Delaware Supreme Court Affirms Reformation of LLC Agreements But Reverses Award of Attorneys' Fees - Law Firm Was Working for Free
Last year the Delaware Court of Chancery reformed the cash distribution waterfall provisions of three real estate joint venture LLC agreements. Chancery also awarded attorneys’ fees to the successful plaintiff, even though the plaintiff’s law firm was not charging to represent it. The law firm was not charging because of its errors in drafting the three LLC agreements. ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Last week the Delaware Supreme Court affirmed Chancery’s reformation decision but reversed the award of attorneys’ fees. Scion Breckenridge Managing Member, LLC v. ASB Allegiance Real Estate Fund, No. 437, 2012, 2013 WL 1914714 (Del. May 9, 2013).
Background. The case involved errors in three Delaware LLC agreements that were entered into in 2007 and 2008. Each agreement was for a real estate development project, each agreement contained a distribution waterfall that allocated cash distributions in a specified order to the members, and each agreement contained the same error in the scheme of distributions. The errors originated in draft agreements prepared by the investors’ law firm.
The errors would have benefited the real estate developer at the expense of the investors, if enforced. The developer knew of the mistake but kept silent, and the investors did not notice the errors and signed the agreements. Eventually the mistakes came to light, but the developer contended there was no mistake. The investors put their law firm on notice of a malpractice claim and sued the developer to reform the LLC agreements to correct the mistake. The investors’ law firm agreed not to charge for representing them in the lawsuit. Scion Breckenridge, 2013 WL 1914714 at *5.
For a more detailed summary of the facts and a review of the Court of Chancery’s analysis, see my 2012 post here and Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog here.
Reformation. In the course of affirming the Chancery Court’s grant of reformation, the Supreme Court clarified prior Delaware case law on two points.
Failure to Read the Contract. The developer argued that failure to read a contract bars a claim for reformation. ASB, the advisor to the investors, had approved the first of the three incorrect LLC agreements based on an internal review and memorandum which summarized the deal terms as agreed upon in the parties’ preliminary emails, not as they were memorialized in the detailed LLC agreement. ASB’s president had relied on the internal review and had reviewed parts but not all of the final agreement. He acknowledged in his testimony that the error was obvious once it was pointed out. The two subsequent agreements were based on the first incorrect agreement and contained the same mistake, which the investors failed to recognize.
The Supreme Court recognized that prior Delaware cases were unclear on whether a negligent mistake, such as failure to carefully read a contract, should bar reformation. To resolve the confusion, the court adopted the standard in the Restatement (Second) of Contracts: “[a] mistaken party’s fault in failing to know or discover the facts before making the contract” will not bar a reformation claim “unless his fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.” Restatement (Second) of Contracts§ 157 (1981). The court expressly overruled prior Delaware cases to the extent inconsistent with this standard.
The court also noted that the rule is different when a party seeks to avoid or rescind a contract. A party cannot seek avoidance of a contract he or she had not read before signing.
Because ASB’s president had acted in good faith and in accordance with reasonable standards of fair dealing, the court held that his failure to read the contracts did not bar the company from seeking reformation of the agreements.
Unilateral Mistake. The developer argued that a unilateral mistake by one party, coupled with knowing silence by the other party, is not enough to support reformation. The Supreme Court recognized that prior Delaware case law was contradictory on whether reformation based on unilateral mistake requires something exceptional beyond the other party’s knowing silence, such as fraud or trickery. The court relied on Cerberus Int’l Ltd. v. Apollo Mgmt., L.P., 794 A.2d 1141 (Del. 2002) and held that unilateral mistake and knowing silence by the other party are sufficient to support a reformation claim. The court ruled that other cases are overruled to the extent they impose additional requirements such as exceptional circumstances.
Ratification. The developer also argued that the investors had ratified the three mistaken agreements by various acts, including an amendment of one of the agreements. All of the alleged acts of ratification occurred before the investors learned of the error. The court affirmed the Chancery Court’s conclusion: “[R]atification does not preclude reformation unless the ratifying party actually knew of the error.” Scion Breckenridge, 2013 WL 1914714 at *9.
Attorneys’ Fees. The agreements contained an attorneys’ fee clause:
In the event that any of the parties to this Agreement undertakes any action to enforce the provisions of this Agreement against any other party, the non-prevailing party shall reimburse the prevailing party for all reasonable costs and expenses incurred in connection with such enforcement, including reasonable attorneys’ fees.
ASB Allegiance Real Estate Fund, 2012 WL 1869416 at *20.
The Court of Chancery had ruled that the investors were entitled to an award of their reasonable attorneys’ fees: “Here, the non-breaching side of the case caption litigated the dispute at significant cost, albeit a cost that DLA Piper and ASB have allocated between themselves. The contractual fee-shifting provision obligates the breaching side of the caption to bear that cost, regardless of the allocation between DLA Piper and ASB.” Id.
The Supreme Court disagreed, instead focusing on the language of the attorneys’ fee clause: “The plain meaning of ‘incurred,’ combined with ‘reimburse,’ does not extend to this situation where ASB did not incur any payment obligation because DLA Piper agreed to represent it without charge.” Scion Breckenridge, 2013 WL 1914714 at *10. Under its arrangement with the law firm, ASB was not liable for payment at any point. The court noted that an award of attorneys’ fees to ASB would either (a) result in a windfall to ASB (if ASB retained the award), or (b) if ASB passed on the fees to its law firm, “effectively reward DLA Piper for successfully litigating this reformation action to correct its own mistakes.” Id. at *11. The court therefore reversed Chancery’s award of attorneys’ fees to ASB.
ASB, however, had also sought attorneys’ fees under the trial court’s inherent equitable powers. Chancery had not ruled on that claim because it relied on the contractual fee-shifting provision.
The Supreme Court noted that trial courts have inherent equitable power to shift attorneys’ fees under recognized exceptions to the American rule that litigants generally bear their own legal fees, except under contractual or statutory rights to receive fees. The court therefore remanded the case to Chancery to consider whether ASB is entitled to attorneys’ fees under the trial court’s equitable powers.
Comment. The Supreme Court’s clarifications on reformation were useful. Its reversal of the award of attorneys’ fees, on the other hand, seems a hyper-technical and strict interpretation of the language of the attorneys’ fee clause in the parties’ agreements.
The denial of an award of attorneys’ fees seems somewhat unfair, given the gist of the parties’ fee-shifting agreement and the facts of the case – the developer’s in-house attorney knowingly let the mistake be written into the contracts and then tried to enforce the mistake. It will be interesting on the remand to see if Chancery sees fit to apply any of the equitable grounds for shifting the investors’ attorneys’ fees to the developer.
The Supreme Court’s analysis also suggests that the investors and their attorneys might have been able to structure a fee agreement that would have satisfied the investors and yet accommodated an award of attorneys’ fees. For example, they could have agreed that the law firm would be paid its customary fees, except that it would be obligated to write off its fees if the lawsuit was not successfully resolved and to the extent the award of attorneys’ fees did not cover its bill. This approach would yield the same result to the investors, who would not end up paying any net attorneys’ fees under any circumstances. And the law firm would not receive a windfall, since it would be owed fees to the extent the court made an award.
LLCs have become the entity of choice for most new businesses, and as a result charging orders are being sought more and more frequently. A novel charging-order question came up recently when the Ohio Court of Appeals was faced with an objection to a charging order against a physician’s member interest in a medical LLC. FirstMerit Bank, N.A. v. Xyran, Ltd., No. 98740, 2013 WL 1183340 (Ohio Ct. App. Mar. 21, 2013).
Background. In May 2010 FirstMerit Bank obtained a judgment against neurosurgeon Bhupinder Sawhny on his guaranty of a promissory note. The bank garnished Sawhny’s wages, and Sawhny later left his employer and opened his own business, The Center for Neurosurgery, L.L.C.
FirstMerit then filed a motion with the trial court for a charging order against Sawhny’s member interest in The Center. The court granted the motion without a hearing.
Charging Orders. Ohio’s LLC Act gives a judgment creditor of an LLC member the right to obtain a charging order against the member’s LLC interest, for payment of the unsatisfied amount of the judgment. Ohio Rev. Code § 1705.19. A charging order gives the judgment creditor only the rights of an assignee, meaning that any distributions by the LLC that would otherwise go to the member must instead be paid to the creditor. The creditor is not admitted as a member, has no right to participate in management of the LLC, and cannot force the LLC to make any distributions. In 2012 Ohio amended its LLC Act to clarify that a charging order is a judgment creditor’s exclusive remedy to satisfy a judgment against the membership interest of an LLC member, which I wrote about, here. Most state LLC acts authorize charging orders.
Charging order issues keep coming up. In the past two years I have written about (a) whether an Illinois LLC whose member interest is being charged must be a party to the suit, here, (b) whether a judgment creditor’s charging order entitles it to quarterly financials from an Iowa LLC, here, (c) whether the holder of a charging order against a single-member Kansas LLC can assert rights to manage the LLC, here, and (d) whether the holder of a charging order against a Florida single-member LLC can foreclose on the member’s interest and take over complete ownership of the LLC, here.
