Here is a summary of three Acts passed by the Colorado Legislature in the 2016 Session which further improves the business entity climate in Colorado. These statutory revisions: (1) correct problems and clarify the impact of UCC Article 9 on transfer restrictions on entity ownership interests; (2) update the Colorado's LLC and Partnership statutes; and (3) allow filings with the SOS to revoke filings made in error.
Pick Your Partner - H.B. 16-1270
Transfer Restrictions on "Owner's Interests"
H.B. 16-1270, signed by Governor Hickenlooper in April, makes the Colorado Uniform Commercial Code (“UCC”) consistent with the Colorado Corporations and Associations Act (“CCAA”) by specifying that some of the UCC’s provisions regarding security interests do not apply to the CCCA. These new changes correct some problems created by the 2006 changes to the CCCA dealing with transfer restrictions of entity ownership interests.
Current Status and the 2001, 2006 UCC Changes
Colorado's entity statutes provide a great deal of flexibility for customizing owner agreements to special situations and allowing business owners to choose the partners with whom they want to do business.
When UCC Article 9 was substantially rewritten (effective July 1, 2001), many of the changes were intended to make it easier for a debtor to borrow against the value of the debtor's assets by allowing security interests to be created in types of collateral in which a security interest could not have been created under earlier law. New Sections 4-9-406 and 4-9-408 provided that a debtor could grant a security interest in various kinds of contract rights, even if the contract specifically stated that the contract rights could not be transferred or subjected to a security interest without the approval of other parties to the contract. The definition of "contract rights" was expansive enough to include the debtor’s ownership interests in LLCs and partnerships.
The changes in UCC Article 9 were of particular concern to lawyers who represent small businesses, many of which were owned as partnerships, limited liability companies or closely held corporations. These lawyers, and their clients, believed in the concept of "pick your partner", meaning that the owners of these businesses had a right to control who could or could not become a fellow owner. For this reason, partnership and LLC agreements, and similar agreements among shareholders in closely held corporations, typically provide that the interest of any owner cannot be transferred without the approval of all or most of the other owners. If a secured party could foreclose on an ownership interest and become the new owner of the interest, without consent from the other owners, this could inject a new owner into the business in violation of the "pick your partner" principle. (For a more detailed discussion of the "Pick Your Partner" principle, see Lidstone, Herrick K. and Sparkman, Allen, Pick Your Partner versus the United States Bankruptcy Code, 46 Texas Journal of Business Law, No. 2 at 23 (Fall 2015).
To address these concerns, on the recommendation of the CBA, CRS 7-90-104 was adopted in 2006. This section states that §§ 4-9-406 and 4-9-408 are entirely inapplicable to the interests of owners in partnerships, limited liability companies and corporations, as well as various other entities. Since 2006, people have recognized that § 7-90-104 has several problems:
1. Section 7-90-104 applies to all ownership interests in the types of entities in question, even if the applicable agreements do not restrict transfer, or even if any required consents to transfer have been given.
2. Furthermore, §§ 4-9-406 and 4-9-408 contained other provisions that benefit both debtors and secured parties. Section 7-90-104 makes those beneficial provisions inapplicable at the same time it invalidates the provisions that would override restrictions on transfer.
3. Section 7-90-104 in effect modifies part of the UCC, which is a uniform act that is often referred to by people who are not familiar with other Colorado statutes, but there is nothing in the affected sections of the UCC to warn readers that another statute has overridden the UCC.
2016 Changes: Problems Corrected
These problems have been the subject of several attempted fixes by the CBA in years past which, because of other issues (timing, resources) never made it to the General Assembly. H.B. 16-1270 addresses all of these problems:
1. It modifies § 4-9-406 and § 4-9-408 to specify that the "overriding of contractual transfer restrictions" language in those sections does not apply to the interests of owners in the types of entities covered by § 7-90-104. Thus, the main objective of § 7-90-104 is preserved - restrictions on transfer of ownership interests are still enforceable.
2. It also modifies § 7-90-104 so that, instead of negating all provisions of § 4-9-406 and § 4-9-408, it will (going forward) negate only the provisions that might otherwise override restrictions on transfer of ownership interests.
As a result, the UCC language is now consistent with the "pick your partner" principle set forth in the CCAA, and the other provisions of the UCC which may be helpful are preserved.
Updates to Colorado Limited Liability Company Act and the Partnership Laws
H.B. 16-1329-Concerning laws governing limited liability companies
H.B. 16-1333-Concerning laws governing partnerships
H.B. 16-1329 and H.B. 1333 are companion bills, awaiting Governor Hickenlooper's signature, intended to update several aspects of the Colorado Limited Liability Company Act (§ 7-80-101 et seq.) [H.B. 16-1329], the Colorado Uniform Limited Partnership Act (§ 7-62-101 et seq.) and the Colorado Uniform Partnership Act (§ 7-64-101 et seq.) [H.B. 16-1333].
