Assignment of LLC Membership Interests

Topics Covered

Part One: Law Applicable to LLC Membership Assignments
Part Two: Due Diligence by the Assignee-Buyer
Part Three: Clauses and Provisions in the Assignment Instrument

Introduction

This article discusses legal points to consider when transferring and assigning a membership interest in a limited liability company from one individual to another. It does not address the initial issuance of such interests when the LLC is formed nor sales of membership interests by an existing LLC to incoming members.

As a general rule, an interest or asset is assignable in Texas unless expressly provided otherwise by law or contract. One must distinguish between absolute assignments (a permanent transfer to a new owner and holder) versus collateral assignments (made to a lender as collateral for a loan). Many interests and assets may be assigned in either way. Our discussion focuses solely on absolute assignments.

The Traditional Sale and Assignment Process

There is a best-practices process applicable to the sale and assignment of any interest or asset: (1) a non-binding letter of intent setting out a tentative agreement (LOI); (2) a contract to sell the asset (e.g., an earnest money contract) that allows for an inspection or option period for due diligence, a cure period for objections, and an unrestricted buyer right to terminate; followed by (3) a formal closing where a final sale and assignment instrument is executed and the interest or asset is delivered to the assignee-buyer.

The assignee-buyer should expect to make three main payments: (1) earnest money plus a non-refundable option fee to cover the inspection period; (2) a second payment due at the end of the inspection period (a more substantial amount), and then (3) payment of the balance of the sales price or assignment fee at closing. This basic payment schedule is subject to variation to suit the circumstances.

PART ONE:
LAW APPLICABLE TO LLC MEMBERSHIP ASSIGNMENTS

Statute Authorizing LLC Membership Assignments

The legal authority to enter into a sale and assignment of an LLC membership interest is found in the Business Organizations Code:

BOC Sec. 101.108. Assignment of Membership Interest

(a-c) A membership interest in [an LLC] may be wholly or partly assigned. [Such an assignment] (1) is not an event requiring the winding up of the company; and (2) does not [by itself] entitle the assignee to: (A) participate in the management and affairs of the company; (B) become a member of the company; or (C) exercise any rights of a member of the company.

Consent Requirement

Consent by other members is required by the Business Organizations Code. Section 101.103(s) states that a “person who, after the formation of a limited liability company, acquires directly or is assigned a membership interest in the company or is admitted as a member of the company without acquiring a membership interest becomes a member of the company on approval or consent of all of the company’s members.”

Section 101.105 states that a “limited liability company, after the formation of the company, may: (1) issue membership interests in the company to any person with the approval of all of the members of the company. . . .”

An additional consent requirement is found in Section 101.356(c) which provides that, for the most part, “a fundamental business transaction of a limited liability company, or an action that would make it impossible for a limited liability company to carry out the ordinary business of the company, must be approved by the affirmative vote of the majority of all of the company’s members.”

Accordingly, it is advisable to accompany an assignment of membership interest with a special meeting of members that approves and ratifies the change. One or more LLC resolutions may be produced as well. All affected parties (and their spouses, even if non-members) should sign off.

LLC Memberships are Personal Property

An LLC membership interest “means an owner’s interest in an entity. The term includes the owner’s share of profits and losses or similar items and the right to receive distributions. The term does not include an owner’s right to participate in management.” Bus. Orgs. Code Sec. 1.002(64). An LLC membership is personal property, not real property, even if the LLC owns real estate. A member of an LLC or an assignee of a membership interest in an LLC does not have an interest in any specific property of the company. Bus. Orgs. Code Sec. 101.106.

An LLC membership interest is not a negotiable instrument subject to the Uniform Commercial Code Bus. & Com. Sec. 3.201 et seq. Nor is a small-business LLC membership interest usually considered to be a security subject to state and federal securities laws: “An interest in a partnership or limited liability company is not a security unless it is dealt in or traded on securities exchanges or in securities markets, [and the company agreement] expressly provide[s] that it is a security . . . or it is an investment company security.” Bus. & Com. Code Sec. 8.103(c).

The foregoing applies regardless of whether the membership interest is considered certificated or uncertificated.

Statutory Qualifications for LLC Membership

Qualifications and requirements for LLC membership are addressed as follows:

BOC Sec. 101.109. Rights and Duties of Assignee of [an LLC] Membership Interest before Membership

(a) [An assignee of an LLC membership interest] is entitled to: (1) receive any allocation of income, gain, loss, deduction, credit, or a similar item that the assignor is entitled to receive to the extent the allocation of the item is assigned; (2) receive any distribution the assignor is entitled to receive . . . ; (3) require, for any proper purpose, reasonable information [concerning] the transactions of the company; and (4) make . . . reasonable inspections of the books and records of the company.

