Joining Closely Held Business Entities As Parties in Equitable Distribution Actions

By Chris Graebe

Full disclosure at the outset: I’m not a family law practitioner. My practice involves a wide array of business litigation matters, including so-called “business divorce,” but never actual divorce. I will retire happily never having represented a spouse in an equitable distribution matter. However, I have represented business clients who have been joined as parties in equitable distribution actions, and I thought it might be worthwhile to write something about the intersection between the law of equitable distribution and the law that governs the business entities that may be marital property. This post will focus on the law of LLCs, because that is the corporate form most often chosen for closely-held entities. Most, but not all, of the principles discussed here are equally applicable to corporations. Furthermore, this post focuses on the joinder of LLCs in cases involving a non-owner spouse. When a spouse owns an interest in the LLC at issue, the spouse has certain rights under the LLC Act and may have additional rights (or limitations) under the operating agreement. Finally, this post discusses, but does not take a deep dive into, the specific facts of Campbell v. Campbell, 241 N.C. App. 227, 773 S.E.2d 93 (2015) and Geoghagan v. Geoghagan, 254 N.C. App. 247, 803 S.E.2d 172 (2017), the two cases most often cited in connection with the joinder of closely held companies in equitable distribution actions. The reader is encouraged to read those opinions closely if she is not already familiar with them.

The Basics

North Carolina law is clear that corporations and limited liability companies are legal entities distinct from their owners.  Glob. Textile All., Inc. v. TDI Worldwide, LLC, 375 N.C. 72, 76-77, 847 S.E.2d 30, 35 (2020); Keith v. Wallerich, 201 N.C. App. 550, 558, 687 S.E.2d 299, 304 (2009) (courts “are not free, for the sake of convenience, to completely ignore the existence of a legal entity, such as [an] LLC”); N.C. Gen. Stat. § 57D-2-01 (“An LLC is an entity distinct from its interest owners”). The North Carolina General Statutes vest the management and control of limited liability companies exclusively in the managers, subject to any variation in the operating agreement. N.C. Gen. Stat. § 57D-3-20. The only owners of an LLC are its “interest owners,” which the LLC Act defines to include both members and economic interest owners. N.C. Gen. Stat. § 57D-1-03(15). Both of these roles are carefully defined and circumscribed by statute. A “member” is a person who has been admitted as a member under the terms of the operating agreement or G.S. § 57D-3-01. N.C. Gen. Stat. § 57D-1-03(21). An “economic interest owner” is the owner of a proprietary “interest in the capital, income, losses, credits, and other economic rights and interests of a limited liability company, including the right of the owner of the interest to receive distributions from the limited liability company.” N.C. Gen. Stat. § 57D-1-03(10)-(11). An interest in an LLC is personal property. N.C. Gen. Stat. § 57D-5-01.

Chapter 57D prescribes the exclusive means of becoming a member or an economic interest owner in an LLC. N.C. Gen. Stat. § 57D-3-01. No person may be admitted as a member without the approval of all existing members, subject to variation by the operating agreement. N.C. Gen. Stat. § 57D-3-03. An economic interest may be transferred (unless prohibited by the operating agreement), but the transfer of an economic interest “does not entitle the transferee to become or exercise any rights of a member other than to receive the economic interest or the portion thereof assigned to the transferee.” N.C. Gen. Stat. § 57D-5-02.

“The operating agreement governs the internal affairs of an LLC and the rights, duties, and obligations of (i) the interest owners, and the rights of any other persons to become interest owners, in relation to each other, the LLC, and their ownership interests or rights to acquire ownership interests . . . .”  N.C. Gen. Stat. § 57D-2-30(a). The LLC is deemed to be a party to the operating agreement and may independently enforce it. N.C. Gen. Stat. § 57D-2-31.

