Money and Dirt: A blog on legal issues impacting California real estate investment, development, and secured lending

LLC Managers Are Not Above The Law (Or Equity)

In an earlier series of posts, I flagged several mistakes frequently made by real estate LLCs.  One of those mistakes is ignoring member rights and duties.  That mistake is a big one, and often leads to litigation.

A recent appellate decision illustrates the point.  In Feresi v. The Livery, LLC, the California Court of Appeal (Second District in Ventura) held that despite California’s statutory scheme governing the “perfection” and “priority” of security interests in an LLC membership, an earlier-perfected security interest can be subordinated based on equitable considerations — like a manager breaching his fiduciary duty to a member.

The LLC Membership Interest Serving as Security

James Mesa and Renee Feresi married in 1995 and separated in 2002.  While married, they acquired a 25% membership interest in The Livery, LLC.  Under the divorce judgment, Mesa and Feresi each retained half of that interest, giving them each a 12.5% stake in the LLC.

Mesa’s 12.5% interest ended up securing two separate obligations.

The Ex-Wife’s Security Interest

Under their divorce judgment, Mesa was required to make the monthly payments on Feresi’s home mortgage and to pay it off within five years.  Mesa’s obligations to Feresi were secured by Mesa’s 12.5% interest in the LLC, among other property interests.

Feresi did not file a California Uniform Commercial Code financing statement (UCC-1 financing statement) to “perfect” her security interest in Mesa’s share of the LLC.

But she did give the LLC manager, Mark Hartley, and the other LLC members written notice of the divorce judgment’s terms, including her 12.5% ownership interest in the LLC, and Mesa’s pledge of his remaining 12.5% interest as security for his financial obligations to her.

Accordingly, the LLC amended its books and records to reflect Feresi’s 12.5% ownership interest in the LLC.

The LLC Manager’s Security Interest

Mesa struggled to comply with the terms of the divorce judgment and fell behind on his obligations to Feresi.

Hartley, the LLC manager, made a short-term loan of $200,000 to Mesa.  Even though Hartley knew that Mesa’s 12.5% LLC interest served as security for Mesa’s obligations to Feresi, Hartley secured his loan to Mesa with the same 12.5% LLC interest.  Hartley didn’t disclose his loan, or his competing security interest, to Feresi.

The Security Interests Collide

Feresi notified Hartley that she intended to enforce Mesa’s obligations to her by taking Mesa’s 12.5% LLC interest that was pledged to her as security.  Feresi initiated legal proceedings to enforce her security interest, including a family law Order to Show Cause and a separate action seeking to “quiet title” to Mesa’s 12.5% LLC interest.

Meanwhile, Hartley sensed an opportunity.  Knowing that Feresi had not filed a UCC-1 financing statement to perfect her security interest, Hartley quickly asserted his own, conflicting security interest with apparent “first priority” by filing a UCC-1 covering the loan from Hartley to Mesa.

The family law court ordered Mesa to convey his 12.5% LLC interest to Feresi, and Mesa complied with that order.  Feresi notified Hartley and the other LLC members that the LLC records should be amended again to reflect her 25% ownership interest.

But Hartley instead published a “Notice of Disposition” announcing that Mesa’s 12.5% LLC interest would be sold to satisfy the debt Mesa owed to Hartley.  Feresi sued for declaratory and injunctive relief.

The Court of Appeal’s Opinion

The trial court ruled for Feresi, and the court of appeal affirmed.

The court first recited the California “fiduciary duty” rules that should be (but sometimes, sadly, are not) familiar to every LLC manager:

“The manager of an LLC has a fiduciary duty and owes to the members of the LLC the same duties of loyalty and good faith as a partner owes to the partnership and its partners. … Thus, Hartley is obligated to act with the utmost loyalty and in the highest good faith when dealing with any member of the LLC, including Feresi. He may not obtain any advantage over Feresi (or any other member of the LLC) by even the slightest misrepresentation or concealment.”

The court held that Hartley breached his fiduciary duty to Feresi “by destroying the value of her security interest in Mesa’s ownership share in the LLC to advance his own.”

The court rejected two defenses asserted by Hartley.

First, Hartley invoked the standard LLC operating agreement clause stating that the manager doesn’t violate his duties merely by conduct furthering his own interest. The court held that this provision only excused managerial conduct that provided incidental personal benefits without detriment to the LLC or its members.

Second, Hartley cited the “hard line” and unbending UCC requirements governing perfection and priority of security interests. But the court held that where the conduct at issue is inequitable (like a breach of fiduciary duty), the priority rules can and do bend, and earlier-perfected liens can be subordinated to later-perfected liens.

Lesson

With a properly designed operating agreement, LLC managers can enjoy a lot of discretion.  But fiduciary duties can’t be eliminated.  And as long as those fiduciary duties exist, LLC managers must conduct themselves accordingly.

As rigid as the UCC security interest perfection and priority scheme might seem, priority is always subject to equitable adjustment by the courts.  Courts will not hesitate to equitably subordinate a security interest that was “perfected” through a breach of fiduciary duty.

In case you missed my earlier series of posts regarding real estate LLC mistakes (and how to avoid them), links are here:

MISTAKE #1: Choosing the Wrong Business Partners

MISTAKE #2: Skimping on the Formation and Operating Documents

MISTAKE #3: Ignoring Member Rights and Duties

MISTAKE #4: Stepping into “Alter Ego” Liability

MISTAKE #5: Misunderstanding Secured Loan and Guaranty Rights / Liability

MISTAKE #6: Failing to Protect Trade Secrets

MISTAKE #7: Sinking Profits on Messy “Business Divorce” (Judicial Dissolution)

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