Judicial Dissolution of LLCs Under RULLCA: Iowa Supreme Court Takes the Stage

Farrell Fritz, P.C.
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Iowa was one of the first states to adopt the 2006 Revised Uniform Limited Liability Company Act.  As of this year, 21 others have done so not including New York which continues to limp along with its creaky LLC Law enacted in 1994.

Iowa’s statute governing judicial dissolution of LLCs is based on RULLCA Section 701 which in the main carried forward the provisions in Section 801 of the predecessor Uniform Limited Liability Company Act (1996). The statute authorizes judicial dissolution upon application by a member on the principal grounds (1) that it is not reasonably practicable to carry on the LLC’s business affairs in conformity with its organizational documents, or (2) the controlling managers or members are acting in an “oppressive” manner that is directly harmful to the member seeking dissolution.

I’ve previously written about several interesting decisions by Iowa’s intermediate appellate courts in LLC dissolution cases (here, here, and here). Last month, in its first foray into LLC dissolution, the Iowa Supreme Court interpreted and applied Iowa’s LLC dissolution statute in a fascinating case called Barkalow v Clark. The case involves a dispute among family members who formed an LLC to acquire rental properties near the University of Iowa football stadium in Iowa City.

The court’s lively and scholarly opinion, authored by Justice Edward Mansfield, agreed with the lower court that the petitioning member did not establish oppression, but reversed the lower court’s dissolution order where the LLC was fulfilling its intended contractual purpose. For business divorce practitioners and others who study closely held business entities, Barkalow is a case well worth reading and understanding.

The LLC

Barkalow tells the story of the Clark brothers – Bryan, Jeff, and Joe – and their brother-in-law Tracy Barkalow. Barkalow was the sole owner of a company that owned apartment buildings. He also owned a property management company.

In 2009, Barkalow had an opportunity to purchase a rental property near the Hawkeye’s football stadium but lacked the required cash. Initially he approached Bryan for a loan. Instead, he and the three Clark brothers as co-equal 25% members formed Outside Properties, LLC (“OP”) to acquire the property with an initial capital outlay of $164,000. The Clarks, who in the past supported Barkalow’s borrowings by cosigning loans for him, loaned his $41,000 share on a verbal agreement.

OP’s organizational documents included several provisions regarding capital contributions and distributions that became important in the later litigation:

  • The certificate of organization stated that no additional capital contributions will be required and that the return of capital and distribution of profits “shall be determined from the company’s books.”
  • Each member received a management certificate stating that the “stated capital contribution and proportionate equity interest is subject to change” as reflected in the books and records.
  • The operating agreement gave each member a single vote on management issues but allowed any member to demand that voting on a particular issue be in proportion to capital contributions “as adjusted from time to time” based on additional contributions and withdrawals.
  • The operating agreement’s quorum provision was based on a majority of the equity interests as determined by the members’ capital contributions.
  • The operating agreement required unanimous agreement for distribution of profits.

Over the next few years OP acquired six additional rental properties, the down payments for which were financed by loans from the Clark brothers, with the balance of the purchase prices financed by the seller, a bank, or the Clarks.

The four members performed different roles in the LLC. Barkalow did the day-to-day property management. Bryan performed maintenance. Jeff did some remodeling. Joe was a passive investor.

The Family Feud

Over a four-year period beginning in 2013, Barkalow’s relationship with his brothers-in-law began to deteriorate and then boil over to litigation.

2013: Barkalow claimed, and the Clarks denied, that the Clarks had orally agreed to sell their interests to Barkalow at a fixed fee. Meanwhile, Bryan and Jeff were tiring of tying up their funds in loans to Barkalow that he used to sustain his separate investment properties. Barkalow also challenged the validity of the Clarks’ undocumented loans to OP, telling them “no note, no mortgage, no payment.”

2014: By this time the Clarks had taken on all of OP’s financing except for one seller-financed loan of approximately $1 million (the “Shultz Loan”). OP stopped making payments on the Clark loans and Barkalow unilaterally halted efforts to refinance the Clark loans with bank loans. Barkalow’s loan for his initial capital contribution in OP remained unpaid (until 2016). Barkalow unilaterally paid his management company $8,000 from the OP account.

