the partnership is ?passed through? to the individual partners and is treated as personal income of the partner. A corporation on the other hand, pays taxes on the profits of the corporation and, if dividends are distributed to the shareholders, then the dividend is taxed as personal income of the shareholder. An LLC thus avoids the ?entity level? taxation of the corporation.

The second reason for the popularity of the LLC is the substantial amount of structural freedom the legislation allows regarding the organization, management and financial arrangements of the LLC. An LLC can be structured and managed in many different ways. It can have a formal decision-making structure similar to a corporation with a board of directors and officers, or it can have a highly informal structure with all of the decision-making authority delegated to one individual, much like a partnership is managed.

The advantages of this type of business entity are summarized as follows:

• Pass through taxation rather than entity level taxation.
  
  
• Limited liability for the equity owners (called members). There is no personal liability for limited liability company debts.
  
  
• Flexibility in the structure, management and financial arrangements of the LLC.

Formation

A limited liability company is, like a corporation, a creature of statute. The LLC form of business entity was not recognized in California until this recent legislation passed. Like a corporation or a limited partnership, an LLC must make certain filings with the Secretary of State to be recognized as a legal entity.

The following must be accomplished for an LLC to be created in accordance with state law:

• Articles of Organization must be filed with the Secretary of State on a form prescribed by the Secretary of State called an LLC-1.
  
  The Articles of Organization must set forth certain information on the LLC-1.
  
  The name of the limited liability company, which must include the words ?limited liability company? or ?LLC? in the name. The words ?limited? and ?company? may be abbreviated ?Ltd.? and ?Co.?, respectively.
  
  A date certain for the dissolution of the limited liability company. In other words, the latest date upon which the LLC is to dissolve.
  
  The following statement of purpose: ?The purpose of the limited liability company is to engage in any lawful act or activity for which a limited liability company may be organized under the Beverly-Killea Limited Liability Company Act.?
  
  A statement of the form of management of an LLC. An LLC may be managed by the members themselves, or by one or more managers elected or appointed by a majority in interest of the members. The manager may be, but is not required to be, a member of the LLC.
  
  Other optional information may be included such as provisions limiting the scope of business to be engaged in or the scope of authority of the members or manager(s) to bind the LLC.
  
  
• There must be an operating agreement. The statute sets forth that the operating agreement may be oral or written. For title insurance purposes, Stewart Title Guaranty will require that the operating agreement be in writing. If you are asked to insure or approve a transaction in which there is no written operating agreement, contact STG underwriting personnel.
  
  An operating agreement is similar to a partnership agreement or the by-laws of a corporation. It is the document that governs how an LLC will be managed. It will state who the managers are and what the authority of the manager is for the day-to-day operations of the LLC and if there are any limits on the authority of the manager. This document is the real key to understanding the organizational structure of the LLC. The flexibility of the legislation allows for the operating agreement to take almost any form, but most of the ones you encounter will resemble partnership agreements or corporate by-laws.

An operating agreement should address the following issues:

• the identity of the members of the LLC
  
  
• the members' respective obligations to contribute money or other property to the LLC
  
  
• distributions to members during the term and upon liquidation of the LLC
  
  
• allocations of profits and losses for tax purposes
  
  
• the management structure of the LLC
  
  
• voting rights of the members
  
  
• transfer rights and restrictions on transfer of members' ownership interests

If an operating agreement fails to address these issues they will be governed by the default provisions of the legislation. If the operating agreement fails to or does not adequately address the form of management structure and powers and/or fails to define the members' voting rights clearly, consult with STG underwriting personnel for guidance.

A limited liability company must have at least two members.

A limited liability company begins its existence upon the filing of the Articles of Organization.

As is true with limited partnerships, the filings made with the Secretary of State's office may be amended or corrected from time to time. An amendment is made by filing an LLC-2 form and a correction is made by filing a certificate of correction form called an LLC-11.