Statutes of Frauds - LLC Act, CUPA and CULPA
Perhaps the most important aspects of the bills are that they resolve a potential confusion should a litigant claim that Colorado's statutes of frauds invalidate an oral operating agreement or partnership agreement.
Section § 7-80-102(11)(a) of the Colorado LLC Act defines the term "operating agreement" to include the statement that, "except as otherwise provided in this article or as otherwise required by a written operating agreement, the operating agreement need not be in writing."
Both the Colorado Uniform Partnership Act (CUPA, in § 7-64-101(20)) and the Colorado Uniform Limited Partnership Act (CULPA, in § 7-62-101(9)) define partnership agreement to mean "the agreement, whether written, oral, or implied, among the partners that governs relations among the partners and between the partners and the partnership."
Thus, the operating agreement of a Colorado LLC or the partnership agreement under CUPA or CULPA may be oral – in whole or in part. These statutory provisions are inconsistent with the statute of frauds. There are several versions of the statute of frauds in Colorado, but the two most likely to be applicable to LLCs and partnerships are found in:
C.R.S. § 38-10-108: Every contract for the leasing for a longer period than one year or for the sale of any lands or any interest in lands is void unless the contract or some note or memorandum thereof expressing the consideration is in writing and subscribed by the party by whom the lease or sale is to be made.
C.R.S. § 38-10-112(1): Except for contracts for the sale of goods which are governed by section 4-2-201, C.R.S., and lease contracts which are governed by § 4-2.5-201, in the following cases every agreement shall be void, unless such agreement or some note or memorandum thereof is in writing and subscribed by the party charged therewith:
(a) Every agreement that by the terms is not to be performed within one year after the making thereof;
(b) Every special promise to answer for the debt, default, or miscarriage of another person;
(c) Every agreement, promise, or undertaking made upon consideration of marriage, except mutual promises to marry.
Both H.B. 1329 (for the LLC Act) and H.B. 1333 (for CUPA and CULPA) provide that the statute of frauds does not apply to invalidate operating agreements or partnership agreements which may be oral in whole or in part. This does not change the burden of proof if the agreement is oral, but it permits the parties to proceed to prove the substance of an oral operating agreement or partnership agreement. As a result, the LLC Act (in § 7-80-108(5)), (with similar provisions added to CUPA in § 7-64-103(3) and CULPA, in § 7-62-110) now provide:
An operating agreement is not subject to any statute of frauds, including section 38-10-112, C.R.S., regarding void agreements, but not including any requirement under this article [80] that a particular action or provision be reflected in a writing.
While this may seem obvious and unnecessary in light of the statutory language, the CBA Business Law Section drafting committee believed this to be appropriate as a result of the decision by the Delaware Chancery Court in Olson v. Halvorsen, 986 A.2d 1150 (Del. 2009) which applied the statute of frauds to an unwritten operating agreement under the Delaware LLC Act. The goal was to avoid that issue in Colorado. There is no argument that the burden of proof for an oral agreement is high, but the inapplicability of the statute of frauds to the LLC operating agreement at least allows the parties to argue about the substance of the dispute - whether there is an agreement, rather than using the statute of frauds to avoid that argument. Of course, no lawyer would recommend that any client proceed with an oral operating agreement or any other agreement without a writing.
Compensation While Winding Up - LLC Act
H.B. 16-1329 is also intended to bring the LLC Act into consistency with partnership laws regarding remuneration to be paid to members of an LLC who are involved in the winding up of an LLC’s affairs. CUPA, § 7-64-401(8), provides that "[a] partner is not entitled to remuneration for services performed for the partnership except for reasonable compensation for services rendered in winding up the business of the partnership." CUPL provides similarly in § 7-60-118(1)(f). Until H.B. 16-1329, there was no similar provision in the Colorado LLC Act.
This issue came before the Colorado courts in the case of LaFond v. Sweeney, 343 P.3d 939 (Colo. 2015). There the Colorado Supreme Court noted the difference between the provisions in CUPA and CUPL permitting reasonable compensation to partners in the winding up process, and the LLC Act with no comparable provision. In LaFond, a lawyer left a two-person law firm, taking a contingency fee case with him. The lawyer successfully pursued the case to completion and earned a sizeable contingent fee. The law firm had been organized as an LLC, but did not have an operating agreement or any other writing addressing the dissolution of the law firm or the "unfinished business doctrine." (For a more detailed discussion of the unfinished business doctrine in the context of lawyers leaving law firms, see Lidstone, Herrick K., Issues in Partner Migration and Law Firm Dissolution.
As a result, the Court held that the departing member of the law firm completed the contingency fee case for the benefit of the LLC in the winding up process and was obligated to share 50% of the fees earned with his former 50% fellow member – with no reduction for compensation to the member performing the work due to the large number of hours involved. Whether that is a fair result is debatable, but the Court’s reasoning was consistent with the statute. In the partnership context, the departing lawyer would have been entitled to compensation, although still with the obligation to account for all benefits to the partnership.