“Specific assets of an LLC . . . are owned by the entity and are not the property of the interest owners.” Chafin v. Chafin, 250 N.C. App. 19, 27, 791 S.E.2d 693, 699, (2016); see In re C & M Invs. of High Point Inc., 2018 Bankr. LEXIS 2651, *7-8 (M.D.N.C. Bankr. Sept. 4, 2018) (in bankruptcy of an individual who owned an interest in an LLC, court lacked jurisdiction to determine LLC’s rights in specific intellectual property, because “[u]nder North Carolina law, an LLC’s assets are owned by the entity and not by its interest owners”). Put simply:

• LLCs own assets;
• LLC members own interests in LLCs.

For example, if Jane is the 100% member of a one-woman moving company called JaneCo, LLC, and JaneCo, LLC owns a truck and a trailer, Jane does not own a truck and a trailer.  Jane owns a membership interest in the LLC.

Closely Held Entities and Marital Property

The distinction between the property owned by JaneCo, LLC (the truck and trailer) and the property owned by Jane (membership interest in the LLC) is critical. “In an equitable distribution proceeding, only marital property is subject to distribution by the court.” Nicks v. Nicks, 241 N.C. App. 487, 495, 774 S.E.2d 365, 372 (2015), quoting Lawrence v. Lawrence, 100 N.C. App. 1, 16, 394 S.E.2d 267, 274 (1990). “’Marital property,’ as defined by N.C. Gen. Stat. § 50-20, ‘means all real and personal property acquired by either spouse or both spouses during the course of the marriage and before the date of the separation of the parties, and presently owned. . . .’” Nicks, 241 N.C. App. At 495, 774 S.E.2d at 372 N.C. Gen. Stat. § 50-20(b)(1) (2013) (emphasis original). Let’s assume that JaneCo was formed during the marriage, and Jane is still operating it at the date of separation and now.

The truck and trailer owned by JaneCo, LLC are not and will never be themselves marital property.  The potential marital property is Jane’s membership interest in the LLC. See N.C. Gen. Stat. § 57D-5-01 (ownership interest in LLC is personal property).

And even as to her membership interest, N.C. Gen. Stat. § 50-20 gives the other spouse no interest in any specific property of Jane, but only a right to equitable distribution of what is determined to be marital property in toto. See Kroh v. Kroh, 154 N.C. App. 198, 201, 571 S.E.2d 643, 645 (2002) (“Under N.C. Gen. Stat. § 50-20, we have consistently held that an equitable distribution claim is not a property right in specific marital property.”), citing Perlow v. Perlow, 128 B.R. 412, 415 (E.D.N.C.1991). “Nor does the separation create a lien on specific marital property in favor of the spouse. It only creates a right to an equitable distribution of that property, whatever a court should determine that property is.” Id. (quoting Wilson v. Wilson, 73 N.C. App. 96, 99, 325 S.E.2d 668, 670, cert. denied, 314 N.C. 121, 332 S.E.2d 490 (1985)); In re Rose, 563 B.R. 606, 612, 2016 Bankr. LEXIS 4433, *11-12 (E.D.N.C. Bankr., Dec. 22, 2016) (“[I]t is well-settled in this district that a spouse’s statutory right to equitable distribution does not create a lien on specific marital property but is a general unsecured claim in a bankruptcy proceeding, regardless of whether the claim has been reduced to judgment.”). Thus, Jane’s spouse has no specific “marital interest” in Jane’s membership interest in JaneCo, LLC, but only an interest in the marital property as a whole.

The Injunction Provision in N.C. Gen. Stat. § 50-20

N.C. Gen. Stat. § 50-20 permits preliminary injunctive relief to preserve property alleged to be marital property, divisible property, or the separate property of the movant:

Upon filing an action or motion in the cause requesting an equitable distribution or alleging that an equitable distribution will be requested when it is timely to do so, a party may seek injunctive relief pursuant to G.S. 1A-1, Rule 65 and Chapter 1, Article 37, to prevent the disappearance, waste or conversion of property alleged to be marital property, divisible property, or separate property of the party seeking relief.