Management

A key consideration in the underwriting process when an LLC is involved is the authority of the member or manager to bind the LLC. The general rule is that each member of an LLC has an equal right to manage the affairs of the LLC in relation to their economic interests. Unless the operating agreement provides otherwise, an affirmative vote of a majority in interest of the members of the LLC is required to approve actions taken by the LLC regarding real property.

If the LLC is, pursuant to the operating agreement and properly designated in the LLC-1, managed by one or more managers, then the general rule does not apply. It will be necessary in every transaction to carefully examine both Articles of Organization (LLC-1) and the written operating agreement to determine whether a particular member or manager has the authority required to bind the LLC in the particular transaction.

Some operating agreements will provide for the appointment of officers such as a president, chairperson, secretary, chief financial officer, etc.. Don't be fooled by these titles. The operating agreement will set out the duties, responsibilities and authority of these positions.

When reviewing an operating agreement and Articles of Organization for the purposes of underwriting a particular transaction, the two key questions to bear in mind are:

• Who has the necessary authority to bind the LLC?
  
  
• Is any special approval of the other members, managers or officers necessary?

Underwriting Guideline

The following language should be included in all preliminary reports and commitments issued where one of the parties to the transaction is a limited liability company:

Prior to the issuance of any policy of title insurance, the Company will require the following with respect to ____________________, a California limited liability company:

A copy of its operating agreement and any amendments thereto must be submitted to the Company for review.

A certified copy of its articles of organization (LLC-1), any certificate of correction (LLC-11), certificate of amendment (LLC-2), or restatement of articles of organization (LLC-10) must be submitted to the Company for review.

With respect to any deed, deed of trust, lease, subordination agreement or other document or instrument executed by such limited liability company and presented to the Company for recording or upon which the Company is asked to rely, such document or instrument must be executed in accordance with the following:

If the limited liability company properly operates through officers appointed or elected pursuant to the terms of the written operating agreement, such document or instrument must be executed by at least two duly elected or appointed officers as follows: the chairman of the board, the president, vice president, and any secretary, assistant secretary, the chief financial officer or any assistant treasurer.

If the limited liability company properly operates through a manager or managers identified in the articles of organization and/or duly elected officer pursuant to the terms of a written operating agreement, such document or instrument must be executed by at least two such managers or by one manager if the limited liability company properly operates with the existence of only one manager.

Other requirements which the Company may impose following its review of the material required herein and other information which the Company may require.

By following these guidelines, the underwriting risk is greatly reduced and the Company will be able to invoke the ?safe harbors? (a safe harbor in a statute is a statement contained in the legislation which creates a rebuttable or conclusive presumption of the existence or non-existence of a fact on which a third party can rely) which exist in the statute regarding third party reliance on acts of managers, members and/or officers who exceed their authority. These safe harbors all require absence of actual knowledge on the part of the third party of the fact that the manager, member or officer is acting beyond the scope of his or her authority.

Liens And Judgments

Liens and judgments recorded against limited liability companies will be indexed to the name of the LLC and not to the individual members or managers. Liens and judgments against individual members, including federal tax liens, will not attach to real property vested in the name of the LLC. In this respect, limited liability companies are very similar to corporations and the general index run should be performed in the same manner. An exception to this is discussed below in the Mergers section.

Assignment Of Interests

The general rule with respect to assignment of interests in a limited liability company is that a member may not assign an interest to another party (whether or not that party is already a member) without the unanimous consent of the other members of the limited liability company.

It is helpful to visualize the member's interest as having two parts, an economic interest which entitles the member to participate in the distribution of profits (and the apportionment of losses) of the LLC and a second interest which creates a right and duty to manage and participate in the affairs of the LLC. This second interest exists by virtue of the member being a party to the operating agreement.

The operating agreement should address the issue of and set forth procedures for the assignment of a member's economic interest. It should also clearly set forth the member's rights and duties regarding the management of the limited liability company.

This issue is important because members are statutorily prohibited from assigning their right and duty to manage or otherwise participate in the affairs of the limited liability company without the unanimous consent of the other members. The only exception to this rule is if the articles of organization or the operating agreement provide otherwise.

