Many California-based LLC managers and members are lured by the potential benefits of forming the LLC under the laws of a jurisdiction outside of California. Delaware can be an enticing option. Delaware is known for its slightly management-friendlier laws, and for its court system with deep expertise in handling LLC and other corporate disputes.
But there can also be serious disadvantages to forming an out of state LLC.
The jurisdiction of formation may bind the LLC to procedural rules less favorable than those under California’s Revised Uniform Limited Liability Company Act (RULLCA). And any efforts to obtain judicial dissolution (the common result of LLC infighting) may have to be litigated outside of California — a serious inconvenience to California-based LLC stakeholders.
A recent case published by California’s First Appellate District — Boschetti v. Pacific Bay Investments Inc. — illustrates some pitfalls.
Giampaolo Boschetti and Adam Sparks did business together through several entities, but had a falling out.
Boschetti sued Sparks and several of the entities in the California trial court, alleging that their jointly-owned LLCs and partnerships owned multiple pieces of commercial property, that Sparks-controlled entities provided real property management services for the properties, and that the Sparks-controlled entities breached fiduciary duties by paying themselves improper distributions.
Sparks cross-complained, alleging that he and Boschetti had a general partnership together, which — through various LLCs and limited partnerships (LPs) — owned properties in several different states. Sparks sought dissolution of the general partnership (the “mother-ship” entity only) and winding up of its affairs.
Importantly, all of the entities through which Boschetti and Sparks owned property were “out of state” — i.e., formed pursuant to another state’s jurisdiction, as specified in the operating agreements.
In his answer to the cross-claims, Boschetti asserted that dissolving any general partnership between he and Sparks would require dissolution of the LLCs and LPs that owned the properties. Boschetti filed a motion asserting a right to avoid dissolution of all of the property-owning LLCs by purchasing Sparks’ membership interests in each of the LLCs at a price determined by disinterested appraisers.
That statutory “buy-out” right is based on specific provisions in the California Corporations Code that govern dissolution of California-based LLC and partnerships. Most other states do not provide similar buy-out rights.
Trial Court’s Ruling
The trial court initially granted Boschetti’s motion, but later reversed course, issuing in an order that it lacked jurisdiction to order dissolution of the out of state LLCs and LPs, so there could be no buyout proceedings for those entities.
Court of Appeal’s Opinion
The Court of Appeal affirmed the trial court’s order.
The court emphasized that all of the LLCs and LPs at issue were organized under the laws of other states — Texas, Delaware, or Hawaii. Those states, the court noted, “do not provide for compulsory buyout rights in the event of a judicial dissolution.”
The court acknowledged several authorities supporting the notion that “a California court lacks jurisdiction to order the dissolution of a foreign LLC or LP.” In addition to jurisdictional concerns, the court relied on the “internal affairs doctrine,” a conflict of laws principle under which: “only one State should have the authority to regulate a corporation’s internal affairs — matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders — because otherwise a corporation could be faced with conflicting demands.”
Dissolution, the court held, was a “quintessential internal governance” issue, and should be regulated by the laws of the “state of incorporation.” The court noted: “what is at stake here is not a mere transfer of property, but the continuing existence of the entities and the relations of the partners or members[.]”
For California stakeholders, forming an out of state LLC might make sense if you are an LLC manager looking looking to optimize your authority and discretion, while minimizing your fiduciary duties. Or if your LLC is a serial litigator in need of the Delaware courts’ judicial expertise in resolving internal conflicts.
But for the vast majority of California stakeholders, LLCs governed by California law probably makes more sense.
Other states’ laws don’t have the same procedures as California, such as the buy-out option to avoid dissolution. The buy-out option certainly has its flaws. (For example, how does an appraiser accurately account for pending breach of fiduciary duty or other claims, which may or may not be valid, but which could affect the value of the LLC membership interest?) But it can be very effective to avoid unnecessary and premature dissolution (death) of LLCs where at least one of the stakeholders wants to keep the business going.
More important is efficiency. Good lawyers tend to be expensive. Keeping legal expenses limited to core and worthy tasks makes good business sense.
If you are living in California with a stake in an LLC that owns real property and does business in California, but is formed under Delaware law, you probably have a California attorney advising you and/or the LLC on the key rights and duties impacting the LLC, its membership interests, and its assets. Any interests in California real property, alone, will require legal counseling from a California lawyer. But what happens when your partner sues for dissolution? You have to hire a second set of lawyers who litigate the dissolution proceedings in Delaware. Litigation is not known for its efficiency. Having two sets of lawyers working in two different states can be a serious misallocation of resources.