The Use of LLCs in Structuring Transactions

1. The Use of LLCs in Structuring Transactions July 23, 2008 John R. Heronimus, Esq.

2. Replacing Joint Ventures • Simple Question posed by Lee Reichert circa 1999: • “Hey John, what’s a Joint Venture? Do a little research if you have the time.”

3. Replacing Joint Ventures • What is a Joint Venture? • Special combinations of two or more persons for a specific undertaking, in which a profit is jointly sought without any partnership designation as such and without intent to pursue a general or continuing business. - Rabkin and Johnson (Legal Forms with Tax Analysis)

4. Replacing Joint Ventures • No, seriously, what is a Joint Venture? • A legal entity in the nature of a partnership engaged in the joint undertaking of a particular transaction for mutual profit. An association of persons or companies jointly undertaking some commercial enterprise; generally all contribute assets and share risks. It requires a community of interest in the performance of the subject matter, a right to direct and govern the policy in connection therewith, and duty, which may be altered by agreement, to share both in profits and losses. -Black’s Law Dictionary

5. Replacing Joint Ventures • Do you have a shorter version? • An enterprise undertaken by several persons jointly to engage in a common plan or project for their mutual benefit with a sharing of capital, skill and effort. - Glover & Wasserman (Partnerships, Joint Ventures & Strategic Alliances)

6. Replacing Joint Ventures • Now for something completely ironic… • The most common definition is a business venture that involves two or more entities working together to achieve mutually agreed upon business objectives. To the extent companies desire to structure their relationship as a separate legal entity, that entity typically is referred to as a "joint venture." - Fogler & Reichert (circa 2002)

7. Replacing Joint Ventures • How about in 10 words or less? • Isn’t it just a general partnership for a specific purpose? - My Dad

8. Replacing Joint Ventures • A Brief History: General Partnership • A writing NOT needed to form. • Joint ownership of assets. • Share profits and losses. • Joint and several liability. • Ongoing business.

9. Replacing Joint Ventures • A Brief History: General Partnership • In the beginning… • As early as 476 A.D., groups of Saxon miners in Western Europe owned and operated Saxon mines together and financed their enterprises with individual capital contributions from the miners or periodic assessments from the miners in relation to production. • If a Saxon miner failed to pay his initial capital contribution or periodic assessment when called for, his name was permanently struck from the list of owners unless he paid within four days.

10. Replacing Joint Ventures • A Brief History: General Partnership • Cost-Book System Develops • The primitive Saxon miner form of business was later formalized in England by copper and tin miners. • Because capital was scarce and there were many shareholders, more detailed records were needed. • A manager was appointed to manage the mine and keep meeting minutes and financial records in a “cost-book.”

11. Replacing Joint Ventures • A Brief History: General Partnership • Note the legal concepts developing early on: • Capital contributions from Saxon miners to the enterprise. • Capital calls or assessments against Saxon miners to fund the enterprise. • Appointment of managers to run the cost-book enterprise. • Keeping of minutes and financial records in the cost-book system.

12. Replacing Joint Ventures • A Brief History: General Partnership • Codified Framework: • English courts began to recognize common law partnership principles. • First statutory framework was England’s Partnership Act of 1890. • Adoption of Uniform Partnership Act of 1914 across the U.S. • Revised Uniform Partnership Act of 1994 in U.S. • Refined in Colorado by Uniform Partnership Act of 1997.

13. Replacing Joint Ventures • A Brief History: Mining Grubstake Contract • Common in Western American gold mining history in the mid 1800s. • Investor supplies food and supplies (or “grub”) to a gold prospector in exchange for a share (or “stake”) in any gold that was found. • If gold is found and a claim is staked, the investor and prospector jointly owned the claim as tenants in common.

14. Replacing Joint Ventures • A Brief History: Mining Grubstake Contract • Note similarities to General Partnership: • Writing not needed to form • Joint ownership of the claim once located • Generally share profits and losses • But note as well, introduction of certain limitations on losses. In contrast to a General Partnership, investor and prospector each bear their respective losses. • But NOT a General Partnership. Could become a Mining Partnership if the investor and the prospector work the claim together in an ongoing enterprise after it is located.

15. Replacing Joint Ventures • A Brief History: Mining Partnership • In Smaller v. Leach (1957), the Colorado Supreme Court compared a Mining Partnership to a Grubstake Contract: • “The line of demarcation between the ordinary ‘grubstake’ contract and a mining partnership is sometimes difficult to determine. Generally, it may be said that if the agreement extends beyond the discovery and location [of a claim], and contains a stipulation for exploiting and developing [a claim], a mining partnership arises when actual work commences.”

16. Replacing Joint Ventures • A Brief History: Mining Partnership • Mining Partnerships are similar to General Partnerships: • Writing not needed to form. • Joint ownership of assets. • Share profits and losses.

17. Replacing Joint Ventures • A Brief History: Mining Partnership • However, Mining Partnerships were adapted to meet the needs of miners and therefore introduce some key differences: • Generally, if a partner leaves a General Partnership, the General Partnership dissolves. Miners did not want to go through a dissolution process every time a mining partner died, went into bankruptcy, or transferred his interest. Therefore, these interruptions do not dissolve a Mining Partnership.

18. Replacing Joint Ventures • A Brief History: Mining Partnership • Key distinction between Mining Partnerships and General Partnerships: • Since a mining partner may freely transfer his interest in the mining partnership to a third party without dissolving the mining partnership, mining partners do not have the general partners’ implied authority to bind each other unless it is necessary to the mining partnership. • Therefore, a certain limitation of liability concept is introduced because a mining partner is less at risk to be liable for other mining partner actions. • Mining Partnership limited to specific undertaking as opposed to an ongoing business (the mining operation).

