Does an Operating Agreement Provision that Transfers Membership Upon a Member's Death Govern if the Operating Agreement is Not Executed Like a Will?

December 14, 2021

By: Stephen B. Stern

     In Potter v. Potter, 250 Md. App. 569 (2021), the Maryland Court of Special Appeals held that a provision in a limited liability company operating agreement that purports to transfer a member’s economic interest at death is not enforceable if the operating agreement was not executed consistent with the formalities required for the execution of a will.  This is a noteworthy decision that has significant ramifications for how membership interests in limited liability companies can be transferred upon the death of a member under Maryland law.

     In Potter, James Potter was a member of a company named TR Steak Pasadena, LLC (the “LLC” or “TR Steak”), which was organized under the laws of Maryland.  The members of the LLC agreed among themselves who should receive an individual member’s interest upon that member’s death.  According to TR Steak’s Third Amended Operating Agreement (the “Operating Agreement”), if a member died, his or her “living trust, estate, legatee or other successor in interest” will “automatically and immediately” become a “Successor Member” as long as the Successor Member is a member of the “Permitted Group,” as defined by the Third Amended Members’ Agreement (“Members Agreement”).  The Members Agreement, however, did not include a definition of Permitted Group.  According to the Members Agreement, James’s membership interest (i.e., his right to share in the profits) transferred to his wife, Ruby Potter, and his membership voting rights transferred to two of the other members of the LLC (there were eleven members of the LLC prior to James’s death).

    Before James’s death, he separated from Ruby, and they signed a separation agreement.  The separation agreement included a general assignment and release of “any and all rights or interest which [the releasing party] now has or may hereafter acquire in the real, personal or other property of the other.”  The separation agreement also included a provision specific to the LLC, in which Ruby waived “any and all interest” in James’s membership interest in the LLC and further stated that James “shall maintain his shares/membership interest[ ] . . . free and clear of any rights, title or interest” that could be asserted by Ruby.  James, however, never changed his designation of Ruby as the transferee of his membership interest.  James later married Denise, and he died intestate (i.e., without a will).  

    As the personal representative of James’s estate, Denise identified James’s membership interest in the LLC as an estate asset.  Ruby later filed a declaratory judgment action against Denise, asserting that she was entitled to James’s membership interest because she was identified as the transferee of James’s interest.  Denise in turn argued that the Operating Agreement (and Members Agreement) could not govern as a matter of law because they were not executed consistent with the requirements of MD. CODE EST. & TRUSTS § 4-102 (the “Statute of Wills”).  The Circuit Court of Maryland for Anne Arundel County granted summary judgment to Ruby and found the operating agreement provision was enforceable.  The personal representative (i.e., Denise) appealed.

      On appeal, the Court of Special Appeals started its analysis by noting that “property” as that term is defined in the Maryland Estate and Trusts Article includes any interest that a decedent has in real or personal property “which does not pass, at the time of the decedent’s death, to another person by the terms of the instrument under which it is held, or by operation of law.”  Denise contended that under Maryland law, with few exceptions, a document that purports to pass title to property at the owner’s death must comply with the Statute of Wills in order to be effective.  The Court of Special Appeals agreed with Denise’s contention that what renders a document testamentary is its effect, not its form or the parties’ intent.  The Court of Special Appeals found Denise’s argument “straightforward” in that the intended effect of the Operating Agreement and related Members Agreement was to transfer ownership of property upon the death of a member, which necessarily made the Operating Agreement and related Members Agreement testamentary in nature and, therefore, required compliance with the Statute of Wills.

    Ruby argued in response that the definition of “property” excluded James’ membership interest in the LLC because it passed to her at the time of his death “by the terms of the instrument under which it was held.”  In the alternative, Ruby argued that the Maryland Limited Liability Company Act “expressly permits members . . . to agree that the membership agreement can control the disposition of a member’s interest upon the member’s death.”  Ruby contended that adoption of Denise’s position would by contrary to Maryland’s policy that promotes the “freedom to contract” that was expressly authorized in the Limited Liability Act.  

     The Court of Special Appeals rejected Ruby’s interpretation of the term “property” as being contrary to legislative history and case law.  As a result, the court determined that James’s interest in the LLC was an interest in “property” that was subject to the Statute of Wills.  The Court of Special Appeals devoted several pages to analyzing the relevant history and case law, but, for the sake of brevity, a summary of that analysis will not be included here.  

     The Court of Special Appeals also rejected Ruby’s argument that relied on the express provisions of the Limited Liability Company Act.  The court noted that the statute provides, “[u]nless otherwise provided in this title, the policy of this title is to give the maximum effect to the principles of freedom of contract and to the enforceability of operating agreements.”  The court further noted that another provision of the Limited Liability Company Act provides members of a limited liability company may “[m]ake and alter operating agreements not inconsistent with its articles of organization or with the laws of this State.” (emphasis added by the Court of Special Appeals).  The court then noted that Ruby also relied on a provision of the Limited Liability Company Act that provides, “[u]nless otherwise agreed, a person ceases to be a member of a limited liability company upon the occurrence of . . . death.”  Although James ceased being a member of the LLC upon the occurrence of his death, by the terms of the Operating Agreement, his membership interest passed at the time of his death to his “living trust, estate, legatee or other successor in interest.”  The court explained this contractual provision could not be inconsistent with the laws of Maryland because the laws of Maryland deem a contract that attempts to transfer title to property upon the death of a person to be testamentary in nature unless it is both irrevocable and based on a present legal obligation whose performance is deferred during the decedent’s lifetime.  In this case, James had the absolute right to change his designation of his successor at any time and his designation of Ruby did not arise out of any duty that he owed to her.  Thus, the court concluded that Ruby did not have the right to enforce the Operating Agreement or Members Agreement, either during his lifetime or after, and, furthermore, the provisions that called for the membership interest to pass to the successor in interest upon James’ death were unenforceable, at least with respect to James, because they were not executed in accordance with the Statute of Wills.

     The Court of Special Appeals decision in Potter is noteworthy because it has significant ramifications on how membership interests in limited liability companies can be transferred upon the death of a member under Maryland law.  This decision has the potential to affect Maryland limited liability companies as well as limited liability companies organized under the laws of other states if one or more members are subject to Maryland’s Statute of Wills.  It also should be noted that the decision may be revisited in the future, as the case was appealed to the Court of Appeals (Maryland’s highest court), but the parties dismissed the appeal before oral argument.