Maryland Operating Agreement Does Not Take the Place of a Will

In the context of a limited liability company, practitioners often address business succession (preferably at inception) and what happens when one of the members dies or no longer wants to be a member. To address the former issue, operating agreements sometimes provide that the company will buy out the estate of the deceased member utilizing a predetermined valuation formula. Insurance is often purchased to fund the buy-out.

In a recent case from the Maryland Court of Special Appeals, however, the LLC operating agreement provided that the members could designate a successor in the event one of them dies so long as the successor is one of a predetermined group. While this would allow the members to ensure continuity to their chosen successors, it also calls into question Maryland’s testamentary and probate laws.  Like other states, Maryland requires certain things to be done when executing a will.  The question for the Court was whether the successor provision was required to comply with Maryland's statute of wills. Spoiler: The Court ruled that the membership interest was probate property and conveyed the interest to the member’s estate, not his chosen successor.  The case is Potter v Potter, and can be found here.

The facts of the case are straightforward and were not in dispute. The limited liability company operating agreement and members agreement provided that members of the company could designate a successor, who would then take the member’s interest upon the member’s death. A member so designated his wife, however, he later divorced and remarried. Although there is evidence that he no longer wanted his first wife to succeed him, he did not change the successor designation in any of the internal company documents. When the member died, his first wife and his estate (his second wife was the personal representative) both claimed the interest.

The appellate court looked at the legislative history of Maryland’s testamentary and probate law and ultimately ruled that the limited liability company interest was property subject to probate. Accordingly, any provision that would control its disposition upon the member’s death must comply with Maryland’s statute of wills. While the Court noted several specific assets excluded from this requirement, and their specific statutory provisions governing transfer on death (i.e., life insurance proceeds, transfer on death securities, payable on death accounts, etc.), it did not examine the securities exclusion. Since the successor provision was not attested to and witnessed by two or more people (as required by Maryland’s statute of wills), the Court ruled it invalid, and the membership interest went to the estate as a probate asset.

While parties to an operating agreement are generally free to contract around the default provisions, they cannot do so if the agreed upon provision conflicts with Maryland law. I would not be surprised if this case ended up in the Court of Appeals on two grounds. First, whether the statutory definition of probate property, which excepts property that passes to another “by the terms of the instrument under which it is held, or by operation of law” (Md. Est. & Trusts § 1-102(r)) applies to exclude the interest. Second, whether the LLC interest falls under the Uniform Transfer-On-Death Security Registration Act (Md. Est. & Trusts § 16-109), which would specifically exclude the interest.