Court of Appeals. Sawhny appealed the grant of the charging order. He contended that the charging order assigned his ownership interest in The Center to FirstMerit in violation of Ohio’s statute barring the unauthorized practice of medicine, Ohio Rev. Code § 4731.41. He also argued that The Center’s operating agreement did not permit him to assign his member interest to anyone who is not a licensed physician in Ohio.
The court’s analysis ran as follows: Under Section 1705.19 a judgment creditor receives only “the rights of an assignee of the membership interest as set forth in section 1705.18.” “Membership interest” is defined in Section 1705.01 as “a member’s share of the profits and losses of a limited liability company and the right to receive distributions from that company.” Under Section 1705.18 an assignee is not entitled to become a member or to exercise any rights of a member, unless authorized by the LLC’s operating agreement, and therefore FirstMerit had no right to manage the Center. The court concluded that the charging order merely allowed FirstMerit to garnish Sawhny’s financial interest in The Center, and therefore did not allow the unauthorized practice of medicine or violate The Center’s operating agreement. FirstMerit Bank, 2013 WL 1183340 at *1.
Sawhny also argued that the trial court violated his constitutional rights to due process by failing to hold a hearing on FirstMerit’s motion for a charging order. Id. But, said the Court of Appeals, Sawhny’s brief failed to set forth a legitimate basis for opposing the charging order, because the only objections raised were those relating to the unauthorized practice of medicine and the prohibition in the LLC’s operating agreement. Id. at *2. Both of those issues had been resolved by the court in the first part of its opinion, and there was no reason for an evidentiary hearing. Id.
Sawhny’s ownership of his member interest in The Center had already been established at a debtor’s examination. In Ohio an examination of a judgment debtor takes place pursuant to a court order requiring the debtor to appear and answer concerning his property, in front of the judge or a referee appointed by the judge. Ohio Rev. Code § 2333.09.
The court affirmed the trial court’s grant of the charging order.
Comment. The court’s ruling on the unauthorized practice of medicine issue seems right, given the lien-like nature of a charging order and the limitations on the charging order. Statutes barring the unauthorized practice of medicine are intended to prevent non-physicians from controlling how physicians practice. The holder of a charging order is not admitted as a member and does not have the right to vote or participate in management, so FirstMerit’s charging order could not control how Sawhny practiced medicine.
Two weeks ago Montana joined the nine other states that have authorized series LLCs. Montana Governor Steve Bullock signed House Bill 362 on April 12, 2013, amending the Montana LLC Act to authorize series LLCs, effective October 1, 2013.
Series LLCs. A series LLC is a type of LLC that can be used to partition an LLC’s assets and members into separate cells, each of which is called a series. Each series can have its own designated members and managers, and each can own its assets separately from the assets of the LLC or any other series. Each series can enter into contracts in its own name, and sue and be sued separately from the LLC or any other series. The liabilities of each series will be enforceable only against the assets of that series.
Series LLCs are promoted as a way of avoiding the costs and inefficiencies that result from using multiple LLCs. For example, an owner of multiple real estate parcels could place each parcel in a separate series in one LLC, instead of using multiple LLCs. There would then be only one annual filing fee and only one operating agreement, yet any liabilities from the operations of any parcel would not be enforceable against the other parcels.
Other States. The states have not exactly been jumping on the bandwagon for series LLCs. It’s more like a slow-moving wagon train. Other than Montana, nine states have authorized series LLCs, beginning with Delaware in 1996 and most recently Kansas in 2012. The census is: Delaware, Illinois, Iowa, Kansas, Nevada, Oklahoma, Tennessee, Texas, and Utah. The states have authorized series LLCs by adding the appropriate provisions to their existing LLC statutes, rather than by adopting new, standalone statutes.
I have previously written about series LLCs when Texas and Kansas each passed their series LLC laws, when the IRS proposed regulations for series LLCs, and when the Securities and Exchange Commission limited the use of series LLCs for broker-dealers.
Montana. The Montana statute is similar in many respects to the Delaware Act. The records of each series must account for its assets separately from the assets of the LLC or any other series, and the articles of organization must set forth the liability limitation of each series. All documents filed with the Secretary of State must reflect not only the name of the LLC but also the names of all series of members.
There are some unusual provisions in the Montana statute. The first is a change to Section 35-8-202, which lists the items that an LLC’s articles of organization must set forth. The amendment adds a new subsection (h): “if the limited liability company has one or more series of members, the operating agreement of each series of members in writing. ” (Emphasis added.) This is the only reference in the bill to a series operating agreement, and it’s unclear what the operating agreement of a series would be. The Act’s definition of an operating agreement refers only to an agreement for the entire LLC. Mont. Code Ann. § 35-8-102(23).
It’s also odd that if the LLC has one or more series of members, then the “operating agreement of each series,” whatever that is, must be included in the articles of organization that are publicly filed with the Secretary of State. The Montana Act does not otherwise require that an operating agreement be filed with the articles of organization, with good reason. LLC operating agreements often contain detailed, private information that the members don’t want to make publicly available, such as information about the LLC’s management, members, investors, compensation, distributions, and so on. The states usually require the filing of only a streamlined document, with basic information such as the LLC’s name, address, and registered agent, in order to form an LLC. Operating agreements normally need not be filed or made publicly available.
The other issue I take with the amendment is that it does not establish whether a series has the powers of an entity, i.e., the power to own property and incur obligations in its own name, to make contracts, and to sue and be sued. Delaware, for example, clearly sets out the powers of a series: “Unless otherwise provided in a limited liability company agreement, a series established in accordance with subsection (b) of this section shall have the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interest, and sue and be sued.” Del. Code Ann. tit. 6, § 18-215(c).
The Montana amendment contains one provision that may have been intended to address the powers of a series. Current Section 35-8-107 of the Montana LLC Act sets out the powers of an LLC, and the amendment adds a new subsection (2): “This section [i.e., the list of an LLC’s powers] applies to a limited liability company that has one or more series of members.” This language may have been intended to mean that the powers of an LLC are also the powers of a series of an LLC, but it doesn’t say that. It simply says that the powers of an LLC are not limited if it happens to have one or more series of members.
Comment. Series LLCs have not become widely used. In some respects series LLCs are a solution looking for a problem. There are many unresolved legal questions about series LLC issues, such as bankruptcy, taxation, liability limitations, and piercing the veil, and corporate lawyers are leery of using them. Professor Goforth has provided a good discussion of these issues in Carol Goforth, The Series LLC, and a Series of Difficult Questions, 60 Ark. L. Rev. 385 (2007).
In 2011 Ott v. Monroe threw a monkey wrench into the transferability of Virginia LLC member control interests. The Virginia Supreme Court ruled that a member’s control interest is not transferable on the member’s death without the consent of the other members, notwithstanding provisions in the LLC’s operating agreement allowing such a transfer. Ott v. Monroe, 719 S.E.2d 309 (Va. 2011). The Virginia LLC Act was recently amended to change that result.
The case involved a two-member LLC. The 80% member, Admiral Dewey Monroe, Jr., died and bequeathed his interest to his daughter, Janet Monroe. After the will was probated, Janet called a member meeting and voted her 80% to substitute herself as the manager of the LLC. The other member objected and a lawsuit ensued.
Section 2 of the LLC’s operating agreement appears to allow a member to transfer the member’s ownership by will without consent of the other member:
Except as provided herein, no Member shall transfer his membership or ownership, or any portion or interest thereof, to any non-Member person, without the written consent of all other Members, except by death, intestacy, devise, or otherwise by operation of law.
Id. at 310. The trial court, however, ruled that the deceased member was dissociated upon his death by operation of the LLC Act, and that therefore only the deceased member’s economic rights, i.e., his rights as an assignee, survived to be inherited. Section 13.1-1040.1(7)(a) of the LLC Act lists a number of events, including the death of a member, that will cause the member’s dissociation unless otherwise provided in the articles of organization or operating agreement.
Supreme Court. Janet argued that Section 2 of the operating agreement superseded Section 13.1-1040.1(7)(a). But the court pointed out that Section 2 does not explicitly address statutory dissociation and does not state an intent to supersede that section, and concluded that therefore “[Section 2] lacks specific language that would constitute an exception to the rule of dissociation set forth in Code § 13.1-1040.1.” Id. at 312. The decedent was therefore dissociated on his death, and Janet “became a mere assignee by operation of Code § 13.1-1040.2, entitled under Code § 13.1-1039 only to his financial interest.” Id.
The court then went further, and stated that “[e]ven if Paragraph 2 had superseded dissociation under Code § 13.1-1040.1, it is not possible for a member unilaterally to alienate his personal control interest in a limited liability company.” Id. The court reached that conclusion because of the structure of Section 13.1-1039:
A. Unless otherwise provided in the articles of organization or an operating agreement, a membership interest in a limited liability company is assignable in whole or in part. An assignment of an interest in a limited liability company does not of itself dissolve the limited liability company. An assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member. Such an assignment entitles the assignee to receive, to the extent assigned, only any share of profits and losses and distributions to which the assignor would be entitled.