Underwriting Guideline

If you are asked to rely on the acts of a person or entity purporting to be a member of the limited liability company by reason of an assignment of a member's interest, the following steps must be followed:

• Review the written assignment of member's interest
  
  
• Review the operating agreement and the articles of organization for a determination of the assignability of the interest
  
  
• Review the written consent of the other members for a determination of compliance with the articles of organization and the operating agreement

If, after undertaking all of the above, the matter is still not clear, consult with your Stewart Title Guaranty underwriter for guidance.

DISSOLUTION

There are many events which will trigger a dissolution of a limited liability company, and a limited liability company will dissolve upon the earliest of the following:

• The date set forth in the articles of organization (LLC-1) as the latest date upon which it is to dissolve.
  
  
• Upon the happening of a certain event as specified in the articles of organization or operating agreement.
  
  
• The vote of a majority in interest of the members or, if so specified in the articles of organization or operating agreement, the vote of a greater percentage in interest of the members.
  
  
• Unless otherwise provided in the articles of organization or written operating agreement, upon the death, withdrawal, resignation, expulsion, bankruptcy, or dissolution of a member that is a corporate, partnership or limited liability company entity, unless the business of the limited liability company is continued by a vote of all the remaining members within ninety days of the happening of that event.
  
  
• Entry of a final decree of judicial dissolution.

Just as when a corporation or partnership is being dissolved, the limited liability company will continue to exist for a variety of purposes including the winding up of its affairs. Unless dissolved by judicial decree, the manager or members have the same authority with respect to the distribution of assets as they would have had but for the event giving rise to the dissolution.

Insuring a transaction involving a limited liability company which is in dissolution or has been dissolved and is winding up its affairs can be very risky from a title insurer's point of view. Transfers made during dissolution raise significant creditor's rights issues. Consideration must be given to whether or not reasonably equivalent value is being given and whether or not the contemplated transaction is taking place at arm's length or whether it involves ?insiders? of the LLC or others in a special relationship with the limited liability company or its members, such as related corporate or partnership entities or the spouses or other relatives of any member of the LLC.

If a loan transaction is involved, the question of why money is being borrowed by an entity in dissolution must be asked. Insuring this type of transaction should be seriously questioned.

Foreign Limited Liability Companies

The legislation provides for foreign limited liability companies (those organized under the laws of a jurisdiction other than that of California) to be legally recognized in California and for them to be able to transact business within the sate, subject to certain restrictions.

A foreign limited liability company must register with the California Secretary of State prior to ?conducting business? in California. In order to register, an application for registration as a foreign limited liability company must be completed and filed with the Limited Liability Division of the Secretary of State's office. This form is designated as LLC-5.

A filing fee must be paid at the time the LLC-5 is filed.

For title insurance purposes, the underwriting considerations are substantially the same for a foreign LLC as for a domestic LLC. The biggest and most important difference is the question of authority of the members, managers and/or officers signing deeds, leases, mortgages, etc.. Many of the other states' limited liability company legislative acts do not contain the same safe harbors discussed above. As a result, when dealing with a foreign LLC careful consideration must be given to the question of authority.

Under California law, the foreign LLC must comply with California law when conducting business in this state. However, for purposes of formation and authority, the laws of the jurisdiction in which the limited liability company is organized will govern. Some states require statutorily that special approval be given by a majority in interest of the members for a sale or encumbrance of all or a substantial part of the assets of the LLC.

Underwriting Guideline

A certified copy of the LLC-5 must be obtained and recorded in the county in which the transaction is taking place.

Evidence of the good standing of the foreign limited liability company in its ?home? jurisdiction must be obtained.

Copies of the articles of organization and the written operating agreement must be obtained and reviewed.

Consultation with a Stewart Title Guaranty senior underwriter or a Stewart Title Guaranty underwriter in the foreign LLC's home jurisdiction must be made to determine whether any special approval of the transaction by the members is required under the laws of the home jurisdiction.