(b) An assignee of a membership interest in [an LLC] is entitled to become a member of the company on the approval of all of the company’s members.

(c) An assignee of a membership interest in [an LLC] is not liable as a member of the company until the assignee [formally] becomes a member of the company.

BOC Sec. 101.110. Rights and Liabilities of Assignee of Membership Interest after becoming Member

(a) [A]fter becoming a member of the company, [an assignee] is: (1) entitled . . . to the same rights and powers granted or provided to a member of the company by the company agreement or this code; (2) subject to the same restrictions and liabilities placed or imposed on a member of the company by the company agreement or this code; and (3) except as [otherwise provided], liable for [any obligation(s) on the part of the assignor] to make contributions to the company.

(b) An assignee of a membership interest in [an LLC], after becoming a member of the company, is not obligated for a liability of the assignor that: (1) the assignee did not have knowledge of on the date the assignee became a member of the company; and (2) could not be ascertained from the company agreement.

It is important to note that statutory rights and duties of LLC members are subject to “restrictions and liabilities” that may be imposed by the company agreement. This reinforces the principle that the company agreement should be a quality document and not merely a form downloaded from the Internet.

PART TWO:
DUE DILIGENCE BY THE ASSIGNEE-BUYER
OF AN LLC MEMBERSHIP INTEREST

The importance of thorough due diligence conducted during an adequate inspection period cannot be overstated. If one must sign a confidentiality or non-disclosure agreement in order to get relevant information on the LLC and its members then the prospective buyer of the interest should request a reciprocal provision requiring full disclosure of known material facts.

Checking the LLC’s Governing Documents

The company agreement is essentially a partnership agreement among LLC members, so it will directly bind a prospective assignee.

Is the company agreement fully executed by all LLC members? Is it a legal document of substance or is it a three-page printout from the internet that is not even specific to Texas? Are provisions of the company agreement compatible with the intentions and goals of the prospective buyer? What limitations does the company agreement impose (for example, restrictions on transfer of membership interests?

Company agreements often contain buy-sell provisions or rights of first refusal on the transfer of membership interests. It is also common for a company agreement to require that a membership interest be first offered pro rata to other members and/or to the company itself before a transfer may be made to a non-member third-party assignee. Unless waived, such provisions may be accompanied by an open offer period that can be as long as six months.

A prospective assignee-buyer should want to see other core LLC documents as well, including the certificate of formation; the certificate of filing (the secretary of state’s approval); the minutes of the first organizational meeting of members along with subsequent minutes of special meetings (if any) and annual meetings; company resolutions or grants of authority; and any membership certificates that may have been issued (or at least a record of same).

Also: where are the official LLC records kept? Who is responsible for keeping them, and is access readily available? Is there an actual company book, i.e., a binder containing these? Failure of an LLC to keep organized and complete records is a warning sign for a potential assignee.

Voting Agreements

These may or may not exist. Any one or more of the members may enter into voting agreements (including but not limited to proxies and pledges) that can affect control of the entity. These can exist outside of the company agreement.

Valuation of the Membership Interest

Most small-business assignments of LLC membership interest occur among insiders who are already acquainted with the company’s assets, liabilities, management, and operations. For potential assignees who do not fall in this category, the question of valuation arises—not just valuation of the membership interest itself but valuation of the LLC as a whole, since the two are effectively inseparable.

A lengthy treatise could be written on how to evaluate and appraise a business; suffice it to say that there should be some rational basis for the asking price that can be independently confirmed by looking at the company’s assets and revenue. Certain numbers will be hard (real property and bank accounts) and others will be soft (marketing strategy, proprietary information, and value of the brand).

If assets include real properties, an evaluation of value may include appraisals by licensed appraisers or the less-formal alternative of a broker price opinion (BPO). It is impressive if a real estate investment firm has an inventory of 30 rental properties; it is less so if half the properties are drowning in deferred maintenance. Believers in traditional, thorough due diligence will want to physically inspect the properties during the option period.

Good Standing of the LLC

It is important to verify that the LLC and the assignor (if a registered entity) are in good standing with the secretary of state and the comptroller. If not, they do not have the legal capacity to do business, which could potentially make execution of an LLC membership assignment invalid.

Managers and Members

It is operationally important to determine if the LLC is member-managed or manager-managed and, if the latter, to identity of the managers. Can the assignee work with these persons? Are they professional and competent? What is their track record?

LLCs are required to keep current lists of members, their respective interests in the company, and a list of all contributions to the company. BOC Sections 101.501(a)(1)-(7). Fellow members of a smaller LLC are effectively one’s partners in the enterprise, so it is good to know something about them.