The court pointed out that the phrase “unless otherwise provided in the articles of organization or an operating agreement” applies only to the first sentence. Therefore, said the court, the operating agreement could not alter the last two sentences’ prohibition on transfers of control. “Thus it was not within Dewey’s power under the Agreement unilaterally to convey to Janet his control interest and make her a member of the Company upon his death because the Agreement could not confer that power on him.” Id. at 313. Janet could only become a member if the other, remaining member approved her admission. Va. Code Ann. § 13.1-1040(a).
Surprisingly, the court omitted any consideration of Section 13.1-1001.1(C), which requires the LLC Act to be construed so as to give maximum effect to the principles of freedom of contract and of enforcing operating agreements. And, other than a passing reference in its initial review of the background, the court also omitted consideration of Section 13.1-1040(a), which states that, except as provided in the LLC’s articles of organization or operating agreement, an assignee may become a member only by the consent of a majority of the members or managing members. That section seems to allow operating agreements, such as the operating agreement for Janet’s LLC, to provide for certain classes of assignees to receive control rights along with economic rights.
The Amendment. The Virginia Bar Association sponsored Senate Bill 779, which was passed by both houses of the General Assembly and signed by Governor McDonnell, effective July 1, 2013:
§ 13.1-1039. Assignment of interest.
A. Unless otherwise provided in the articles of organization or an operating agreement, a membership interest in a limited liability company is assignable in whole or in part. An assignment of an interest in a limited liability company does not of itself dissolve the limited liability company.
An Except as provided in subsection A of § 13.1-1040, an assignment does not entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights of a member. Such Unless otherwise provided in the articles of organization or an operating agreement, such an assignment entitles the assignee to receive, to the extent assigned, only any share of profits and losses and distributions to which the assignor would be entitled.
(Changes in bold and italics.) The amendment clarifies that an LLC’s operating agreement can allow an assignee of a member’s interest to also receive the associated control rights, or in other words to allow the assignee to automatically be admitted as a member. The report of the Virginia Bar Association and the legislative summary indicate that the measure is intended to overturn Ott v. Monroe’sholding limiting the transferability of an interest in an LLC.
This is a welcome amendment, and it puts Virginia in line with most if not all other states’ provisions regarding the primacy of an LLC’s operating agreement and its power to control and define which types of assignments will result in the assignee receiving control rights and being admitted as a member.
Last fall the Delaware Supreme Court surprised many corporate lawyers when it declared that whether the Delaware LLC Act imposes fiduciary duties on LLC managers is an open question. Gatz Props., LLC v. Auriga Capital Corp., 59 A.3d 1206, 1218 n.62 (Del. 2012).
Prior to Gatz, most Delaware lawyers believed that Delaware LLC managers were subject to fiduciary duties, absent contrary provisions in the LLC agreement. The Delaware LLC Act does not explicitly say that, but it’s implied in Section 18-1101(c):
To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement ….
(Emphasis added.) There was also case law from the Court of Chancery, most notably the Chancery opinion in the Gatz case: Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 839 (Del. Ch. 2012). The Chancery opinion comprehensively explained how and why the Delaware LLC Act applies fiduciary duties to LLC managers. I discussed that decision here.
The Supreme Court affirmed the judgment of the Court of Chancery, but it did so by relying only on the LLC agreement’s contractual provisions for fiduciary duties. The court rebuked the Court of Chancery for unnecessarily expounding on the statute’s interpretation, since deciding whether the LLC Act imposed fiduciary duties was not necessary to resolve the dispute. The Supreme Court declared that Chancery’s “statutory pronouncements must be regarded as dictum without any precedential value.” Gatz, 59 A.3d at 1218.
The Supreme Court’s opinion in Gatz was startling and generated a lot of commentary. I discussed it here. Not only did it reveal a gaping hole in Delaware’s LLC law, it also reflected some tension in the relationship between the Supreme Court and the Court of Chancery.
The Fix. Recognizing that the LLC Act may be ambiguous on whether fiduciary duties apply to LLC managers, the Supreme Court suggested that the Delaware State Bar Association “may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.” Id. at 1219.
And lo, it is happening. The Corporation Law Section of the Delaware State Bar Association has approved proposed legislation which is now awaiting the Bar Association’s final approval. Approval is expected by the end of this month, after which the proposal presumably will be introduced as a bill in the Delaware General Assembly. It would then proceed through the legislative process, and if all goes well will be passed by the legislature and signed into law by Governor Markell. Given the importance of predictable rules to Delaware’s prominence in the world of corporate law, I think it likely that this proposal will be adopted relatively soon.
The proposed amendment would add 11 words to the LLC Act. Section 18-1104 would be modified to read as follows (the new language is underscored):
In any case not provided for in the chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.
The Synopsis to the proposed bill elaborates on the amendment:
Section 8. The amendment to Section 18-1104 confirms that in some circumstances fiduciary duties not explicitly provided for in the limited liability company agreement apply. For example, a manager of a manager-managed limited liability company would ordinarily have fiduciary duties even in the absence of a provision in the limited liability company agreement establishing such duties. Section 18-1101(c) continues to provide that such duties may be expanded, restricted or eliminated by the limited liability company agreement.
Comment. This is an intriguingly short insert to the statute. In one sense it says nothing, because the current language – “the rules of law and equity” – would normally be read to mean all the rules of law and equity. If the rules of law and equity include the rules relating to fiduciary duties, then why the insertion?
Sometimes lawyers will use a phrase in contracts – “including, for the avoidance of doubt” – as a way of clarifying the purpose of an “including” clause. That thinking may be behind the proposed revision, i.e., it may be intended to eliminate any doubt whether fiduciary duties are included in the statute’s reference to “the rules of law and equity.”
Chancery’s opinion in Auriga Capital characterized fiduciary duties as originating in equity, and the proposed amendment’s emphasis on equitable rules can be viewed as a nod to the Chancery Court analysis.
Veil-piercing law varies widely from state to state, and a recent Maryland case is an example of the member-protective end of the spectrum. Its requirement for a showing of fraud in order to pierce an LLC’s veil creates a high hurdle for a plaintiff wishing to pierce the veil and impose liability on an LLC’s member. Serio v. Baystate Props., LLC, 60 A.3d 475 (Md. Ct. Spec. App. Jan. 25, 2013).
An LLC will normally shield its members from personal liability for the company’s debts and obligations. That liability shield is not impenetrable, though, and can sometimes be pierced in court by the company’s creditors. When an LLC’s veil is pierced, the LLC’s separate entity status is disregarded and the company’s creditors can assert their claims not only against the LLC but also against the members personally.
Veil-piercing claims in lawsuits are common for two reasons. One is that often the LLC has few or no assets and cannot satisfy a judgment if the plaintiff wins its case. The other is that veil-piercing law in many states is unclear and unpredictable, which increases the likelihood of a plaintiff adding a veil-piercing claim in hopes of increasing its ability to collect on a judgment.
Facts. Baystate Properties, LLC contracted in 2006 with Serio Investments, LLC to build homes on two lots owned by Vincent Serio, the sole member of the LLC. The contract required Serio Investments to provide an escrow account from which Baystate was to be paid according to a draw schedule. Baystate also was to be paid an additional $25,000 upon the sale of each of the homes.
Payments to Baystate slowed and Baystate received none of the sale proceeds when the two homes were sold. In 2007 Baystate sued both Serio Investments and Vincent Serio for the amounts owing on the construction contract. After a bench trial in 2009, the court found for Baystate on its breach of contract claim, pierced the veil of Serio Investments, and entered judgment against Vincent Serio individually.
According to the trial court, the evidence did not support a finding of fraud but was sufficient to establish a paramount equity, and there would be an inequitable result if the corporate veil was not pierced. Id. at 484. The trial court based its conclusion on findings that (i) Serio individually owned the two lots that were the subject of the construction contract; (ii) Serio gave assurances to Baystate about impending sales of the lots; (iii) Serio lied about the sale and settlement of the first lot; (iv) Serio Investments had significant debts and no income other than Serio’s deposits, and was virtually insolvent; and (v) an escrow account was never established as required by the construction contract. Id.
Court of Special Appeals. The court first noted that Section 4A-301 Maryland’s LLC Act provides that no LLC member is to be personally liable for the LLC’s obligations solely by reason of being a member of the LLC, and that Maryland law treats piercing the veil of an LLC much like piercing the veil of a corporation. Id.
According to the court, the basic rule in Maryland is that “shareholders generally are not held individually liable for debts or obligations of a corporation except where it is necessary to prevent fraud or enforce a paramount equity.” Id. at 484 (quoting Bart Arconti & Sons, Inc. v. Ames-Ennis, Inc.,340 A.2d 225 (Md. 1975)).
Perhaps as a harbinger of its eventual conclusion, the court stated: “This standard has been so narrowly construed that neither this Court nor the Court of Appeals has ultimately ‘found an equitable interest more important than the state’s interest in limited shareholder liability.’” Id. (quoting Residential Warranty v. Bancroft Homes Greenspring Valley, Inc., 728 A.2d 783, 789 n.13 (Md. 1999) ). (The Maryland Court of Appeals is the state’s highest court.)