2015: Tensions ratcheted up over the Shultz Loan which had a balloon payment due in December  of that year. Barkalow refused to cooperate in arranging outside financing to pay the loan. To avoid a default, the Clarks made capital contributions of about $334,000 each to cover the balloon payment. Barkalow declined the opportunity to participate in the capital contribution even while he continued to expand his separate real estate portfolio.

2016: Barkalow declined the Clarks’ offer to buy out his interest in OP for the undiscounted fair market value assuming a full 25% share. Barkalow also declined their proposal to obtain $2 million third-party financing to repay the Clark loans totaling about $950,000 and to reimburse their 2015 capital contributions, thereby restoring the four members to 25% each. Bryan and Jeff (but not Joe, who objected to his brothers’ use of a Clark-owned entity for funding) made voluntary capital  contributions to repay in full the Clark loans. Barkalow unilaterally withdrew about $145,000 of OP funds to pay “retroactive” fees to his management company and for costs of a class action settlement.

Barkalow Sues

In 2017, Barkalow sued the Clark brothers, seeking an order expelling them as members of OP, dissolving OP, and awarding damages. The Clarks counterclaimed.

In late 2018, the court held a bench trial at which the opposing positions centered on the members’ capital accounts and ownership percentages. There was no dispute, however, that OP was profitable and that its real estate holdings were then worth about $4 million and increasing in value. It also was uncontested that the members contemplated OP as a long-term investment and that dissolution would have adverse tax consequences.

In mid-2019, the lower court issued a post-trial decision that generally rejected Barkalow’s contentions and adopted those of the Clarks as regards the propriety of the capital contributions made by the Clarks and the resulting imbalance in ownership and voting percentages. Describing Barkalow as a “difficult partner,” the court denied his claims for dissolution based on majority oppression and for breach of fiduciary duty. The court also found there was an agreement from the beginning that each member would provide services to OP free of charge, and ordered Barkalow to repay over $150,000 for his unilateral withdrawals.

In the end, however, the decision veered in Barkolow’s favor, granting his request to dissolve OP based on the impracticability of continuing its business “in light of the intensity, longevity and number of disputes and issues existing between [Barkalow], Bryan and Jeff which are fueled by their long time acrimonious, bitter, and toxic relationship.” It also ordered that the Clark brothers’ 2015 and 2016 capital contributions be recategorized as debt, thereby returning all four members to a 25% equity position.

The Supreme Court Reverses the Dissolution and Debt Recategorization Orders

Both sides appealed to the Iowa Supreme Court. Bryan and Jeff appealed the dissolution order and the court’s recategorization of their capital contributions as debt. Barkalow argued that the lower court erred by not ordering dissolution based on oppression and by rejecting his claim for damages for breach of fiduciary duty.

The Supreme Court’s ruling last month handed victory to the Clarks, reversing the lower court’s orders granting dissolution and recategorizing capital contributions as debt. Justice Mansfield’s opinion includes in-depth discussion of the standards for finding oppression and impracticability under Iowa’s judicial dissolution statute based on RULLCA Section 701, drawing upon the Official Comments to Section 701 and citing leading decisions from other states including New York.

Oppression.  Justice Mansfield’s opinion wastes few words importing into the LLC dissolution statute the reasonable expectations test for determining oppressive conduct used in Iowa and most other states to determine oppressive conduct under analogous dissolution statutes for close corporations. The opinion cites and quotes from last year’s Manere v Collins decision by the Appellate Court of Connecticut — another RULLCA state — which likewise applied the reasonable expectations test to a claim for dissolution of an LLC based on oppression and set forth a useful, five-factor analysis which, as quoted in Barkalow, includes:

whether the expectation: (i) contradicts any term of the operating agreement or any reasonable implication of any term of that agreement; (ii) was central to the plaintiff’s decision to become a member of the limited liability company or for a substantial time has been centrally important in the member’s continuing membership; (iii) was known to other members, who expressly or impliedly acquiesced in it; (iv) is consistent with the reasonable expectations of all the members, including expectations pertaining to the plaintiff’s conduct; and (v) is otherwise reasonable under the circumstances.