Mergers

Mergers of limited liability companies with each other or with virtually any other form of business entity are allowed under California law. However, just because the law makes provision for it doesn't make it valid. The organizational documents and the laws under which the merging entities are organized must also provide for the entities to merge.

This is a very complicated area of the law and underwriting assistance is required if you are faced with a merger involving a limited liability company. However, some details of the legislation and basic underwriting requirements are worth discussion.

The merger legislation creates certain safe harbors upon which reliance can be made. For example, one requirement of merger is that a certificate of merger be filed with the Secretary of State on a form promulgated by the Secretary of State called an LLC-9. A certified copy of the certificate of merger is conclusive evidence of the merger of the limited liability company into one surviving business entity (which may or may not be a limited liability company).

Upon the merger of two or more limited liability companies or other business entities pursuant to the Act, the separate existence of the ?disappearing? LLC or other business entity ceases and the ?surviving? LLC or other business entity succeeds, without any transfer, act or deed, to all of the rights and property, both real and personal, of the disappearing LLC or other business entity. Constructive notice via the recording statutes is accomplished by recording, in the county in which the real property of the disappearing LLC or other business entity is located, a copy certified by the Secretary of State of (i) a Certificate of Merger (LLC-9), or (ii) the agreement of merger. This serves to vest title to the real property of the disappearing LLC or other business entity in the surviving LLC or other business entity.

Any lien or judgment which affects the title to any property owned by either the disappearing or surviving limited liability company or other business entity remains unimpaired and may be enforced against the surviving LLC or other business entity. Liens or judgments affecting the disappearing entity are limited to enforcement against property that was subject to the lien immediately prior to the time the merger was effective. The effective date of the merger is either the time of the filing of the certificate of merger (LLC-9) with the Secretary of State or within 90 days of the filing if the certificate provides for such a delayed effective date. The law is unclear on the issue of whether or not a lien or judgment recorded against the disappearing entity would create a lien against property acquired by the surviving company after the effective date of the merger.

Example: Limited liability company A (LLC-A) and limited liability company B (LLC-B) merge. LLC-A disappears and LLC-B survives. Prior to the merger both companies incurred many liens and judgments which were properly recorded and indexed in the county records where each company's respective real estate holdings were located. What liens and judgments attach to which property?

The liens and judgments recorded against LLC-A prior to the merger would not affect title to the property vested in LLC-B prior to the merger.

Any liens or judgments recorded against LLC-A after the effective date of the merger might affect title to the property vested in LLC-A and/or LLC-B, whether or not title was acquired before or after the merger.

The liens and judgments recorded against LLC-B either before or after the merger affect title to all the property of either limited liability company whenever it was acquired.

Underwriting Guidelines

When dealing with property vested in an LLC which has merged into another LLC or other business entity (i.e., becomes the disappearing limited liability company) a certified coy of the Certificate of Merger (LLC-9) must be recorded in order to vest title into and through the surviving limited liability company. A deed is not necessary; the recording of the LLC-9 is sufficient.

Whenever you are handling a transaction where the buyer, seller or borrower is a limited liability company which has been involved in a merger, you must require that a certified copy of the LLC-9 be recorded.

The general index (G.I.) must be run on both the disappearing limited liability and the surviving limited liability company or other business entity both before and after the effective date of the merger. Extreme caution and care must be utilized in this situation. The examples above set forth the necessity for doing this. The LLC-9 must be carefully examined for the necessary names. The law allows the surviving limited liability company to change its name to that of the disappearing or any other name. Carefully track which liens affect which entity for which time period (before or after the effective date of the merger). If you find any judgments or liens against either the disappearing or surviving company, contact your STG underwriter for guidance.

If you are involved with a transaction involving companies merged or to be merged you must, in addition to the organizational documents already required, require that a copy of the merger agreement be submitted for review. This is not the LLC-9, but the actual merger agreement. The merger agreement is an amendment to the operating agreement. It may contain information important to the underwriting of the transaction.