The court looked to the analysis of the Court of Appeals in Hildreth v. Tidewater, 838 A.2d 1204 Md. 2006), which concluded that in the absence of fraud, a paramount equity could be based either on preventing evasion of legal obligations, or on the company’s failure to observe the corporate entity (the “alter ego” doctrine). Serio, 60 A.3d at 486. Hildreth indicated that the alter ego rule should be applied only with great caution and in exceptional circumstances, id., and that generally the “evasion of a legal obligation” grounds will not apply if the party seeking to pierce the corporate veil has dealt with the corporation in the course of its business on a corporate basis, id. at 488.
After reviewing the conduct of Serio Investments, the court found that it was a valid, subsisting LLC when it entered into the contract with Baystate, that the addenda to the parties’ contract were all with Serio Investments, that the payments to Baystate were made by Serio Investments, and that other documents related to the project were all in the name of Serio Investments. Baystate understood that it was doing business with Serio Investments, and there was not enough evidence of either an attempt to evade Serio Investments’ legal obligations or of disregard of the entity status of Serio Investments. “In sum, Serio Investments fulfilled the contract with Baystate until, as Serio testified, the collapse of the housing market caused problems.” Id. at 489.
The court concluded that the trial court had abused its discretion in finding Serio personally liable and reversed the trial court’s judgment.
Comment. Maryland LLC members can take comfort that the Maryland courts will not lightly pierce the veil of their LLC, even if it is a single-member LLC. I have blogged about at least 11 different veil-piercing cases, and according to my informal survey Maryland’s case law appears to be the most resistant to piercing the veil.
Serio Investments was a single-member LLC, and the court put no emphasis on that factor. Some other states appear to have been strongly influenced by the single-member character of an LLC when piercing its veil. E.g., Martin v. Freeman, 272 P.3d 1182 (Colo. App. 2012), which I blogged about, here.
The homestead exemption is important to the many debtors in bankruptcy who own their own homes. But what if the debtor owns the home through his or her single-member LLC? Is that good enough? A Bankruptcy Appellate Panel recently said no, ruling that a debtor whose home was owned by her single-member LLC could not take advantage of the homestead exemption. In re Breece, No. 12-8018, 2013 WL 197399 (B.A.P. 6th Cir. Jan. 18, 2013).
The homestead exemption prevents a debtor’s principal residence from being sold in the debtor’s bankruptcy to satisfy unsecured creditors. The amount of the exemption varies widely by state. If the debtor’s equity in the residence is more than the exemption’s limit, the residence may be sold but the debtor can then retain the exempt amount. In some states, most notoriously Florida, there is no dollar limit on the exemption.
The Facts. Monae Breece and her grandmother jointly purchased a home in Union Town, Ohio in 2004. Several months later they formed an Ohio LLC and transferred ownership of the home to their LLC. Breece’s grandmother subsequently died and Breece became the sole member of the LLC. The residence is subject to a mortgage, and Breece is personally liable for the debt secured by the mortgage. Breece has resided in the home since 2004.
In 2011 Breece filed a voluntary Chapter 7 bankruptcy and claimed a homestead exemption in her residence. The Trustee objected to Breece’s claimed homestead exemption on the basis that the property was owned by the LLC and not by Breece. The bankruptcy court disallowed the homestead exemption, and Breece appealed.
Breece’s claim of homestead exemption was based on Ohio’s exemption statute, which allows an exemption for “the person’s interest, not to exceed [$21,625], in one parcel or item of real or personal property that the person or a dependent of the person uses as a residence.” Ohio Rev. Code § 2329.66(A)(1)(b). The Bankruptcy Appellate Panel therefore had to determine whether Breece had a sufficient interest in her home to satisfy the Ohio statute.
Breece contended that her interest in the residence was sufficient because it was derivative of her interest in the LLC. For example, absent the bankruptcy filing she would be entitled to a distribution of the residence on dissolution of the LLC. Breece, 2013 WL 197399, at *3.
Court’s Analysis. The court began by examining Ohio’s LLC Act. The Act provides that an LLC is a separate legal entity and that a member’s interest in an LLC is personal property. Ohio Rev. Code § 1705.01, § 1705.17. Any real estate owned by an LLC is owned solely by the LLC, and a member has no specific interest in property owned by the LLC. Ohio Rev. Code § 1705.34.
The court then reviewed a decision from the Northern District of Ohio Bankruptcy Court that was closely on point, with very similar facts, In re Stewart, No. 09-7257 (Bankr. N.D. Ohio, Oct. 1, 2010). The arguments and the Stewart court’s conclusions were three-fold. First, the debtors (husband and wife) argued that as sole members of the Delaware LLC, they had an interest in the real estate. But the Stewart court found that under both Ohio and Delaware law, the real estate was owned by the LLC and the members had no ownership interest in the LLC’s property. Stewart, slip op. at 6.
Second, the debtors argued that they had an oral lease in the property, which qualified as an exempt interest under the Ohio statute. The court found, however, that the debtors had only a tenancy at will, which did not qualify as an exempt interest under the statute. Id. at 8.
Third, the debtors raised the alter-ego doctrine and claimed the court should disregard the separate nature of the LLC. The court said that under Ohio law the alter-ego doctrine only applies to third parties and as justice requires, and declined to apply an alter-ego construction. Id. at 11.
The Breece court agreed with the Stewart analysis: “Based on Ohio law, this Panel concludes that the bankruptcy court correctly held that [Breece’s] membership interest in [the LLC] does not bestow on her an interest in the Real Property.” Breece, 2013 WL 197399, at *5.
Breece also argued that Ohio’s homestead exemption should be construed liberally, and that the court should focus on the statute’s reference to the debtor’s use of the property: “real or personal property that the person or a dependent of the person uses as a residence.” Ohio Rev. Code § 2329.66(A)(1)(b) (emphasis added). The court was unconvinced, and found the debtor’s use and possession of the property as a residence to be a necessary but not a sufficient condition for the exemption.
Breece contended that her LLC’s ownership of the residence gave her an equitable interest in the residence. She referenced an Ohio case which had held that equitable title to the debtor’s residence was sufficient to qualify for the homestead exemption. The court pointed out that the equitable title in the earlier case was nothing more than a financing mechanism, which gave the beneficial owner the right to acquire legal title on payment of the debt, and rejected Breece’s equitable-interest argument.
Property of the Estate. The Bankruptcy Code provides that the homestead exemption only applies to property of the estate. Breece, 2013 WL 197399,at *8; see 11 U.S.C. § 522(b). “Property of the estate” is broadly defined at 11 U.S.C. § 541(a), but it does not reach further than the rights the debtor had in property at the commencement of the bankruptcy case. Breece, 2013 WL 197399, at *8.
The court again reviewed Ohio’s LLC Act, emphasized that LLC members do not own the property owned by the LLC and that LLCs are separate and distinct entities, and held that neither the residence nor any interest in the residence is property of the estate. Id. at *9. The homestead exemption therefore could not apply.
In summary, the court held that Breece did not hold an interest in her residence that qualified her for Ohio’s homestead exemption, and that Breece could not claim a homestead exemption because neither the residence nor any interest in it was property of the estate. The court rejected Breece’s homestead exemption claim and affirmed the Bankruptcy Court’s disallowance.
Comment. The court’s conclusions are admirably supported by citations to statutes and case law, but the trees appear to have obscured the court’s view of the forest.
The policies behind the Bankruptcy Code include providing debtors with a clean start and using property exemptions to avoid leaving families destitute and homeless after a bankruptcy. The bankruptcy courts recognize that exemption statutes are generally to be liberally construed in a debtor’s favor, and the Ohio Supreme Court has long recognized that exemption statutes should receive as liberal a construction as can fairly be given to them. Stewart, slip op. at 4-5.
Against that backdrop, consider that there is no other human being with any interest in Breece’s home, whether legal, equitable, direct, indirect, beneficial, or otherwise, other than the owners of the mortgage holder. Consider also that “interest” is neither defined nor limited in the Ohio homestead exemption statute. Breece obviously holds an interest of some sort in the property, whether it be characterized as inchoate or indirect. She controls the LLC and could at any time transfer legal title of the property to herself. Instead of recognizing that reality, the Breece court exalted form over substance and held that Breece had no interest in her home.
Barring further review, though, the Breece result stands. Is there a way for a homeowner to hold his or her residence in a single-member LLC and still preserve the homestead exemption? One possibility would be to execute a written lease from the LLC to the homeowner, with a definite term and some level of rent payment. Because there would be no other members in the LLC, the rent would not have to be at market.
Recall that in Stewart the debtors contended they had an interest in the property because they had an oral lease, but the court found that it was nothing more than a tenancy at will. A written lease with a definite term should normally be construed as creating a real estate interest in the property.