N.C. Gen. Stat. § 50-20 (i). As noted above, the truck and trailer owned by the LLC (as opposed to Jane’s membership interests in the LLC) are not marital property, divisible property, or the separate property of Jane’s spouse as a matter of law; therefore, the injunction provided for in the equitable distribution statute does not reach the assets of the LLCs.[1]

The Cases Regarding Third Parties As Necessary Parties

In Upchurch v. Upchurch, the North Carolina Court of Appeals recognized the principle that, “when a third party holds legal title to property which is claimed to be marital property, that third party is a necessary party to the equitable distribution proceeding, with their participation limited to the issue of the ownership of that property.” 122 N.C. App. 172, 176-77, 468 S.E.2d 61, 63-64 (1996) (holding the trial court lacked jurisdiction to order equitable distribution of a note “executed for the benefit of Husband ‘or’ Jack A. Upchurch” because Jack A. Upchurch was never joined as a party to the action); see also Daetwyler v. Daetwyler, 130 N.C. App. 246, 252, 502 S.E.2d 662, 666 (1998) (holding that the trial court lacked jurisdiction to order equitable distribution of certificates of deposit jointly titled in the names of the husband and his mother and sister, who were not named as parties to the action), affirmed per curiam, 350 N.C. 375, 514 S.E.2d 89 (1999). It follows, conversely, that if a third party holds legal title to property that is not marital property as a matter of law, then that third party is not a necessary party to an equitable distribution action. Because JaneCo’s truck and trailer in our example are not themselves marital property, JaneCo is not a necessary party to Jane’s equitable distribution case. Put differently, Jane personally holds legal title to the marital property, i.e., the membership interest in JaneCo.

Campbell and Geoghagan

The two cases often cited as somehow permitting or even requiring the joinder of LLCs to equitable distribution actions, Campbell and Geoghagan, do not expand the statutory limitation of preliminary injunctions in equitable distribution cases to marital property, divisible property, or the separate property of the movant. In Campbell v. Campbell, 241 N.C. App. 227, 773 S.E.2d 93 (2015), the parties to the equitable distribution action were both members of an LLC. The Court of Appeals held that the trial court erred by entering a preliminary injunction that required the transfer of LLC assets and affected the operations of the LLC. The basis for the court’s ruling was that, because the LLC was not a party to the equitable distribution action, the trial court did not have jurisdiction to exercise control over the LLC’s assets, operations, and management structure. Far from blurring the distinction between the LLC membership interests and the LLC’s assets, Campbell recognized the distinction and held that even if both parties were members of the LLC, an order could not affect the assets of an unjoined non-party that has separate legal existence.

The Campbell court did not hold that (a) the assets of a closely-held LLC in which one or both spouses have a membership interest are themselves marital property or (b) the mere existence of an equitable distribution action between a non-owner spouse and a member of the LLC somehow created an independent basis for jurisdiction over the LLC. The second of these points may be most important in actual practice. In our example, Campbell gives Jane’s non-owner spouse no basis for joining JaneCo, LLC as a party to the equitable distribution case.  The trial court may account for the value of Jane’s membership interest in its equitable distribution order.

Aside: It is worth noting here that the equitable distribution statute expressly recognizes that the presumption of in-kind distribution of marital property does not extend to closely held businesses:

[where a trial court determines] that an equal division is equitable, it shall be presumed in every action that an in-kind distribution of marital or divisible property is equitable. This presumption may be rebutted by the greater weight of the evidence, or by evidence that the property is a closely held business entity or is otherwise not susceptible of division in-kind.

N.C. Gen. Stat. § 50-20(e) (emphasis added). This makes sense, whether the closely held business is owned by a small number of persons or a single owner. It is irrational to distribute an operating business to a stranger to that business when a distributive award can accomplish the division that the Court determines is equitable. Distribution of a closely held business not only damages the livelihood of the spouse operating the business, but also harms the employees, vendors, and others who rely on the health of that business.

