Title Insurance For Limited Liability Company Transactions
by John C. Murray
The principal purposes of limited liability company ('LLC") formation are to obtain favorable tax benefits, create and maintain contractual flexibility (including the freedom of members to contract among themselves with respect to financial aspects of the LLC and the management and standards governing the internal affairs of the LLC such as the establishment of classes of members, voting, and procedures for holding meetings or considering matters without a meeting), and shield a member's personal assets from claims of outsiders and other members.
All fifty states, as well as the District of Columbia, have adopted LLC statutes. Wyoming, which enacted the first LLC statute in 1977, did so primarily at the request of the large mining businesses located in the state. Many states have revised and updated their LLC legislation in the past few years. In general, these recently enacted statutory revisions affect the organization and operation of LLCs.
Title Issues and Endorsements
A. The Fairway Endorsement.
If an LLC has obtained an owner's policy of title insurance, a lapse of coverage may subsequently occur because, under most state LLC statutes, the LLC must dissolve when only one member remains or when any member dies, withdraws, or becomes bankrupt, insolvent or incompetent. However, under a typical LLC state statute, the articles of organization or the operating agreement may nonetheless specifically provide for continuation of the business of the LLC or permit all or a majority of the remaining members to authorize continuation of the business. For example, under the Delaware Limited Liability Act, Del. Code Ann. tit. 6, § 18-101, et seq. ("DLLC Act"), a Delaware LLC is dissolved at any time there are no remaining members, provided that the LLC is not dissolved, or required to be wound up, if the LLC is continued by a new member in a manner permitted by the DLLC Act or the LLC operating agreement.
Under the "Fairway" rule, if less than the statutorily or contractually required number of members decides to reconstitute or continue the business of the LLC, coverage under the LLC's owner's policy may be terminated. This rule was established by the court in Fairway Development Co. v. Title Ins. Co. of Minn., 621 F. Supp. 120 (N.D. Ohio 1985). In this case, the title insurer successfully asserted that when two of the partners in an existing general partnership sold and transferred their interests in the partnership to the remaining partner and a new partner, who then entered into a new partnership agreement with the same partnership name, the original partnership was dissolved under applicable state law. The court held that a new partnership was created when the partnership interests were transferred, and the new partnership thereby created had no insurable interest under the policy with respect to an alleged defect in the partnership's title to the property.
When buying title insurance, the LLC should also consider requesting a Fairway type of endorsement, protecting against any lapse of coverage resulting from a change in the membership of the LLC or from any resulting dissolution. However, title companies may be understandably reluctant to issue such an endorsement because the law regarding LLCs is not as clear-cut as the law regarding partnerships, and even if they are willing to issue this type of endorsement it may provide assurance only if the dissolution or change in composition of the LLC does not result in the LLC being dissolved or discontinued under applicable state law. The title company would also need to carefully analyze the articles of organization and the operating agreement of the LLC when deciding whether to issue a Fairway endorsement and, if issued, the form of such endorsement. There is no standard form and the Fairway endorsement, if available at all, must be negotiated on a case-by-case basis with the title insurer. There is likely to be a charge for such an endorsement. This endorsement provides that the title insurer will not deny coverage under the policy issued to the LLC based on either of the following events: (1) the admission, substitution, or withdrawal of any individual or entity as a member in the insured LLC, or (2) a change in any member's interest in the capital or profits of, or a managing or non-managing member in, the insured LLC where, under the circumstances of the operating agreement of the insured LLC (as amended and restated) the business of the insured LLC continues after such event.
B. The Additional-Insured Endorsement.
If an LLC is used as an estate-planning vehicle, with the transfer of real property to the LLC, special care must be taken to avoid termination of coverage under the owner's title insurance policy. In Gebhardt Family Restaurant, L.L.C. v. Nation's Title Ins. Co. of New York, 132 Md. App. 457, 752 A.2d 1222, 1226-27 (2000), the court held that a transfer of land from two family members to an LLC, of which they were the only members, terminated coverage under a policy naming the individual family members as the insured parties. The Gebhardts, husband and wife, owned a 31.7-acre parcel of property, upon which they held an owner's title insurance policy. In 1995, they discovered that another party was paying property taxes on 4.75 acres of the property. They submitted a claim to their title insurer, demanding that the insurer correct the situation by "negotiating a purchase from the alleged owner (who also has a cloud on title) . . . and obtaining a quitclaim in favor of [the Gebhardts]." In 1996, before the claim was resolved, the Gebhardts executed, for estate-planning purposes, a special warranty deed conveying all of the property to a Virginia LLC of which they were the sole members. The deed recited a consideration of approximately $161,000.
