LLC Operating Agreement with Arbitration Was Postnuptial Agreement
In this consolidated divorce action, an LLC operating agreement with an arbitration provision was found to be a postnuptial agreement affecting a spouse’s separate property. The after-marriage property transactions that took place in this case involved a limited liability company, two irrevocable trusts, and one revocable trust.
The spouses were married in 1982. The wife was independently wealthy with two children from a previous marriage. In 1987, she created two irrevocable grantor trusts with her children as beneficiaries. The Valer Trust was a 15-year grantor retained income trust (GRIT) funded by wife as grantor. The Josiah Trust was a 20-year GRIT funded by wife, but with husband as grantor. Husband was appointed trustee of both trusts in 1996.
Organization of the Limited Liability Company
El Coronado Holdings, LLC (ECH), was formed in 1997 with four initial members: Husband, wife, Valer Trust, and Josiah Trust. At the time, wife’s separate property brokerage account was valued at $58 million, all of which was transferred into ECH.
Under the ECH operating agreement, husband was made the sole manager. The manager could only be removed by a 2/3rds ownership interest (essentially husband could not be removed without his consent). A member’s withdrawal would be a breach of agreement allowing for damages to offset any amount distributable to the withdrawing member. The husband had sole power to determine if distributions would be made and, if so, whether they would be pro-rata or not. Lastly, all disputes not resolved through mediation would be arbitrated.
Although both spouses executed the 1997 operating agreement, wife testified that she was unaware of the contents before signing because it was “her practice to trust her husband as to signing what he put in front of her.” She was never advised on the operating agreement, or of the arbitration provision, or of the impact it would have on her property rights. Husband stated he may only have given his wife the signature page, not the document.
Creation of the Austin Family Revocable Trust
In 2000, wife signed the Austin Family Revocable Trust. First, she executed the instrument without advice on potential transmutation of her separate property into community property. Second, without advice on property transmutation in the event of divorce. And third, without the trust instrument identifying the assets to be transferred into it.
Amended LLC Operating Agreement
In 2005, husband had wife execute the signature page of an amended ECH operating agreement without giving her the full text. She did not get advice and signed the instrument. The amended operating agreement provided for the following three members: The Valer Trust, Josiah Trust, and Austin Family Revocable Trust. Husband was appointed sole manager and could not be removed without 90% of the members.
Wife Files for Arizona Divorce
Wife filed for divorce in November of 2013. The children were joined as necessary parties. The following January, husband filed a civil complaint against his wife and her children to compel arbitration under the ECH operating agreement. After consolidating the divorce and civil suit, the trial court denied husband’s motion to compel arbitration. Husband appealed.
Did Court Err in Not Applying Ordinary Contract Principals?
Husband argued that the trial court erred by failing to apply ordinary contract principals to the ECH operating agreement. Instead, the court applied the heightened standard for postnuptial agreements set forth in the Arizona Supreme Court case, In re Harber’s Estate, 104 Ariz. 79, 449 P2d 7 (1969). Harber’s Estate involved a postnuptial agreement between the spouses. In such transactions, spouses are in a confidential and fiduciary relationship with each other.
Under Harber’s Estate, married couples can divide their property presently and prospectively so long as “built-in safeguards … ensure the agreement is ‘free from any taint of fraud, coercion or undue influence; that the wife acted with full knowledge of the property involved and her rights therein, and that the settlement was fair and equitable.’” If wife attacks the transaction that divides property outside divorce or separation on grounds it was fraudulent, coerced, inequitable, or unfair, as in this instance, then she is entitled to a determination of whether the agreement is invalid as to her. Husband then has the “burden to prove by clear and convincing evidence that the agreement was not fraudulent or coerced, or that it was not unfair or inequitable.”
Is Arbitration Provision in LLC Operating Agreement Enforceable?
Is the ECH operating agreement actually a postnuptial agreement wherein Harber’s Estate applies? The arbitration provision is not enforceable if the operating agreement satisfies the requirements of a postnuptial agreement. A postnuptial agreement, or postmarital contract, is made during the marriage and defines each spouse’s property rights upon death or divorce. In its analysis, the Court of Appeals determined that the operating agreement was in actuality a postnuptial agreement:
- The agreement was between husband and wife;
- It allowed the spouses to obtain discounts on valuation of assets and tax savings upon death;
- It severely and permanently limited wife’s property rights;
- It was a significant transfer of authority to husband;
- It included potential transmutation of wife’s separate property into community property;
- It was not an arm’s length business transaction;
- The impact was no less severe than a traditional postmarital property division contract;
- And the LLC was entered into at a time when neither divorce nor separation was contemplated.
The appeals court held there was no error at trial. The ECH operating agreement was a postnuptial contract. Harber’s Estate applied, requiring husband provide clear and convincing evidence that no fraud, coercion, unfairness, or inequity occurred in the after-marriage property transaction.
Were the Children Bound By the Arbitration Provision?
The trial court did not err in concluding the children were not bound by the arbitration clause of the ECH operating agreement. The general rule is that only parties to the agreement are bound by an arbitration clause in a contract. An exception is when the arbitration provision is being enforced against a third party beneficiary who received a direct benefit from the agreement.
Although the children were third party beneficiaries, they did not receive any direct benefit from ECH that they were not already entitled to under the irrevocable trusts (GRITs). Furthermore, husband’s placing the GRITs in the ECH was detrimental to the children’s interests. Evidence at trial demonstrated that the limited liability structure was a vehicle allowing husband to take all assets for himself, to the exclusion of the children, in the event his wife predeceased him. The children’s interests in the GRITs were exposed to ECH’s creditors. And any judgment creditor of the children could obtain a charging order against ECH and intercept any ECH assets that might be paid to the children. The Court of Appeals also rejected the direct benefits estoppel doctrine.
Austin v. Austin, 2 CA-CV 2014-0134 (April 30, 2015)
For precise language, read the court’s original opinion. Legal citations omitted.
For more information about property division in Arizona divorce law, read our discussion on property settlement agreements.