New York Court Says De Facto Merger Rule Not Applicable When LLC Transfers Business to an Individual
New York’s Appellate Division recently had to decide whether the “de facto merger” doctrine applied when an LLC transferred its business to a sole proprietor, i.e., to an individual person. The court concluded there could be no de facto merger because New York’s LLC Act does not authorize the merger of an LLC with an individual. Hamilton Equity Group, LLC v. Juan E. Irene, PLLC, 2012 WL 6720735 (N.Y. App. Div. Dec. 28, 2012).
The de facto merger doctrine, if applicable, allows an LLC’s creditor to assert its claims not only against the LLC but also against a successor to the LLC’s business. Under this doctrine, a court can treat the sale of a business as a merger between the buyer and seller. In that event, the buyer is liable for all obligations of the seller, even if the buyer only acquired the assets of the business and assumed none of its obligations. A number of factors are considered by the courts in determining whether a de facto merger has occurred, including continuity of ownership and management, and use by the buyer of the same assets, personnel and location. E.g., Sweatland v. Park Corp., 587 N.Y.S.2d 54 (App. Div. 1992).
Facts. Juan Irene practiced law as the sole member of Juan E. Irene, PLLC, a New York professional service limited liability company. The LLC entered into a line of credit with HSBC Bank in 2002, and defaulted on the loan in 2009. The LLC dissolved after the loan default, and Irene continued his law practice in his individual capacity at the same location where the LLC had been located. He also used a similar assumed name, “The Law Office of Juan Irene, Esq.” Personal injury cases that the LLC had been handling were transferred to Irene, and Irene conceded that the Bank had a security interest in a portion of the attorneys’ fees generated by those cases.
The Bank’s assignee brought suit on the loan against both the LLC and Irene personally. The trial court concluded that Irene was liable to the plaintiff as a “successor by merger” to the LLC, and ordered summary judgment for $124,984 against both the LLC and Irene personally. Hamilton Equity Group, 2012 WL 6720735, at *1. Irene appealed the judgment against him.
Court’s Analysis. The court began by noting that the New York doctrine of de facto merger was developed to protect shareholders and the claimants in products liability and breach of contract actions. The doctrine creates an exception to the general rule that a buyer of a company’s assets normally does not become responsible for the preexisting liabilities of the acquired company, unless it expressly assumes those obligations.
The court then examined New York’s LLC Act, which authorizes a professional service LLC to merge with another LLC, a foreign professional service LLC, or any “other business entity” formed under the laws of any state. N.Y. Ltd. Liab. Co. § 1216. “Other business entity” is defined as “any person other than a natural person or domestic limited liability company.” Id. § 102(v) (emphasis added). The court concluded that the statute’s plain language does not authorize a merger between an individual and a professional service LLC. Hamilton Equity Group, 2012 WL 6720735, at *2. (The same is true of LLCs that are not professional service LLCs. N.Y. Ltd. Liab. Co. § 1001(a).)
The court then ruled that because an LLC cannot carry out a statutory merger with an individual, the de facto merger rule could not apply when an LLC transfers its business assets to an individual. The court treated the de facto merger rule as if application of the rule would impose a merger on the parties: “Thus, even if defendant and the PSLLC desired to be merged, rather than having such merger imposed upon them by a judicially created doctrine, such a merger could not be accomplished under the Limited Liability Company Law.” Hamilton Equity Group, 2012 WL 6720735, at *2.
Finding that there was no de facto merger, the court reversed the judgment against Irene.
Comment. The court’s conclusion that people and LLCs can’t merge is completely conventional. But it is a little surprising that the court gave such short shrift to the policy behind the de facto merger doctrine. It is, after all, an equitable rule that disregards the form of a transaction in order to recognize its substance. If all the circumstances – continuity of management, continuity of ownership, the same assets, the same personnel, the same or similar name, same location, etc. – would result in treatment of the business acquisition as a “de facto merger,” why should it make a difference whether the buyer is Joe Doakes, an individual, or Joe Doakes’ single-member LLC? The doctrine should make the successor liable for the bank debt in either case.
The court did refer briefly to Tift v. Forage King Industries, Inc., 322 N.W.2d 14 (Wis. 1982), which the plaintiff had used in support of its argument, and rejected it. In Tift the Wisconsin court applied both the “amounts to a merger” rule and the “mere continuation” rule to a business acquisition where the predecessor business was a sole proprietorship, i.e., an individual. Id. at 14, 17. “[T]here is ‘identity,’ because in substance the successor business organization which the plaintiff sues is, despite organizational metamorphosis, the same business organization which manufactured the product which caused his injury.” Id. at 17. The Tift court applied Wisconsin’s version of the “de facto merger” rule and found the successor liable, even though the predecessor was an individual.
The Tift opinion makes a strong argument for disregarding the difference between an entity and a sole proprietorship when applying the de facto merger rule.
A contract that limits a corporate director’s vote is generally invalid, but not so for LLC managers. The guiding principle for LLCs is freedom of contract, unlike corporations, but that principle can clash with the principles undergirding an LLC manager’s fiduciary duties. For example, what’s the result if an LLC’s operating agreement requires that one of the LLC’s managers vote as directed by a designated member? Does that manager have any fiduciary duties? The Delaware Court of Chancery recently held that such a manager was not without fiduciary duties, even though he had no power to vote. Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. C.A. 4113-VCN, 2013 WL 764688 (Del. Ch. Feb. 28, 2013).
The plaintiffs owned units in Advance Realty Group, LLC, a Delaware LLC. Several of the plaintiffs were individuals who were executives of the LLC until their termination in 2007, and the other plaintiffs were entities owned by the individual plaintiffs. The plaintiffs raised a number of claims after their termination, but the most noteworthy was their contention that defendant Ronald Rayevich, a manager of the LLC, had breached his fiduciary duties to the LLC.
Rayevich was a member of the LLC’s managing board, which had the duty to manage the business and affairs of the LLC. He had no discretion in how to vote as a member, however, because he was required by the LLC’s Operating Agreement to follow the voting instructions of one of the LLC’s members.
The defendants moved for partial summary judgment on several of the plaintiffs’ claims, including the claim against Rayevich.
The Claim. The plaintiffs’ claim against Rayevich centered on his involvement in the managing board’s approval in 2008 of the LLC’s Conversion and Exchange Agreement (Agreement), which the plaintiffs contended negatively affected their LLC interests. The plaintiffs argued that although Rayevich had no choice in voting for the Agreement, he nonetheless violated his fiduciary duties because he failed (1) to evaluate whether the terms of the Agreement were in the best interests of the members, (2) to voice his opposition in light of the conflicts of interests involving his fellow board members, or (3) to take any steps to prevent the self-dealing of the insider defendants. Id. at *3.
Rayevich contended that he was entitled to summary judgment because (a) the plaintiffs had not overcome the presumption that he acted in good faith, and (b) even if he did breach his fiduciary duties, he was not acting willfully or in bad faith and therefore was exculpated from liability under the provisions of the LLC agreement.
The court pointed out that Rayevich is presumed to have acted on an informed basis in good faith, but said that he could not avoid liability simply by pointing out that he had no discretion to vote as a board member. Even though he could not vote, he had an obligation to consider the interests of the members and to take action to protect their interests. “[F]iduciary duties extend beyond voting. They may involve, for example, studying the proposed action, determining the appropriateness of the proposed action, setting forth a dissenting view to fellow board members, and, in the proper circumstances, informing unit holders about the potential adverse affects of a proposed action.” Id.
Procedural Posture. The court’s opinion is a ruling on the defendants’ motion for summary judgment. To prevail on a summary judgment motion the moving party must demonstrate that there is no material question of fact, and that on the undisputed facts it is entitled to judgment as a matter of law. Id. at *1. The party resisting a summary judgment motion does so either by showing that the moving party is not entitled to judgment under the law, or that the relevant facts are disputed. The parties establish the facts through affidavits submitted to the court, and there is no live testimony. A summary judgment motion can be an efficient way to resolve issues before trial.
The plaintiffs’ claim against Rayevich failed because they did not establish the facts necessary to resist his summary judgment motion. “Specific facts, as contrasted with mere allegations, are needed to resist a motion for summary judgment.” Id. at *3. The plaintiffs did not put forth facts to show Rayevich’s lack of good faith, that he was not independent and disinterested, that he was not informed about or had not considered the Agreement, or that his conduct was willful or in bad faith. Rayevich was therefore presumed to have acted in good faith and was entitled to exculpation under the LLC’s Operating Agreement, and the court ordered summary judgment in his favor on the plaintiffs’ claims.
Comment. Ross Holding points out the need for LLC managers to be proactive, and that fiduciary duties extend beyond mere voting. In the context of a multi-manager board, a manager who either has no vote or who is outvoted must be informed and give independent consideration to the proposal, and must consider expressing a dissenting view when appropriate and possibly informing the members about the potential adverse impact of a proposed action.
Illinois Court Issues Charging Orders Against LLC Member Interests When LLC Is Not a Party to the Suit
The Illinois Appellate Court was recently faced with an appeal of a trial court’s charging orders against 72 LLCs and limited partnerships (LPs), where none of the entities were made parties to the lawsuit. The Appellate Court upheld the charging orders on the grounds that the LLCs and LPs were not necessary parties because their interests were not sufficiently affected by the charging orders. Bank of America, N.A. v. Freed, 1-11-0749 et al., 2012 WL 6725894 (Ill. App. Ct. Dec. 28, 2012).