In Geoghagan v. Geoghagan, 254 N.C. App. 247, 803 S.E.2d 172 (2017), the parties were both shareholders of a closely-held corporation. In making its distributive award, the trial court purported to order the company to limit distributions to the husband from the jointly-owned corporation or its wholly-owned LLC subsidiaries. The Court of Appeals held that it was error to enter a final equitable distribution order without adding the corporation and the LLCs as parties. Although the Geoghagan court did not find it necessary to explain the basis for jurisdiction over those distributions, a corporate shareholder (like the complaining spouse in that case) or an LLC member (like the complaining spouse in Campbell), has statutory grounds for asserting their own rights to distributions and corresponding rights to prevent wrongful distributions by a co-owner. See N.C. Gen. Stat. § 55-6-40 (governing distributions to shareholders or corporations); N.C. Gen. Stat. § 57D-4-03 to -06 (governing distributions to members of LLCs). That is, unlike Jane’s case, the member or shareholder had independent standing as a co-owner of the corporate entity to assert claims related to the operations of that entity. Query whether adjudicating those rights in family court in an equitable distribution case is the best idea when North Carolina has a Business Court focused on such matters, but that is beyond the scope of this post.

More illustrative of the situation in which a complaining spouse has no interest in the corporate entity he or she seeks to affect, like Jane’s case, is Mugno v. Mugno, 693 S.E.2d 276 (N.C. App. 2010). In Mugno, the complaining spouse was a non-owner of Liberty Computer Systems, Inc. (“LCS”), a corporation in which the defendant spouse was a shareholder. The parties had stipulated to the joinder of LCS as a party to the equitable distribution action. Still, in review of the trial court’s equitable distribution order that included a requirement that LCS pay the parties’ home equity loan, the Court of Appeals reversed, because there was no basis for jurisdiction over LCS:

It is clear from this record that LCS is not a sole proprietorship, but a corporation in which Mr. Mugno only owns stock. As a corporation, LCS is a separate legal entity which has more than one shareholder. While third-party entities, whether corporations or individuals, holding marital assets in trust or whom are transferees defrauding a creditor spouse may be subject to legal action to secure marital property in an equitable distribution action, there are no findings here to suggest that such subterfuge was present. Upchurch v. Upchurch, 122 N.C. App. 172, 176, 468 S.E.2d 61, 63-64 (1996).

. . .

An equitable distribution order is not the proper means to hold LCS, a third party, responsible for a debt owed, and should Mrs. Mugno desire to further LCS’s obligation to pay the HELOC, an equitable lien or another lawsuit would be the proper method for obtaining such relief. Accordingly, we hold that the trial court erred by ordering LCS to pay funds to Mrs. Mugno; therefore, we vacate paragraphs 6 and 7 of the trial court’s equitable distribution order.

Id. at 278-279.

Such is the case in Jane’s situation, where her spouse has no interest in JaneCo. If Jane’s spouse had an independent claim against JaneCo, whether for an equitable lien, a voidable transfer, or some other claim that could be made in good faith, then such a claim could give the Court a jurisdictional foundation upon which to order relief to that non-owner spouse. Otherwise, there is no basis to join JaneCo as a party.

But What About Waste?

One issue that has not been elucidated well in the case law (at least I don’t know about it) is whether a business entity may be joined as a defendant in an equitable distribution action by a non-owner spouse if the owner spouse is devaluing the company through waste, self-dealing, or other misconduct. That sort of misconduct raises two separate issues: (a) may the non-owner spouse obtain a preliminary injunction against the company in the equitable distribution action to prevent devaluation of the owner spouse’s membership interest? and (b) may the non-owner spouse bring claims directly against the company in the equitable distribution action?