In 1997, the Gebhardts sued the title insurer for breach of contract for failing to resolve the title dispute. The sole issue before the court was whether the Gebhardts or the LLC were the insured party under the policy. At the trial, Mr. Gebhardt testified that in fact no consideration changed hands (despite the deed recitation of consideration in the amount of $161,000), and that the only reason for the deed recitation was so that the State of Maryland could "assess the transfer taxes from the individual to the L.L.C." The Maryland appellate court noted that "there is no dispute" that the Gebhardts did not remain insureds under the title policy by virtue of a purchase money mortgage or by virtue of covenants of warranty. (Paragraph 2 of the Conditions and Stipulations of the standard ALTA owner's title insurance policy provides that coverage under the policy continues if the insured retains an estate or interest in the land, holds a purchase money mortgage from the purchaser, or retains continuing liability by reason of deed covenants of warranty). The Gebhardts had also conceded, at oral argument before the appellate court, that the LLC had not acquired title by "operation of law." (The policy definition of "insured," as set forth in Paragraph 1(a) of the title policy Conditions and Stipulations, includes "those who succeed to the interest of such insured by operation of law as distinguished from purchase").
The Gebhardts argued that they nonetheless remained insured parties under the title policy because the conveyance was, in effect, to themselves, and therefore they still retained an "interest" in the property. However, the appellate court ruled that "[i]n contrast to a partnership, a limited liability company in Virginia is an entity separate from its members and, thus, the transfer of property from a member to the limited liability company is more than a change in the form of ownership; it is a transfer from one entity or person to another (emphasis in text). The court held that while the Gebhardts had an interest in the LLC (which was a personal property interest), they no longer had an interest in the real property as the result of their conveyance of the property to the LLC. The court also rejected the Gebhardts' claim that there was no "real" conveyance because the LLC in fact paid no consideration, ruling that the conveyance to the LLC provided the Gebhardts with actual and substantial benefits, including limited liability and estate planning benefits. The court found that the Gebhardts' argument was "circular," i.e., a valid conveyance had occurred because a transfer tax is imposed on the transferring of property and if there had not been a conveyance, no transfer tax would have become due.
The court also noted that as the result of conveying by special warranty deed, the Gebhardts covenanted to protect the LLC only against claims made "by, through, or under" the Gebhardts, as grantors, and did not warrant title against someone else. Therefore, the court held, the Gebhardts had transferred to the LLC the unresolved title claim, and the LLC became the proper party to defend any action by another party to quiet title (with no recourse against the Gebhardts as grantors). Finally, the appellate court rejected the Gebhardts' assertion that they had suffered a loss under the policy, and reported it to the title insurer, before the conveyance to the LLC. The court noted that the Gebhardts had admitted in their appellate court brief that no actual loss had yet occurred. The court held that because of the conveyance to the LLC, which was a legally distinct entity, any subsequent loss would be the LLC's loss, which entity was not the insured party under the title policy either before or after the conveyance.
It may seem, at first blush, that the Gebhardts may have avoided a loss of title coverage for the LLC by conveying the property by a full warranty deed instead of by special or limited warranty deed. However, in many jurisdictions recovery under warranty deed covenants is limited to the consideration the grantors actually received, i.e., the measure of damages for breach of warranty is limited to such an amount; therefore, no title insurance coverage would exist where there is no actual consideration. Even if valid consideration for the deed were established, the successor LLC would be required to assert a claim against the grantors for breach of the deed covenants in order to trigger the title company's obligation to defend and indemnify. The insured grantors could easily become offended at the prospect of becoming involved in a legal action, with depositions and interrogatories, filed against them by family members to whom they intended to convey a valuable benefit.
A more prudent course of action for an LLC, to which real property has been transferred as part of an estate plan, may be to obtain a new owner's title policy at the time of the conveyance. The LLC would clearly become the insured party, the status of title would be identified and insured through the date of closing, the validity of the transfer would be insured, and the property would be insured for its current value. However, obtaining a new owner's policy may be expensive (although a reissue rate may apply).