Applying that standard, Justice Mansfield agrees with the lower court that “Barkalow’s expectations were unreasonable, rather than reasonable.” The specifics include:

  • Barkalow contributed no money to OP, “not even the funds for his original capital position.”
  • Barkalow expected the Clark brothers to finance everything and blocked efforts to obtain outside financing.
  • Barkalow “wanted something from the Clarks that would function like a capital contribution without actually being a capital contribution. That was not realistic.” [Italics in original.]
  • Barkalow pledged his own assets as collateral to expand his personal realty holdings, “not for the use or benefit of the LLC in which he was only a 25% participant.”
  • The management certificate and operating agreement “made clear that a member’s capital position was subject to change.”
  • The certificate of organization contemplated the acquisition of additional properties.
  • Barkalow “refused to accept a buyout of his interest for its undiscounted fair market value.”

Impracticability.  Calling it the “more difficult” issue in the case, Justice Mansfield next addressed the Clarks’ appeal from the lower court’s order of dissolution based on its finding that it was not reasonably practicable to carry on OP’s business in conformity with its certificate of organization and operating agreement. Acknowledging that the Court had not previously had occasion to interpret the not-reasonably-practicable standard, Justice Mansfield’s opinion cited a number of out-of-state decisions, including the New York Appellate Division’s opinions in the 1545 Ocean Avenue and Mizrahi v Cohen cases, for the propositions, first, that “[t]ypically, dissolution is ordered when there is actual, unbreakable deadlock,” and second:

In the absence of deadlock, courts have been reluctant to order dissolution so long as it is possible to continue to operate the company in accordance with its certificate of organization and management agreement. In other words, there has to be either a deadlock or a clear inability to fulfill the contracted purposes of the LLC, usually but not invariably for financial reasons.

Justice Mansfield’s opinion also discussed at length the South Dakota Supreme Court’s decision reversing a dissolution order in Dysart v Dragpipe Saloon, LLC, which I wrote about here, concluding that,

The lesson of Dragpipe is that LLC’s are ultimately member contracts, and courts should not be rewriting contracts unless it is truly necessary to do so. While the operating agreement here (unlike in Dragpipe) does not have a “put” that allows a member to sell out their interest for fair market value, there is no indication in this record that such a buyout would not be available. And in some ways, the present case is a weaker one for judicial dissolution because the present allocation of interests means there will be no tie votes.

Justice Mansfield’s opinion concludes that OP “is fulfilling its intended purpose of investing in real estate properties, and is doing so profitably.” Dissolution under the statute, the opinion sums up,

is not a wide-ranging mechanism for doing equity, but a drastic remedy to be ordered when an LLC is truly in an unmovable logjam or cannot as a practical matter carry on its contractual purpose. Neither circumstance is present here. Because we reverse the district court’s decision to order dissolution of [OP], we also reverse its order recategorizing the Clark capital contributions as debt that was part of the dissolution decree.

The Upshot Barkalow has something for everyone. For other RULLCA states whose courts have yet to construe definitively their version of Section 701, Barkalow likely will play an influential role in shaping those states’ LLC jurisprudence and, especially the contours of the reasonable expectations and practicability standards as applied to contract-centric LLCs.

For RULLCA and non-RULLCA states like New York whose LLC statutes do not include oppression as ground for judicial dissolution, Barkalow is a useful reminder that equity has its limits even in the face of bitter relations between LLC co-members where the LLC is functioning as intended under its constitutive documents.

For everyone else, Barkalow is a cautionary tale about the sometimes toxic mix of family and business that can lead to litigation and rupture family ties when, as co-owners of a closely held business, family members engage in financially significant matters without reducing their understandings to writing.

Finally, the Iowa Supreme Court has a terrific website where you can readily access the parties’ briefs, the Court’s decision, and video of the oral argument in each case. Click here to access the Barkalow case’s web page.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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