Appointing a Receiver to Safeguard Against LLC Shenanigans
A prior post — A Receiver For Your LLC? — covered the basics of court-appointed receivers acting on behalf of an LLC. It is always worth keeping in mind that a receiver appointed to handle the affairs of an LLC is a “general equity” receiver, which is much different than a limited-scope receiver such as those appointed to preserve property and collect rents and profits pending a foreclosure sale. This distinction was explored in the Money and Dirt post Receivers Gone Wild.
An opinion recently filed by California’s First Appellate District — Leon v. San Francisco Eagle Bar LLC — provides a good illustration of the type of LLC misconduct that can provide good cause for a court to appoint a receiver. While the Leon opinion is unpublished and therefore not binding precedent, it still provides a useful guidepost.
Facts: two LLC members; one dies; the other takes advantage
Two business partners — Mike Angel Leon and Jesus Alejandro Montiel — formed San Francisco Eagle Bar LLC, in which they were equal owners and members. According to Montiel, shortly after the bar opened Leon “showed little interest in the bar operations” and failed to pay his share of the bar’s expenses. After six years of operations Montiel approached Leon about a buyout, but they came to no agreement.
Leon filed a complaint for involuntary dissolution of the LLC in September 2018. The next month, Montiel filed papers with the Secretary of State to form a corporation with the same name — San Francisco Eagle Bar, Inc. — that did not mention Leon as a participant. In January 2019, Montiel filed a cross-complaint against Leon for breach of the LLC’s operating agreement.
In May 2019, Leon unexpectedly died. His mother opened probate and was appointed administrator of his estate. The estate’s attorney requested business and tax records from Montiel. The estate’s attorney asserted that she witnessed Montiel remove “thousands of pages of business records” from the LLC’s office before she could inventory them. Several motions to compel ensued.
In September 2019, Montiel dissolved the LLC. He filed tax forms for the LLC for the years 2019 and 2020 claiming Leon individually remained a 50% owner despite his death. In January 2021, Montiel formed a new LLC with the same name as the original LLC, listing Montiel as the sole owner.
Trial court: receiver appointed
Leon’s estate filed a motion for appointment of a receiver under Code of Civil Procedure section 564, arguing that the facts showed the estate’s probable interest in the LLC and a danger of that interest being materially injured.
The trial court granted the motion, and Montiel appealed.
Court of Appeal: affirmed
The Court of Appeal affirmed the trial court’s order appointing a receiver on three grounds.
First, the court found there was ample evidence that Montiel had refused to acknowledge the estate’s full membership interest in the LLC and “was operating the business as the sole owner after Leon’s death.” The court was not persuaded by Montiel’s arguments that Leon had “abandoned” the business prior to his death.
- Side note: this highlights the importance of the operating agreement setting forth expectations regarding work commitments and capital contributions, as well as remedies for noncompliance such as dissociation and buyout.
Second, the court pointed to “Montiel’s formation of a new corporation soon after Leon sued him, unilateral dissolution of the LLC soon after Leon died, replacement of the LLC with a new limited liability company with the same name, and apparent exclusion of Leon and the Estate” from the new entities. The court held that the trial court “reasonably construed these actions by Montiel as a wrongful attempt to eliminate the Estate’s interest in the LLC.” The court rejected Montiel’s arguments that his actions were merely an “honest, if misguided, attempt to reduce the tax burden of the LLC” and pointed out “there appears to be no evidence that Montiel attempted in any way to preserve Leon’s or the Estate’s interest in the LLC after this reorganization was complete.”
And third, the court pointed to the LLC’s filing of tax returns for the 2019 and 2020 tax years claiming that Leon (and not his estate) remained a 50% owner (potentially on the hook for $245,000 in recourse debt), without providing any notice to Leon or his estate. The court held that “Montiel’s failure to contact the Estate regarding the LLC’s taxes suggests he was acting against the interests of the Estate.”
Lesson
While there is a high standard for the appointment of a general equity receiver over a business entity, that standard can be satisfied when the evidence shows that a legitimate interest is at risk of material injury. The unpublished Leon opinion provides an example of the type of situation where the appointment of a receiver is appropriate.