The best solution may be for the grantee LLC to request an "additional insured" endorsement from the title insurer (in those jurisdictions where it is available), which would be effective as of the date of the conveyance. This endorsement specifically amends the existing owner's policy to add the LLC as a named insured. The cost of the endorsement is usually nominal ($100 to $300) and many title insurers will routinely issue the endorsement for successor LLCs as well as for trustees for inter vivos trusts, who are acquiring title from the insured owner(s). The title insurer will want to satisfy itself that, from an underwriting standpoint, no greater risk will occur as the result of the transfer. However, the coverage provided by the additional insured endorsement is no greater than that provided under the original policy, and is subject to all the defenses available to the title insurer under the original policy. For example, there is no protection for the additional insured if the conveyancing deed is itself defective.
C. The Non-Imputation Endorsement.
If the LLC procures a new owner's policy, it should request a "non-imputation" endorsement from the title insurer if the grantee LLC contains members other than the original grantors. This will prevent any subsequent denial of coverage by the title insurer based on policy defenses for matters "created, suffered, assumed or agreed to" by the insured and for matters not available in the public records or known only to the insured and not to the title company. The non-imputation title endorsement provides assurance that the title insurer will not deny coverage under the policy based on matters known to an outgoing member being imputed to an incoming member by operation of law, or that the title insurer will not deny coverage under the policy based on matters known to the insured LLC being imputed to a new member. In connection with the issuance of this endorsement, the title insurer would require that a non-imputation affidavit be executed by all of the current members of the LLC, certifying to the title company that to the best of their knowledge no matters exist that would affect title to the property.
D. LLC Conversion Statutes.
Many states have recently enacted "conversion" statutes, which permit transfers from existing legal entities, such as general and limited partnerships, to LLCs. These statutes generally provide that the entity that has been converted remains for all purposes the same entity that existed before the conversion. Such a statutory conversion does not result in a conveyance of property and is considered merely a "name change.' This statutory language would support the position that a "transfer or conveyance of such estate or interest" has not occurred within the meaning of paragraph 2 of the ALTA title policy's Conditions and Stipulations, thereby providing continuing title-policy coverage for the successor LLC. Furthermore, the successor LLC would be deemed an "insured," as defined in the policy, because it would "succeed to the interest of such [original] insured by operation of law as distinguished from purchase."
Whether an existing entity has been "converted" into an LLC may also affect whether the transferring entity may claim an exemption from the imposition of transfer taxes when real property owned by the converting entity is conveyed to the LLC. In Exton Plaza Associates v. Commonwealth of Pennsylvania, 763 A. 2d 521 (Pa. Cmwlth. 2000), a refinancing lender required that the shopping center owned by the borrower, a general partnership, be transferred to a "single purpose and bankruptcy remote entity" as a condition to obtaining the loan. The general partnership converted itself into a limited partnership of the same name, with each of the two general partners owning a 49.5 percent interest as limited partners in the new limited partnership. A new LLC, of which each of the original partners owned a 50 percent interest, was created to own a one-percent interest as the general partner of the new limited partnership. (The refinancing lender's loan commitment prohibited either of the individual general partners from serving as general partner in the new entity). The deed from the general partnership to the limited partnership recited a consideration of $1.00 and claimed a full exemption from payment of the Pennsylvania transfer tax, stating on the deed that "Principals of grantor and grantee are one and the same." The Commonwealth Court of Pennsylvania upheld the claim of exemption, finding that the deed in this case did not meet the statutory definition of "document" because it did not convey an interest to someone other than the grantor, i.e., it was merely a "name change" and "did not effect a meaningful transfer of title." The court reasoned that the general partnership had merely "converted" to the limited partnership, transferring a one- percent interest to an LLC as the general partner. The court stated that "the shopping center was essentially 'contributed' to the Limited Partnership, and the principals' property rights in the shopping center were essentially unchanged."
Uniform legislation and standard practices, including title standards, will undoubtedly be developed over time with respect to LLCs. Some states have been considering adoption of the Uniform Limited Liability Company Act ("ULLCA"), which was prepared by the National Conference of Commissioners on Uniform State Laws and adopted by the ABA Section of Business Law in 1994. However, to date the ULLCA has received only a lukewarm reception, although several states have adopted many of the ULLCA provisions. With respect to bankruptcy issues affecting LLCs (which are of great concern to title insurers), it is uncertain whether, in the absence of clear-cut case law, the Bankruptcy Code will eventually be amended to specifically define and deal with LLCs. The proposed revisions to the Bankruptcy Code being considered by Congress as of the date of this article do not include any provisions addressing LLC issues.