Bank of America sued the guarantors of a $205 million loan on their guaranty. Before addressing the charging orders, the court dealt with a significant contract law issue.
Nonrecourse Guaranty Carveout. The guarantors’ liability was limited to $50 million, but with a carveout that removed the limit if the guarantors contested, delayed or otherwise hindered any action taken by the lender in connection with the appointment of a receiver or foreclosure of the mortgage. The guarantors contested the Bank’s foreclosure action, and the Bank accordingly claimed that the guaranty was no longer limited and covered the full $205 million. In their appeal, the guarantors contended that the carveout provision was vague, ambiguous, overly broad, and an unenforceable penalty.
The enforceability of carveout provisions in nonrecourse or limited recourse contracts was an issue of first impression in Illinois. Id. at *9. The defendants contended that there was no connection between the additional amounts they owed as a result of the full liability provisions and any actual damages suffered by the Bank, and that accordingly the sole purpose of the carveout was to secure performance of the contract. Id. at *8.
The court concluded otherwise, reasoning as follows. First, the carveout operated principally to define the terms and conditions of personal liability, and not to fix the probable damages. Id. at *9. Second, the carveout provided for only actual damages – the lender could recover only the damages actually sustained, i.e., the amount remaining on the loan at the time of the breach. And third, the carveout did not preclude the guarantors “from contesting the appointment of a receiver or filing defenses to the foreclosure action, but by taking those actions they forfeited their exemption from liability for full repayment of the loan.” Id. at *12. The trial court’s judgment against the guarantors was affirmed.
Charging Orders. After entering judgment against the defendants in the amount of $207 million, the trial court entered charging orders against the defendants’ interests in 72 LLCs and LPs. None of the LLCs and LPs were made parties to the lawsuit. The defendants argued that the charging orders were invalid because the LLCs and LPs were necessary parties, and the court did not have jurisdiction over them. (These 72 LLCs and LPs were apparently formed under Illinois law, although the court never clarified that.)
The charging orders were entered under the authority of Section 30-20(a) of the Illinois LLC Act and Section 703(a) of the Illinois Uniform Limited Partnership Act. Both sections refer to charging orders being entered by a court having jurisdiction, and the defendants contended that the court therefore had to have jurisdiction over the LLCs and LPs. Id. at *12.
The language of the two Acts is not clear about whether the court is to have jurisdiction over the judgment debtor, the LLC, or both. For example, the LLC Act says “[o]n application by a judgment creditor of a member of a limited liability company or of a member’s transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment.” 805 Ill. Comp. Stat. 180/30-20(a) (emphasis added).
The court determined that the statute referred to jurisdiction over the judgment debtor, not necessarily the LLC, and that a charging order on a debtor’s interest in an LLC or LP does not affect the rights of the LLC or LP to the extent necessary to require that it be made a party. Bank of America, 2012 WL 6725894 at *12. For an LLC, for example, the holder of the charging order has only the right to receive distributions to which the member would otherwise be entitled. Even if the charging order is foreclosed, the holder has only the rights of a transferee. In either case the holder of the charging order will not be entitled to vote or otherwise participate in the LLC’s management or affairs. “Hence, the LLC has no interest to be protected and need not be made a party.” Id. The result is similar for an LP. The court therefore concluded that “the trial court did not err in entering charging orders against the 72 LLCs and limited partnerships even though they were not named as parties.” Id. at *13.
Comment. The LLC in a charging order scenario is not a party to the dispute between its member and the member’s creditor. The LLC is merely a potential distributor of assets to the member. (Like corporate dividends, LLC distributions are made to the members generally, per the terms of the LLC’s operating agreement.)
Given the LLC’s lack of skin in the game, and given the inability of the holder of the charging order to interfere with the management of the LLC, the court in Bank of America reached what appears to be a sensible conclusion: the LLC does not have an interest to be protected by requiring its joinder to the suit between the creditor and the member.
So what happens next? How does the Bank ensure that it will receive any distributions from the LLCs or LPs that would otherwise go to the defendants? Presumably the Bank will give formal notice of the charging order to each of the 72 LLCs and LPs. Any LLC or LP that ignores the charging order and makes a distribution to one of the defendants would appear to be liable to the Bank for the amount of the wrongful distribution, just as it would be if it erroneously sent one member’s distribution to another member.
Oregon Supreme Court Overrules Court of Appeals: LLC Manager with a Known Conflict of Interest Does Not Have Authority to Bind LLC
An LLC manager that causes its LLC to enter into a transaction where the manager has a conflict of interest can create havoc. Case in point: An Oregon LLC manager extended the term of a loan agreement between his LLCs and a borrower, but the manager was at the same time chairman of the board and treasurer of the borrower, as well as an investor in the borrower. When the LLCs’ members learned of it later, they attempted to reject the extension on grounds that, because of his conflict, the manager lacked authority to bind the LLCs to the extension.
The trial court dismissed the plaintiffs’ claims on summary judgment and the Court of Appeals affirmed. I wrote about the Court of Appeals’ decision and criticized part of its reasoning, here.
The Oregon Supreme Court reversed the Court of Appeals, holding that the manager’s conflict of interest invalidated the transaction unless the borrower could show at trial that the transaction was fair to the LLC. Synectic Ventures I, LLC v. EVI Corp., 2012 WL 6628093 (Or. Dec. 20, 2012).
The Loans. Three LLC investment funds (Synectic) loaned a total of $3 million to EVI Corporation in 2003. The written loan agreement required EVI to repay the loans by December 31, 2004, but EVI had the right to convert the loans into shares of EVI stock if it received additional financing of at least $1 million before the December 31 deadline.
The Conflict. The Synectic LLCs were managed by Craig Berkman, through entities he controlled. Berkman was involved with parties on both sides of the loans, because he was also the chairman, treasurer, and a shareholder of EVI.
The Amendment. In September 2004 Berkman executed an amendment to the loan agreement on behalf of Synectic that extended EVI’s repayment deadline one year, until December 31, 2005. He also executed a Unanimous Consent on behalf of EVI’s board of directors, which approved the amendment.
The Synectic members were not aware of the amendment at the time it was made and did not discover its existence until early 2005. Berkman was removed as manager in the meantime, in December 2004. In August 2005 the Synectic members notified EVI that the amendment was unauthorized and that EVI was in default on the loan.
EVI raised $1 million in additional investment before December 31, 2005, from another fund managed by Berkman, and purported to convert the loan into equity. The Synectic LLCs filed suit to recover on the loan agreement, based on EVI’s nonpayment as of the original due date. EVI defended on grounds that the loan amendment extended the maturity date, and that the loan had been properly converted into EVI stock.
Supreme Court. The Supreme Court began by reviewing Oregon’s LLC Act and the parties’ operating agreements. The LLCs were manager-managed, and the court concluded that Berkman was their manager and had authority under the statute and the operating agreements to cause the LLCs to enter into contracts such as the amendment to the loan agreement. The LLCs contended, however, that Berkman lacked authority to enter into this particular transaction, the amendment, because he had a conflict of interest.
The court agreed: “An agent ordinarily lacks authority to act on behalf of a principal in a transaction in which the agent has a conflict of interest.” Id. at *6. The court also observed that Berkman had a conflict of interest because as manager of the LLCs and chairman and treasurer of EVI he was acting as agent for two principals with conflicting interests. But the court then pointed out that Oregon’s LLC Act permits self-interested transactions so long as they are fair to the LLC. Id.; Or. Rev. Stat. §§ 63.155(6), 63.155(9)(b).
The court saw the fairness or lack of fairness of the amendment as a factual issue and held that “there was a genuine issue of material fact regarding whether Berkman had a conflict of interest that breached his duty of loyalty in a manner that deprived him of authority to enter into the amendment.” Id. at *7.
The defendants contended that the parties’ operating agreements permitted Berkman to act on behalf of the LLCs notwithstanding any conflict of interest. The agreements provided in Section 3.2 that “[a]ny Member … may engage independently or with others in other business and investment ventures of every nature and description and shall have no obligation to account to the Company for such business or investments or for business or investment opportunities.” Id. at *7. Berkman was referred to in the operating agreements as the “Managing Member,” and the defendants argued that he was therefore allowed by Section 3.2 to act despite his conflict of interest.
The argument that Section 3.2 exculpated Berkman from his conflict of interest was accepted by the Court of Appeals, but in my prior post I pointed out the illogic: Section 3.2 applied to members, but Berkman had a conflict while acting as a manager, not as a member. The Supreme Court likewise rejected the argument that Section 3.2 had any relevance to Berkman’s actions as a manager. Id. at *10.
The defendants also argued that under the operating agreements they were entitled to rely on Berkman’s apparent authority without making any further inquiry. The court disagreed, pointing out that because Berkman was chairman of the board and treasurer of EVI, everything he knew was imputed to EVI and it was therefore well aware of the conflict and Berkman’s resulting lack of authority. Id. at *11.
