LLC disputes frequently lead to the court’s appointment of a receiver under California Code of Civil Procedure section 564. The receiver effectively steps into the shoes of the LLC’s manager, and calls the shots regarding the LLC’s operations and assets.
Here is a quick overview of receiverships for LLCs:
The receiver’s role
The receiver’s role is to preserve the status quo between the parties while litigation is pending. Receivership is a provisional equitable remedy. Receivership is considered an “ancillary” remedy which does not effect the ultimate outcome of the action.
Just like a preliminary injunction, a court can order a receivership even if the dispute is pending in an arbitration forum.
The receiver is a neutral agent of the court and not of any party. The receiver acts for the benefit of all who may have an interest in the receivership property, and holds assets for the court rather than the parties.
Code of Civil Procedure section 664
Code of Civil Procedure section 664 lists the statutory circumstances supporting the appointment of a receiver:
(b) A receiver may be appointed by the court in which an action or proceeding is pending, or by a judge of that court, in the following cases:
(1) In an action by a vendor to vacate a fraudulent purchase of property, or by a creditor to subject any property or fund to the creditor’s claim, or between partners or others jointly owning or interested in any property or fund, on the application of the plaintiff, or of any party whose right to or interest in the property or fund, or the proceeds of the property or fund, is probable, and where it is shown that the property or fund is in danger of being lost, removed, or materially injured.
(2) In an action by a secured lender for the foreclosure of a deed of trust or mortgage and sale of property upon which there is a lien under a deed of trust or mortgage, where it appears that the property is in danger of being lost, removed, or materially injured, or that the condition of the deed of trust or mortgage has not been performed, and that the property is probably insufficient to discharge the deed of trust or mortgage debt.
(3) After judgment, to carry the judgment into effect.
(4) After judgment, to dispose of the property according to the judgment, or to preserve it during the pendency of an appeal, or pursuant to the Enforcement of Judgments Law (Title 9 (commencing with Section 680.010)), or after sale of real property pursuant to a decree of foreclosure, during the redemption period, to collect, expend, and disburse rents as directed by the court or otherwise provided by law.
(5) Where a corporation has been dissolved, as provided in Section 565.
(6) Where a corporation is insolvent, or in imminent danger of insolvency, or has forfeited its corporate rights.
(7) In an action of unlawful detainer.
(8) At the request of the Public Utilities Commission pursuant to Section 1825 or 1826 of the Public Utilities Code.
(9) In all other cases where necessary to preserve the property or rights of any party.
(10) At the request of the Office of Statewide Health Planning and Development, or the Attorney General, pursuant to Section 129173 of the Health and Safety Code.
(11) In an action by a secured lender for specific performance of an assignment of rents provision in a deed of trust, mortgage, or separate assignment document. The appointment may be continued after entry of a judgment for specific performance if appropriate to protect, operate, or maintain real property encumbered by a deed of trust or mortgage or to collect rents therefrom while a pending nonjudicial foreclosure under power of sale in a deed of trust or mortgage is being completed.
(12) In a case brought by an assignee under an assignment of leases, rents, issues, or profits pursuant to subdivision (g) of Section 2938 of the Civil Code.
Subdivisions (b)(1) [claims between partners jointly owning property or funds] and (b)(9) [where necessary to preserve the property or rights of any party] are most commonly invoked in LLC disputes.
Managerial Deadlock or Abuse
One of the most common situations justifying the appointment of a receiver in an LLC dispute is where the LLC’s management is deadlocked.
Some poorly written LLC Operating Agreements appoint co-managers without any tie-breaking mechanism, which is a recipe for eventual deadlock. See prior post: Why Having “Co-Managers” for your LLC is a Terrible Idea. When the co-managers have different opinions regarding the operation of the LLC and are unwilling to budge or compromise, a receiver might be needed to ensure the LLC continues to function.
Likewise, when a manager’s conduct amounts to abuse or breach of fiduciary duties (e.g., diverting LLC assets; selling or encumbering the LLC’s property without a vote as required by the Operating Agreement), a receiver can be appointed to “guard the hen house” while the substance of the dispute is litigated.
Disputes regarding Membership Interests
A receiver can also be appointed to safeguard the LLC — including any funds earmarked for distributions — while the court sorts out disputes regarding the membership roster.
That was the situation in a recent unpublished opinion by California’s Fourth Appellate District addressing receivership in the cannabis LLC context — Razuki v. Malan. There, the court stated: “appointment of a receiver is a tool for the court to gain control over a chaotic ownership dispute[.]”
In Razuki, the plaintiff alleged that he had interests in related cannabis businesses, but the defendants were ignoring those interests and diverting money owed to him. The trial court appointed a receiver to protect the plaintiff’s potential interests and to safeguard the LLC assets until the substantive dispute regarding ownership was determined by the court.
The Court of Appeal affirmed the order appointing the receiver, holding that plaintiff had adequately shown a probability that he was a member of the LLCs with evidence of plaintiff’s “significant financial contributions” to the cannabis dispensary and production facility. The court concluded: “Where there is evidence that the plaintiff has at least a probable right or interest in the property sought to be placed in receivership and that the property is in danger of destruction, removal or misappropriation, the appointment of a receiver will not be disturbed on appeal.”
In an interesting footnote, the court noted that after the trial court filed the order appointing the receiver, the plaintiff was arrested by federal agents “for plotting to hire a hitman to kidnap and murder [defendant] in Mexico to put an end to this litigation” and that at the time of the appeal plaintiff was awaiting trial on charges of conspiracy to murder and kidnap the defendant. While a receivership might include its share of aggravation and expense, it is far better than this type of “self-help” and serving time in federal prison!
Windup and Asset Sales
A receiver might also be useful when an LLC is “broken” and the members want to part ways, but there is deadlock (or extreme lack of trust) regarding the liquidation of the LLC’s assets.
A receiver will typically retain brokers and other third parties to sell real property owned by a dissolving LLC. The receiver might also hire accountants to assist with the distribution of the sale proceeds and reporting for tax purposes.
When “divorcing” partners cannot manage this process themselves, a receiver can provide an attractive (albeit not cheap) alternative.