Community Property and Non-Member Spouses

Are non-member spouses involved? Like real estate, personal property in Texas is presumed to be community property. A frequent error in transfers and assignments generally is failure to secure the signature of the assignor-seller’s spouse. The result is that the entire interest may not have been conveyed.

This is no different than if a grantee in a deed accepts the conveyance without requiring execution by the grantor’s spouse. Since community property is presumed, the transfer may be incomplete if the spouse does not sign off.

Even though BOC Section 101.108 provides that a non-member spouse of an assignee may not assert control over the company, the potential for awkward and potentially disastrous disruption remains. Consider the case of a withdrawing member who is contemplating divorce but has not yet revealed this to other members who may want to buy his LLC membership interest. Will the assignment get tangled up in the parties’ divorce?

As is the case in transfers of real estate, it is common for sellers of an LLC membership interest to argue that the non-member spouse should not be required to sign because the property being transferred is a business asset rather than a part of the homestead. Real estate lawyers hear such excuses all the time. Other reasons may be given (“My wife is in China”). None of these excuses should be allowed to carry any weight unless the membership interest has been lawfully converted into separate property by a written partition agreement according to Section 4.102 et seq. of the Family Code.

Accounting and Tax Consequences

There will likely be tax and accounting consequences as a result of transferring an LLC membership interest, so a CPA should be consulted. Tax returns should also be reviewed.

BOC Section 101.201 partially addresses this issue, stating that the “profits and losses of a limited liability company shall be allocated to each member of the company on the basis of the agreed value of the contributions made by each member, as stated in the company’s records. . . .” This rule will apply unless the members decide otherwise in the company agreement.

Attention should be given to the effective date of the assignment since the transfer date may have more than one level of significance. It is advisable to select an effective date for the assignment that facilitates easier calculation of profits and losses, or at least does not unduly complicate that calculation.

Texas Annual Filings

A prospective assignee should review the franchise tax returns and public information reports (PIRs) that must be annually filed with the comptroller’s office. Do these accurately reflect the LLC’s affairs? Are they diligently prepared and timely filed?

Contracts and Agreements with Third Parties

Any agreements with third parties that affect control, management, or operation of the LLC should be examined. Examples would be contracts with vendors or a property management agreement with a third-party management company. Is the LLC currently part of a joint venture with a different group of investors?

Real Property Management by the LLC

What real property does the LLC own? Are warranty deeds to any such property properly deeded into the name of the LLC? Are the deeds duly recorded in the real property records? How are properties managed and who is responsible for doing so? What do the files and records look like—are they orderly or are they a mess? And what about completeness? Do files for rental properties contain all essential documents like warranty deeds, notes and loan agreements, deeds of trust, leases, appraisals, maintenance records, and so on? A specific person should be responsible for keeping such records at a designated location.

Salaries, Draws, and Distributions

These should be examined to discover if there is a pattern of excessive or erratic compensation to managers or distributions to members. Is there a coherent schedule or plan? Are measures in place to insure that the LLC maintains sufficient working capital to fund existing and planned operations?

Bank and Depository Accounts

Current and recent copies of account statements should be examined. Look for any unusual withdrawals or capital flows. Is the LLC adequately capitalized? Does it have an adequate capital reserve? Inadequate capitalization is the principal cause of small business failure.

Records of Pending, Prospective, and Resolved Legal Actions

Is the LLC being sued? Has it been sued in the past? Do the managers have a history of shoddy or deceptive dealings? Is the LLC continually receiving DTPA notice letters from attorneys? Default letters from HOAs or appraisal districts? Does the company charter get periodically revoked (and then have to be reinstated) because the LLC fails to timely file its franchise tax return or PIR? Consider meeting with the LLC’s attorney and CPA. Require that confidentiality be waived in order to get a frank assessment of the situation.

Integrity and Reputational Evidence

It is important to ascertain whether or not the LLC is run with diligence, integrity, and in compliance with applicable law. What is the company culture with regard to best practices? Does the LLC have a regular business attorney and CPA to advise the managers? Or do the managers wing it on a DIY basis most of the time, counting on a surging market to cover their mistakes?

A prospective assignee may want to do some digging in order to evaluate the business and personal reputations of the managers and members. What is their professional history? The personal lives of the existing members may also be relevant: are any of them getting a divorce from a spouse who might turn into a hostile party? Was one of them just expelled from the country club for non-payment of dues? An internet search is, of course, the bare minimum but it may also be prudent to consider a private investigator (These are not just for the movies).

Company Performance

How have the LLC’s investments fared, particularly over the last three years? What do the company accounts show and are these numbers verifiable? Does the spreadsheet match up with the checkbook? Trends are an important part of value analysis. Try to reduce the LLC’s quarterly and annual results to line graphs for income and costs. Which way are these factors trending?