Bringing out the final arrow in their quiver, the defendants claimed that the LLCs’ seven-month delay in objecting to the amendment amounted to a ratification by silence of the unauthorized amendment. The court said that was an issue of fact, to be decided at trial. The court accordingly reversed the decision of the Court of Appeals and the trial court’s judgment, and remanded for trial.
Comment. Lack-of-authority cases often involve two innocent parties, one of whom will bear the loss resulting from the manager’s unauthorized activities. I have previously written about such cases from Missouri (members bore the loss when manager without authority caused LLC to borrow money and encumber LLC’s real estate, and then misappropriated the loan proceeds), and from Mississippi (bank bore the loss when manager without authority caused LLC to convey real estate to manager’s separate company, and then borrowed money from bank, secured by lien on the real estate).
Synectic was in some ways an easier case because it did not involve two innocent parties. The LLCs’ members were innocent because they had no knowledge of Berkman’s execution of the amendment until months afterward. But EVI was not an innocent party – Berkman’s knowledge of his conflict and lack of authority was imputed to EVI because of his role as EVI’s chairman and treasurer.
Bankruptcy Appellate Panel Says Out-Of-State Member's Interest in Nevada LLC Is Located in Nevada for Venue Purposes
It sounds like the beginning of a bad joke. An individual walks into a bar and says “Where’s my LLC?” But that was the question a Bankruptcy Appellate Panel recently had to answer. The court had to determine whether Nevada was the proper venue in an involuntary bankruptcy case. The debtor’s only connection with Nevada was that his principal assets consisted of interests in a Nevada LLC and a Nevada limited partnership. The creditor claimed that venue in Nevada was proper because the LLC and the partnership were formed under Nevada law and therefore the debtor’s interests in the companies were located in Nevada. The debtor contended that his LLC and partnership interests were located where he resided, in Washington.
The case began in 2011 when the Montana Department of Revenue (MDOR) filed an involuntary chapter 7 bankruptcy petition in Nevada against Timothy Blixseth. In re Blixseth, 484 B.R. 360 (B.A.P. 9th Cir. Dec. 17, 2012). The petition asserted that venue was proper in Nevada because Blixseth had assets in Nevada. (Venue for a bankruptcy case may be based on any of four alternatives: the debtor’s (i) domicile, (ii) residence, (iii) principal place of business in the U.S., or (iv) principal assets’ location in the U.S. 28 U.S.C. § 1408(1).)
Shortly after the petition was filed the bankruptcy court on its own initiative entered an order to show cause why venue was proper in Nevada, and expressed a concern about “the paucity of the connection between Blixseth and … the selected venue.” Blixseth, 484 B.R. at 362. MDOR responded that venue was proper in Nevada because Blixseth’s principal assets were his interests in Desert Ranch LLLP, a Nevada limited liability limited partnership, and in Desert Ranch Management LLC, a Nevada limited liability company.
Blixseth took the court’s hint and filed a motion to dismiss. He argued that venue was not proper in Nevada because he had resided in Washington since 2007, he conducted no business in Nevada, he had no place of business in Nevada, and he had no property in Nevada. He did acknowledge that his primary assets were his interests in Desert Ranch LLLP and Desert Ranch Management LLC. The LLLP owned real estate in the U.S. and abroad, and the LLC owned an interest in the LLLP and was its general partner.
The trial court concluded that intangible ownership interests, such as Blixseth’s interests in the LLLP and the LLC, have no physical location and that therefore venue based on the location of Blixseth’s assets was unavailable. The trial court also held, in the alternative, that if Blixseth’s interests in the two companies had a location it was at his residence, which was in Washington. Venue based on the location of Blixseth’s assets was therefore unavailable, and “because it was undisputed that Blixseth did not reside, was not domiciled, and did not have a principal place of business in Nevada, there was no other basis for venue in Nevada.” Id. at 364. The trial court concluded that venue in Nevada was incorrect and dismissed the petition, and MDOR appealed.
Issue on Appeal. The Bankruptcy Appellate Panel phrased the sole issue as “whether, for venue purposes under 28 U.S.C. § 1408(1), Blixseth’s principal assets, consisting of his intangible equity interests in Desert Ranch and Desert Management, were located in Nevada.” Id. at 365.
The court characterized Blixseth’s interests in the LLC and the LLLP as intangible property having no physical location – “the location or situs of intangible property is a ‘legal fiction.’” Id. at 366 (citation omitted). The court noted that the legal location of intangible property is protean: intangible property may be located in multiple places for different purposes. The court looked to the Ninth Circuit’s rule that for venue purposes the court should use a context-specific analysis and employ a “common sense appraisal of the requirements of justice and convenience in particular conditions.” Id. at 366-67 (quoting Office Depot Inc. v. Zuccarini, 596 F.3d 696, 702 (9th Cir. 2010)).
Applying the Ninth Circuit’s “context-specific” analysis, the court focused on the trustee’s duty to administer the bankruptcy estate and realize on the assets for the benefit of Blixseth’s creditors. The trustee will have the same rights as Blixseth’s creditors to realize on his interests in the LLC and the LLLP. 11 U.S.C. § 544(a)(1).
Because the LLC and the LLLP were formed under Nevada law they are governed by Nevada law, including its rules on the rights of creditors. Under Nevada law the only remedy of a judgment creditor of an LLC member or LLLP partner is to apply to a Nevada court for a charging order. Nev. Rev. Stat. § 86.401 (LLCs); Nev. Rev. Stat. § 88.535 (LLLPs).
The court found that “because Blixseth’s interests in the LLC and LLLP were created and exist under, and his creditor’s remedies are limited by, Nevada state law, that is sufficient reason to deem Blixseth’s interests to be located in Nevada.” Blixseth, 484 B.R. at 369. The court found additional support for its conclusion in the Nevada courts’ exclusive jurisdiction over judicial dissolution of the LLC and the LLLP, given that the trustee might seek the dissolution of the companies in order to reach the assets owned by each. Id. at 369-70.
The court also looked to notions of justice and convenience. The court found it disingenuous for Blixseth to argue that Nevada is not a proper venue for his creditors to pursue his interests in the two companies, given his choice to form them under Nevada law. Also, it would be more convenient for a Nevada trustee than for a trustee appointed in Washington (the venue argued for by Blixseth) to apply to the Nevada courts to obtain a charging order or request dissolution of the LLC or the LLLP. Id. at 370-71.
Accordingly, the court held that Blixseth’s interests in Desert Ranch and Desert Management were deemed to be located in Nevada, and that venue in Nevada was proper. Id. at 371.
Comment. Business people and investors who decide to form an LLC must decide which state law to form it under. Nevada is sometimes held out as a haven for the formation of asset-protection LLCs. Corporate service companies or law firms will sometimes encourage even out-of-state business startups to organize as a Nevada LLC.
The Blixseth case shows the potential for unintended consequences when picking Nevada or any other state as an LLC’s state of formation, if the LLC’s principal owner has no other connection to the state chosen. The owner can find itself litigating in the state where the LLC was formed, even though the owner does not live there, has no business activities there, and owns no other assets there. That’s usually less convenient than litigating in one’s home state.
In fact, the differences between Nevada’s LLC statute and the LLC statutes of other states are not huge. All states’ statutes protect an LLC’s members and managers from liability for the LLC’s contracts and actions, and no state’s law will protect a member from legal liability for the harm caused directly by the member. All state LLC acts are written to provide a high degree of flexibility for the members in structuring their LLC.
There are sometimes good reasons to pick a state of formation other than one’s own state, but the factors should be considered carefully, including the potential for litigation far from home.
Utah Court Says Exception from Derivative Suit Requirements for Closely Held Corporations Applies to LLCs
LLC minority members who want to sue the majority members or managers for breaches of fiduciary duty are sometimes frustrated by a catch-22 – if the LLC was the injured party then the member’s complaint must be brought on behalf of the LLC as a derivative suit, but the procedural requirements for derivative suits may bar the minority member’s lawsuit. Utah has previously recognized an exception to the derivative suit requirements for closely held corporations, and recently applied that same exception to LLCs. Banyan Inv. Co. v. Evans, No. 20100899-CA, 2012 WL 5950664 (Utah Ct. App. Nov. 29, 2012).
Banyan was a 20% member of Aspen Press Company, LLC. The other five members managed the company and Banyan was not involved in its management. Banyan filed a lawsuit against the other members for breaches of their fiduciary duties and for unjust enrichment.
The defendants asked the court to dismiss Banyan’s lawsuit on the grounds that its claims were derivative and therefore could not be brought directly against the members. The defendants argued that Banyan should have filed the claims derivatively and should have complied with Rule 23A of the Utah Rules of Civil Procedure, which requires certain procedures for a derivative suit.