The Court of Appeals has addressed the issue indirectly when the complaining spouse is a co-owner of the business.  In Burgess v. Burgess, 205 N.C. App. 325, 326, 698 S.E.2d 666 (2010), the husband and wife owned a corporation 50/50.  While their equitable distribution action was pending, the wife filed a shareholder derivative suit in superior court, seeking damages and an accounting on behalf of the company based on the husband’s alleged misconduct. The husband moved to dismiss, claiming that it ought to all be decided in district court in the equitable distribution action. The Court of Appeals held that the superior court had jurisdiction over the wife’s claims for breach of fiduciary duty and for an accounting and inspection of corporate books and records, because those claims did not involve the division of marital property, were outside the scope of N.C.G.S. § 50-20, and were separate claims of the corporation. Id. at 331-32. The court further held that even if the corporation were added as a party to the district court action, the wife in Burgess would not be entitled to the relief she sought in the derivative action, and the district court could not obtain jurisdiction over the shareholder derivative suit by statute. Id. at 333-34.

One of the keys to Burgess was that adding an LLC defendant gives rise to statutory and even constitutional issues that courts must consider before doing so. For example, the spouse parties are not entitled to a jury trial in an equitable distribution action. But what if the case strays beyond the strict bounds of equitable distribution and joins corporate parties or even asserts claims for relief against corporate parties? In such a situation, the corporate parties have a constitutionally guaranteed right to jury trial that the equitable distribution case does not offer. Furthermore, certain claims against business entities may be within the mandatory jurisdiction of the North Carolina Business Court. One issue that has not been ruled upon (to this writer’s knowledge, anyway) is what, if any, duty an LLC manager owes to a non-owner spouse when the LLC membership interests are marital property. It is well-established in North Carolina that an LLC manager’s duties run to the LLC and not to the members individually. Kaplan v. O.K. Techs., L.L.C., 196 N.C. App. 469, 474, 675 S.E.2d 133, 137 (2009). If an LLC manager does not owe a duty to members, how could she owe a duty to a non-member? In addition, if a complaining non-owner spouse complains that an LLC manager made improper distributions, the non-owner runs up against N.C. Gen. Stat. § 57D-4-06’s provision that, if a  manager makes improper distributions, the manager “is personally liable to the LLC but not to any other person.” One wonders how the district court could possibly adjudicate relief against LLCs when these rights and limitations are bound to be implicated.

Non-owner spouses are not without remedies, however. The district court may still take into account in its award any devaluation of membership interests caused by the misconduct of the owner spouse. The non-owner spouse may still obtain information about the company through the ordinary channels of discovery. And, although the case law in the equitable distribution context appears sparse on this subject, a non-owner spouse should be able to make claims under the Uniform Voidable Transactions Act for conduct amounting to intentional devaluation or secretion of marital property with the intent to defraud the complaining spouse.  Abdeljabar v. Khalil, 2018 N.C. App. LEXIS 444, *31-32 (N.C. App., May 1, 2018), citing Crowell v. Crowell, 257 N.C. App. 264, 281, 809 S.E.2d 325, 337 (2018) (holding that the transfer of a deed of trust to real property to the plaintiff’s son for no compensation following the separation of the parties was a fraudulent transfer intended to defraud the defendant creditor in the equitable distribution of property and thus was properly avoided).

Conclusion

The law at the intersection of N.C. Gen. Stat. § 50-20 and Chapters 55 and 57D is not well developed. One thing ought to be clear, however: equitable distribution does not give a non-owner spouse a skeleton key to the door of a limited liability company owned by the other spouse. There is great potential for the abusive addition of corporate parties to equitable distribution actions, with incorrect claims that Campbell and Geoghagan allow or require their addition. Business entities are separate legal persons with constitutional rights, including the right to jury trial, and they and their managers have the statutory right to have claims against them that implicate Chapter 55 or Chapter 57D adjudicated in the North Carolina Business Court. If your clients find themselves on the receiving end of these practices and their companies are named as defendants, you may wish to consider advising them to retain separate counsel for the companies to assert their separate rights.