19. Replacing Joint Ventures • A Brief History: Summary • As business enterprises developed from the early first century through the twentieth century, key legal concepts were introduced to meet new business needs: • Capital contributions from Saxon miners to the enterprise. • Capital calls or assessments against Saxon miners to fund the enterprise. • Appointment of managers to run the cost-book system. • Keeping of minutes and financial records in the cost-book system. • Limitations on losses in grubstake contracts. • No automatic dissolution of mining partnership. • Freely transferable interest in mining partnership. • Limited authority to bind other partners in a mining partnership. • Certain limitations on partner liability in a mining partnership.

20. Replacing Joint Ventures • So what is a Joint Venture? • Historically it has been termed a “joint adventure”. • It has been used by various courts and commentators alike as a synonym for many kinds of entities and business relationships: • In a 1959 Wyoming Supreme Court Case the terms “grubstake” and “joint adventure” were used interchangeably. • A 1950 law review article noted that “The search for the historical development of joint ventures as a legal concept is intriguing and elusive.” NO KIDDING

21. Replacing Joint Ventures • So what is a Joint Venture? • Similarities to General Partnership: • Do not need writing to form. • General sharing of profits and losses. • Joint and several liability. • Differences from a General Partnership: • Limited to a specific undertaking. • Joint ownership of assets NOT needed. • Must have joint operation of the venture business.

22. Replacing Joint Ventures • So why use a Joint Venture? • In practice, there is very little reason to. Limited liability companies can be used to achieve better results in virtually every circumstance because they can be formed to include many of the good components of the historical ways of doing business, and can keep out many of the bad.

23. Replacing Joint Ventures • How is an LLC formed? • File Articles of Organization with the Secretary of State. • Complete basic organizational tasks: • Organizational meeting/consent to elect managers, appoint officers, issue membership interests in return for capital contributions, etc. • Fund LLC bank account. • Apply for E.I.N. • Enter into Operating Agreement.

24. Replacing Joint Ventures • What are the main benefits of using LLCs? • Limitation of liability for members. • Accepted tax pass-through treatment. • Flexibility. • In Colorado, almost all statutory requirements of formation can be modified by the Operating Agreement. The purpose is stated in C.R.S. 7-80-108(4): • “It is the intent of this article to give maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.”

25. Structuring Transactions: Real Estate Development Model Manager and Sole Member

26. Structuring Transactions: Real Estate Development Model • Signature Block for Development North, LLC: Development North, LLC,a Colorado limited liability companyBy: Developer Entity, LLC, a Colorado limited liability company, its Manager By: Joe Developer, Manager

27. Structuring Transactions: Real Estate Development Model • Land Banks: • Some Real Estate Developers will set up separate unaffiliated entities to serve as “land banks” whose sole purpose is to hold raw ground prior to development. • When ready for development, there is a sale from the land bank to the development company and capital gains are realized for a portion of the proceeds as opposed to ordinary income in the hands of the developer.

28. Structuring Transactions: Mining Industry Model • Players: • One group has the knowledge, mining claims, and data. (In the old grubstake contract, they would have been the prospector). • One group has the money to finance exploration and development. (In the old grubstake contract, they would have been the investor.)

29. Structuring Transactions: Mining Industry Model Jim Jon Lara Lisa Prospector, LLC, a Colorado limited liability company Investor, Inc., a Colorado corporation 40% 60%** ShowMeTheMoney, LLC, a Colorado limited liability company Claims Surface Lease, Surface Use Agreement, Water Permits, DEQ Permit **Note: Investor Inc. 60% held in escrow pending full purchase of 90%.

30. Structuring Transactions: Mining Industry Model • War Story 1: Those Crazy Australians • In transaction similar to previous chart, Australians and local counsel insisted on setting up as Joint Venture. • I said “Why?” • Answer: “Because that’s what we always use.” • Had to modify the Australian law firm form Joint Venture Agreement to be a Colorado limited liability company operating agreement to keep them happy.

31. Structuring Transactions: Mining Industry Model • War Story 2: HOA with a Big Asset. • HOA finds out it owns a big mineral asset it didn’t realize it had. • HOA is a nonprofit corporation subject to the rules of CCIOA. • How do we sell big mineral asset and realize as much income as possible for members of POA? • Why, we form an LLC of course!

32. Structuring Transactions: Mining Industry Model HOA Members HOA Members HOA, Inc., a Colorado nonprofit corporation HOA, Inc., a Colorado nonprofit corporation Economic Members Voting Member Mineral Asset New LLC, a Colorado limited liability company Mineral Asset

33. Closing Comments • What do you do if a crazy Australian insists on using a Joint Venture? • Say this: • “So if I understand you correctly…for this transaction you’d essentially like to achieve the investor/prospector relationship of a traditional Grubstake Contract, including limitations on certain losses found therein, yet you’d like the enterprise to continue beyond the exploration and location phase and achieve a way to limit the authority of the members to bind other members as found in a Mining Partnership.” “Well…yes.” • “Will we need to have managers or officers running the operation similar to the old English cost-book system?” “Well, I suppose so, yes.” • “O.K., most importantly, do you want to limit the liabilities of the members?” “If possible, of course!” • “Then have I got an entity for you. Let me tell you about the Limited Liability Company…”