California limited liability company disputes | Courtroom war stories and lessons learned

Title Insurance Booby Traps in the LLC Jungle

Title insurance is inexpensive for a reason.

Unlike other insurance policies, it is not prospective in nature.  It does not cover title defects or liens that come into being after the effective date of the policy.

And even as to title defects that existed on the date of the policy, there are many “exclusions, exceptions, and conditions” that might thwart coverage and leave the policy holder high and dry.  One typical policy condition is the “Continuation of Insurance” condition, under which coverage continues “only so long as the insured retains an estate or interest in the land.”  The Money and Dirt blog covered one case addressing this type of condition, which left a foreclosure sale buyer with a huge lien headache.  See Title Insurance Covers That Foreclosure Problem, Right?

Recently, a case addressing the “Continuation of Insurance” condition surfaced from California’s Second Appellate District — Pak v. First American Title Insurance Company.  While unpublished (and therefore not binding precedent), the Pak case illustrates a particular danger for LLCs and their owners.

Facts: owners of insured commercial property transfer title to their LLC, later tender a claim under the title insurance policy

Soon Han Pak and Chung Huyk Pak purchased commercial property in Los Angeles in 2003.  When they purchased the property, they also bought a title insurance policy from First American Title Insurance Company.  The Paks were the named insureds under the policy.

Five years later in 2008, the Paks formed their LLC, in which they were the sole members and co-managers.  They recorded a quitclaim deed transferring the property to the LLC.  The quitclaim deed stated “the grantors and grantees in this conveyance are comprised of the same parties who continue to hold the same proportional interests in the property….”

In 2017, the property across the street from the Paks’ property was purchased by an investor group including Gage & 62nd LLC.  The next year, Gage informed the Paks that a portion of the Paks’ property was burdened by a parking easement in Gage’s favor.

The Paks tendered a claim under the policy to First American, seeking coverage for addressing Gage’s easement claim.  However, First American denied the claim on the grounds that the quitclaim deed to the LLC divested the Paks of any “estate or interest” in the property, and therefore coverage had lapsed under “Condition 2” from the title insurance policy.  Condition 2 stated coverage under the policy “shall continue … in favor of an insured only so long as the insured retains an estate or interest in the land….”

A few months later, Gage sued the LLC, alleging claims relating to the easement.  The Paks again tendered the claim to First American, but again First American denied coverage.

In 2018, the Paks and the LLC signed an agreement rescinding the quitclaim deed.  The Paks sent the rescission to First American, hoping for a change of heart.  But First American rejected the claim again, stating that the policy had been voided by the quitclaim deed and could not be revived through rescission.

The Paks sued First American for coverage under the policy.

Trial court: no coverage under the policy; LLC is separate and distinct from its owners

The trial court sustained First American’s demurrer to the Paks’ complaint, and dismissed the lawsuit.

The court determined that the policy was extinguished by the Paks’ quitclaim deed to their LLC.  Because an LLC and its members are distinct, the court held, the Paks as LLC members no longer held an interest in the property.

Court of Appeal: affirmed

The Court of Appeal affirmed the trial court’s judgment.

The court started with the legal principle that “a limited liability company is a legal entity separate from its members.”  An LLC member has no interest in specific property owned by the LLC.  “Instead, he or she has membership and economic interests” in the LLC itself, which “constitute personal property of the member.”

Since a quitclaim deed transfers “whatever present right or interest the grantor has in the property,” the Paks’ quitclaim deed to their LLC gave the LLC a fee interest in the property.  “The Paks were left with only their interest in the LLC.”

The court rejected the Paks’ argument that they retained an “indirect” interest in the property.  The court held: “The very nature of a limited liability company means they retained no interest in the Property, and regardless, they certainly did not retain the fee interest that the Policy requires.”

The Paks argued that under California’s Revenue and Taxation Code, certain transfers between individuals and entities do not qualify as changes in ownership.  But that statute, the court held, applies only for purposes of determining whether a transfer triggers a tax reassessment under Proposition 13, and “has no bearing on whether the Paks maintained an interest as required by the Policy.”

The court also rejected the Paks’ attempt to resurrect coverage through their rescission of the quitclaim deed.  The quitclaim deed terminated coverage under Condition 2 of the policy.  The court held: “The rescission of the quitclaim deed merely restored the status quo ante as between the Paks and their LLC.  It does not mean the Paks rewound the passage of time and undid the attendant consequences of their original decision.”

Lesson

The legal separateness of an LLC and its owners is a feature, not a bug.  People own property and do business through LLCs to limit their individual liability.

But that concept can trigger unintended consequences in the realm of title insurance.  When property is transferred from an individual into the individual’s LLC, any preexisting title insurance policy benefiting the individual might be in jeopardy under the “Continuation of Insurance” condition.

To ensure continuing coverage, the LLC needs to be added to the individual’s policy, or obtain a policy of title insurance for itself.