Do the managers and members have specific goals or is their strategy more built around finding targets of investment opportunity? Is their plan realistic or pie-in-the-sky? What will the company likely look like in three years? Five years? Is a change in direction required?

PART THREE:
CLAUSES AND PROVISIONS IN THE
ASSIGNMENT INSTRUMENT

Representations and Warranties

An assignment may include a full set of representations and warranties, limited reps and warranties, or no reps and warranties at all—in which case the assignment is made entirely as is, with recourse, representation, or warranty, express or implied.

Most assignor-sellers will seek to minimize post-closing liability by transferring the membership interest “as is” to the maximum extent by including only a minimum number of core representations and warranties. These would include assurances that each party, if a registered entity, is in good standing; each party has power and authority to lawfully enter into the transaction without joinder of others; and there exists no condition or circumstance that would render the transaction illegal or invalid or place the assigning party in breach of an existing contract. A careful seller will also want to entirely exclude any statement that cannot be expressly found in writing within the four corners of the final sale and assignment instrument.

The assignee-buyer instead will prefer a longer and more specific list of reps and warranties that go deeper into the quality and value of the LLC membership itself.

Once reps and warranties are negotiated, it must be determined how long they will survive closing—if at all. Thirty days? Ninety days? Indefinitely?

Covenants and Agreements of the Parties

Covenants and agreements address the legal obligations of the parties going forward—specifically what actions they are required to take in order to implement the assignment. Covenants and agreements of the assignor-seller would include, for example, an obligation to promptly endorse and deliver to the assignee-buyer the original LLC membership certificates.

The assignee-buyer should also covenant and agree to abide by the company agreement and other governing documents. Since Texas is a community property state, the spouse of a new assignee should also be asked to sign off on this commitment. The best practice is to secure the signatures of both the new assignee and any non-member spouse not only on the assignment but on the company agreement itself.

Additional covenants and agreements of the parties may be (and usually are) included. This is another area that is subject to extensive negotiation and customization to the circumstances.

Availability of Recourse

The option for some form of limited or conditional recourse (sometimes called a right to rescind) may be included in any assignment an LLC membership interest. For example, the assignment instrument could provide that, upon occurrence of certain conditions, the assignee-buyer would have the right to re-convey the membership interest back to the assignor-seller and receive the return of all or part of the consideration. Examples of such conditions would be a specified adverse business event or the discovery that the representations or warranties of assignor were materially false or deceptive when made.

The availability of a recourse mechanism is generally time-limited.

Mutual Indemnities

Ideally, and unless there are special circumstances, the assignor and assignee should release and indemnify one another for LLC-related actions, claims, liabilities, and obligations occurring before and after (respectively) the effective date of the assignment. Indemnity provisions are useful and worthwhile, but one needs to clearly understand their limitations. They are not a covenant not to sue.

Non-Compete and Non-Disclosure Provisions

Sale by a departing LLC member to another member may raise concerns that the departing member will utilize proprietary and confidential information in order to compete with the company in the same line of business within the same geographical area. Agreements regarding intellectual property and non-competition are typically stand-alone full-length contracts; nevertheless, it is possible to include compact and enforceable IP and non-compete provisions that fit smoothly and purposefully into a sale and assignment of LLC membership interest. Failing to do this can be an error with serious consequences.

Default and Dispute Resolution

Every good contract includes a default paragraph. Attorneys frequently include a clause requiring that such default be a material (rather than a trivial) breach in order to be legally actionable. The issue is then raised, how does one define material? One method is to impose a monetary floor, e.g., by confining assignor liability to issues that result in a loss or cost of (say) $10,000 or more.

A mandatory mediation clause should require the conflicting parties to first confer in good faith and attempt to resolve the dispute in a way that accommodates the legitimate interests of both sides. If agreement is reached, it should be reduced to a signed writing and implemented. If not, the parties should then agree to formally mediate the dispute before a certified mediator prior to resorting to litigation or filing any complaint with a governmental or administrative agency.

Delivery of Company Books and Records

There should be a clear agreement to deliver possession of physical company books and records to the assignee-buyer if the transaction results in the assignee-buyer being entitled to such possession.

Special Provisions

An assignment of LLC membership interest may involve a new list of members. It may also require a re-allocation of percentage interests among the remaining members. So it may be beneficial to include a stipulation that after conclusion of the assignment, the new membership list (with accompanying revised percentage interests) will be as described in Exhibit A. This usefully erases any doubt as to the overall final outcome of the transaction.

A special meeting of members may be an important companion document to the assignment of LLC membership interest. The meeting, signed by all affected parties, can not only approve the assignment but mention issues such as record date, a general ratification of the assignment and the new member list, and also authorize issuance of new membership certificates.