As a result of the enactment of H.B. 1329, the LLC Act provides in C.R.S. § 7-80-404(6) that, unless the operating agreement provides otherwise:
A member is not entitled to remuneration for services performed for the limited liability company except for reasonable compensation for services rendered in winding up the business of the limited liability company.
Placing this language in § 7-80-404 is consistent with its treatment in the partnership laws where the similar provisions are found in CUPL, § 7-60-118(1)(f) (in a section entitled "Rights and Duties of Partners") and in CUPA, § 7-64-401(8) (in a section entitled "Partner's Rights and Duties").
Is A Contribution a Prerequisite To Becoming A Member? - LLC Act
H.B. 16-1329 is also intended to clear up an inconsistency in the LLC Act, where the contribution may not be a "prerequisite" to becoming a member, such as a promise to perform future services. The original provision was not consistent with the LLC Act's direction to give "maximum effect to the principle of freedom of contract and to the enforceability of operating agreements" (C.R.S. § 7-80-108(4)). As a result, the agreement of the parties will control.
Veil Piercing
Finally, H.B. 16-1329 is also intended to address the effects of some judicial decisions in Colorado and elsewhere which imply or state that they are disregarding the limited liability veil of an LLC and holding the single member liable simply because the single member LLC is treated as a "disregarded entity" for federal tax purposes. See Martin v. Freeman, 272 P.3d 1182 (Colo. App. 2012) which found liability where the sole member was also the entity's manager - a situation which "facilitated misuse"; in Greenhunter Energy, Inc. v. Western EcoSystems Technology, Inc., 2014 WL 5794332 at *16-17 (Wyo. Nov. 7, 2014), the Wyoming Supreme Court allowed piercing the veil of a single member LLC because (among other reasons), the district court "considered Appellant's tax filings as one of many relevant pieces of evidence demonstrating that Appellant directed benefits from the LLC to itself, while at the same time it concentrated wind farm project debts it decided would not be paid in the LLC." A number of states, including Delaware, have adopted similar provisions to clarify this judicial misunderstanding.
Limited Partnership Default Rule - CULPA
When CULPA was adopted in 1981, CUPL (adopted in 1931) was the only general partnership law in Colorado. When CUPA was adopted (effective January 1, 1998), we failed to make the amendment necessary to make CUPA the default general partnership law when considering limited partnerships formed under CULPA. As a result of H.B. 16-1333 and the resulting amendments to C.R.S. § 7-62-1104:
• Any CULPA limited partnership formed after the effective date of the bill will look to CUPA "to the extent applicable in any case not otherwise provided for in" CULPA.
• Any CULPA limited partnership formed before the effective date will look to CUPL for the determination of matters not otherwise provided for in CULPA unless the CULPA limited partnership made the affirmative election to look to CUPA and corrected a cross-reference in CUPL, C.R.S. § 7-60-144.5.
No change was made to CULPL since limited partnerships can no longer be formed under CULPL (although an existing CULPL limited partnership can elect to be governed by CUPA as provided in § 7-61-129).
Filing Statements of Correction to Revoke Mistaken Filings with the Secretary of State
HB 16-1330-Concerning authority to file a correction statement with the secretary of state of a document previously filed was delivered to the secretary of state for filing in error
H.B. 16-1330, also awaiting the Governor's signature, amends the CCAA to permit persons who file documents in error to revoke the filing through the filing of a statement of correction.
The Secretary of State's simple, online filing system leads some to file documents without properly thinking through the consequences. This may include a conversion from a corporation to an LLC (which may have disastrous tax consequences), a name change, or even a dissolution. In one case, in December 2015, articles of dissolution were filed for a company; then in February 2016, the company filed a statement of correction with the Colorado Secretary of State's office which said:
Articles of dissolution were filed in error. Please correct to keep company current. Please revoke articles of dissolution. (See, e.g., filings made for Pincus Holding Company, Sec. of St. ID 20141040178)
The Secretary of State's office “undid” the dissolution and placed the company back into good standing. In reviewing § 7-90-305 (Correcting Filed Documents) one can question whether that was the correct result. Section 305 only permits a statement of correction:
• To correct a filed document when the document contains information that was incorrect at the time the document was delivered to the secretary of state (C.R.S. § 7-90-305(1)(a)); or
• To revoke a filed document when the document reflects a delayed filing date. (C.R.S. § 7-90-305(1)(b), incorporating C.R.S. § 7-90-304(3)).
The statute provided no mechanism for a person to revoke a filing in its entirety made with the Secretary of State’s office when the document was filed in error unless the document stated a delayed effective date that has not yet taken effect. That is usually not the case. As amended, § 7-90-305(1)(b) provides that a statement of correction may:
"Revoke a filed document pursuant to section 7-90-304(3) or revoke a filed document that was delivered to the secretary of state for filing in error" provided that the statement of correction includes some specific information as described in § 7-90-305(2)(e).
The statement of correction is effective as of the date the original, erroneous document was filed except to the extent that any person relied on the original document. In that case, the statement of correction is effective as of the filing date. (C.R.S. § 7-90-305(4), as amended.)
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