Cumulus Radio Corp. v. Olson, U.S. Dist. Ct., C.D. Ill., March 10, 2015

The existence of federal jurisdiction in this case turned on whether an individual who held an unvested profits interest in a limited liability company (“LLC”), and whom the LLC considered a partner for tax purposes, was a “member” of the LLC under Delaware law.  The case illustrates some of the confusion commonly surrounding the nature of LLCs, LLC membership, and “profits interests.”

Defendant Alpha at first admitted being a Delaware “corporation,” which, if true, would have given the court diversity jurisdiction.  The parties could not have missed the initials “LLC” trailing Alpha’s name and may have taken for granted that an LLC is a corporation.  But it eventually dawned on Alpha that LLCs in fact are unincorporated entities, whose citizenship is determined under entirely different principles than that of corporations.  Alpha thought it saw an opening for getting the case out of federal court by demonstrating that, under the correct legal test, diversity could be defeated.

An LLC, like a partnership, has the citizenship of all its members — and the members of its members, and so on through however many membership layers happen to be piled on top of it.  Alpha pinned its hopes on a Cynthia South, the holder of an unvested “profits interest” in an upper tier entity, who shared Georgia citizenship with the plaintiff.

South’s profits interest was intended to comply with Revenue Procedure 93–27, 1993–2 C.B. 343, 1993–2 C.B. 343, and, it seems, with Revenue Procedure 2001-43, 2001-2 C.B. 191, so that the holder would report no income or gain on the receipt or the vesting of the interest.  As evidenced by the Schedule K-1s it sent her, and consistently with the revenue procedures, Alpha considered South a partner for federal income tax purposes from day one, before any vesting could take place.

Alpha apparently cited the tax treatment of South as evidence that South was “substantively” a member.  But the court showed no interest in such alleged “substance” — whatever that might mean.  As the court read the LLC agreement, executing a counterpart of the agreement was unmistakably a precondition to admission as a member.  Since South had not executed the agreement, she was not a member — that’s all there is to it.  The court dismissed as irrelevant all extrinsic evidence of South’s membership status.

The LLC agreement conditioned the receipt of profits interests, as well as membership, on execution of the agreement.  The court’s reading arguably should have invalidated South’s profits interests, as well as barring her from membership in the LLC.  However, the court was not called on to address the validity of South’s profits interest.

The plaintiff was able to point to some rather damning Alpha documents – internal and external – that failed to list South as a member (or as an owner).  But if the court is correct, even a consistent record showing that Alpha had always considered South a “member” would have been irrelevant.

It was Alpha’s understanding that South held a profits interest, whether or not Alpha was clear about the nature of a profits interests or had any idea whether a profits interest holder was a member.  But there is no doubt that the LLC agreement intended for the holders of profits interests, vested or otherwise, to be members.  Based on the facts presented in the opinion, one might speculate that the drafter of the LLC agreement intended for the holder of a profits interest to be a member, but that the LLC’s management was not clear on the question.  It may be that neither South nor the LLC’s management understood that South was supposed to sign the LLC agreement, or that she was supposed to be a member (or an owner).

In refusing to recognize South as a member, the court showed no interest in what “member” might mean, or what the defining characteristics of “membership” might be.  The court seemed satisfied that the literal language of the LLC agreement precluded “membership” — whatever “membership” means.  The court may have been justified in looking only to the words “membership” or “member,” without regard to whatever substance those terms might have.  Given the extent to which the rights of a Delaware LLC member can be shrunk by agreement, and the rights of nonmembers expanded, it would be at best quite challenging to specify the rights and obligations that, in substance, particularly characterize LLC membership.  It can be argued that the Delaware LLC Act, in its circular definition of “member” (see tit. 6 § 18-101(11)) and its rather nonsubstantive rules for the admission of members (see tit. 6 § 18-301), encourages such a formalistic focus on the word “member” without regard to meaning.