Rule 23A (and comparable rules from most other states) addresses the following problem. When a corporate director or LLC manager breaches its fiduciary duties, it directly harms the company. The shareholders or members are only harmed indirectly, so normally only the company would have standing to bring the lawsuit. But if those in charge of the company are themselves the wrongdoers, it’s unlikely that they’ll cause the company to sue themselves. That difficulty has led to the derivative suit, a procedural device by which a shareholder of a corporation or a member of an LLC can assert a claim on behalf of the company against a director or manager that is breaching its duties to the company.
A company’s decision to initiate a lawsuit is normally up to its management, so a derivative suit by its nature interferes with management’s authority. The rules for derivative suits therefore require, among other things, that before filing suit the complaining shareholder or member must first make demand on the company to take action against the wrongdoer, or explain why making the demand would be futile. E.g., Utah R. Civ. P. 23A.
Banyan’s lawsuit made claims for breaches of fiduciary duties directly against the other members. Its lawsuit was not a derivative suit and did not comply with Rule 23A. Banyan’s defense against the defendants’ motion to dismiss was that its suit was permitted under an exception for closely held corporations (referred to in this post as the Exception) that the Utah Supreme Court had recognized in Aurora Credit Services, Inc. v. Liberty West Development, Inc., 970 P.2d 1273, 1281 (Utah 1998) (“We therefore hold that a court may allow a minority shareholder in a closely held corporation to proceed directly against corporate officers.”).
The trial court ruled that the Aurora Credit Exception did not apply to LLCs and dismissed Banyan’s complaint. Banyan appealed. The defendants argued on appeal that the Exception does not apply to LLCs, and that even if it did apply, Banyan did not meet its requirements. Banyan Inv. Co., 2012 WL 5950664, at *4.
The Court of Appeals briskly disposed of the argument that the Exception did not apply to LLCs. The court pointed out that the Utah Supreme Court had previously decided that the corporate principles governing derivative actions apply to LLCs, and that Rule 23A governs derivative actions brought on behalf of LLCs as well as corporations. Id. (citing Angel Investors, LLC v. Garrity, 216 P.3d 944 (Utah 2009)). The court also found that the rationale for the decisions in Aurora Credit and Angel Investors was as applicable to LLCs as to corporations – the majority owners of closely held companies usually are the management, and management is usually not independent. The court concluded that “the trial court erred by dismissing Banyan’s direct claims solely on the basis of its conclusion that the [Exception] does not apply to LLCs.” Id. at *5.
The defendants also argued that Banyan could not maintain a direct action because it could not show that it was injured in a way that was distinct from any injury to the LLC. The court said no, that rule applied only to traditional direct actions by a shareholder or member, not to actions that would otherwise be derivative were it not for the Exception. Id.
The correct rule, said the court, is that for a plaintiff’s claims to come under the Exception, the plaintiff must be able to show that its injury is distinct from that suffered by the other owners: “The closely-held corporation exception applies where a minority shareholder suffers uniquely as a result of majority shareholders engaging in the type of wrongdoing that would ordinarily give rise only to a derivative claim.” Id. at *6 (emphasis added).
The court also stated that an LLC member may proceed directly under the Exception only if (i) the defendants will not be unfairly exposed to a multiplicity of actions, (ii) the interests of the LLC’s creditors will not be materially prejudiced, and (iii) the direct suit will not interfere with a fair distribution of the recovery among all interested persons. Id. (citing GLFP, Ltd. v. CL Mgmt., Ltd., 163 P.3d 636 (Utah Ct. App. 2007)).
The court held that the allegations in Banyan’s complaint satisfied these requirements and that Banyan could bring its derivative claims directly under the Exception. Id. at *7.
Comment. The Banyan court’s application of the Exception to LLCs is sensible and is consistent with the prior Utah case law. The Exception itself is a minority rule but appears to be gaining wider acceptance.
The Exception has been recommended by the American Law Institute. 2 American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 7.01(d) (1994). The American Law Institute indicates that its recommendation in § 7.01(d) is supported by decisions from nine states: Arizona, California, Georgia, Idaho, Maryland, Massachusetts, North Carolina, Ohio, and West Virginia. Id., Reporter’s Note 4, at 31-32.
North Carolina Court Resolves Conflict Between LLC Act Rules on Member Withdrawals and Assignments to Non-Members
A North Carolina court last month was faced with troubling issues involving assignments of LLC member interests and changes of control. There was no dispute that the assignments conveyed the assigning members’ economic rights. The question was whether the associated control rights (management and voting) were retained by the assignor, conveyed to the assignee, or left inchoate and unusable by either the assignor or assignee until and unless the assignee was admitted as a member. The court in Blythe v. Bell, No. 11 CVS 933, 2012 WL 6163118 (N.C. Super. Dec. 10, 2012), had to resolve conflicting provisions of North Carolina’s LLC Act applicable to assignments and member withdrawals.
Drymax Sports, LLC was formed as a North Carolina limited liability company in 2003 by Hickory Brands, Inc. (HBI) and four individuals. The members and their initial percentage holdings were:
William Blythe 40%
Nissan Joseph 20%
Rob Bell 5%
Virginia Bell 5%
In 2007 HBI assigned all of its interest in equal parts to Rob Bell and Virginia Bell. In 2008 Joseph assigned his interest to HBI.
By 2011 a number of disputes between the members had arisen, and Blythe filed a lawsuit against the other members. After completion of pre-trial discovery, the parties filed cross-motions for summary judgment on the effects of the two assignments. The Blythe opinion is the trial court’s ruling. (The Blythe court is a specialized North Carolina Business Court, which handles cases involving complex and significant corporate and commercial law issues.)
Control Dispute. The motions were essentially a fight for control of Drymax. Blythe contended that the assignments by HBI and Joseph divested them of control but did not convey control rights to the assignees because the assignments were not approved by unanimous member consent. Id. at *5. That would leave only Blythe, Rob Bell, and Virginia Bell with control rights, resulting in Blythe’s effective voting control being increased from 40% to 80%, even though his economic interest would remain at 40%.
The defendants contended that HBI’s assignments to Rob Bell and Virginia Bell did not require unanimous member approval because they already were members, and that the assignments therefore conveyed control rights. The defendants also argued that Joseph’s assignment to HBI (which was at that time a non-member) did not convey control rights, and that Joseph retained his control interests because HBI was not admitted as a member. Id. at *6.
The court found that there was no operating agreement and that therefore the effects of the assignments were determined by the default provisions of the North Carolina Limited Liability Company Act. Section 57C-5-02 provides that an LLC interest is assignable but that an assignee receives only the economic rights, i.e., the right to receive the distributions and allocations to which the assignor would have been entitled. Section 57C-5-04(a) provides that an assignee may become a member by complying with the operating agreement (if there is one) or by the unanimous consent of the members, and that an assignee who becomes a member has the rights of a member, including voting control, with respect to the interest assigned.
Section 57C-5-02 disenfranchises members who assign all of their member interests: “Except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of his membership interest.” This rule is phrased as an absolute – it does not depend on whether the assignee is admitted as a member.
These two sections, when read together, appear to require that if a member assigns all of its interest to an assignee that is not admitted as a member, neither the assignor nor the assignee will be able to vote or use any control rights associated with the transferred interest.
The court also referred to Section 57C-5-06, which states: “A member may withdraw only at the time or upon the happening of the events specified in the articles of organization or a written operating agreement.” Withdrawal is not defined in the LLC Act, but the court characterized this section as a limit on a member’s right to terminate its membership. Id. at *5.
Conflicts in the LLC Act. The court was faced with the following rules: (i) a non-member assignee of an LLC interest who is not admitted as a member cannot vote the interest; (ii) an assignor of 100% of its LLC interest is no longer a member, and therefore has no right to vote that interest; and (iii) a member cannot withdraw from the LLC unless allowed by the articles of organization or a written operating agreement. But if the assignor is not able to vote the assigned interest, hasn’t it effectively withdrawn in violation of rule (iii)? And if neither the assignor nor the assignee can vote the assigned interest, then is it correct that no one can vote it and therefore there could be control shifts among the remaining members?
The court concluded that the rule against withdrawal trumps the rule that the assignor of 100% of its interest is no longer a member. It held that (a) HBI’s assignments to Rob Bell and Virginia Bell transferred HBI’s economic and control rights to them because the Bells were already members at the time of the assignment, and (b) Joseph’s assignment to HBI did not cause Joseph to lose his member control rights with regard to the assigned interest because HBI was at that time not a member. Id. at *8. Therefore no voting control was suspended – HBI’s assignments to the Bells transferred control because they already were members, and Joseph retained control regarding his assignment because HBI was not a member. Blythe’s 40% interest continued to represent 40% of the voting.
The court based both prongs of its ruling on the LLC Act’s prohibition on unilateral member withdrawal: “Plaintiffs’ construction providing otherwise would conflict with Section 57C-5-06 … because under Plaintiffs’ construction, a member could voluntarily assign all his interest and immediately cease being a member without the need for any other member’s consent…. The court cannot find a fair reading of the Act, reconciling all its provisions, that reflects a legislative purpose that allow[s] a member to cease being a member leaving his prior control interest inchoate.” Id.
The Court’s Ruling. The Blythe court was on the horns of a dilemma. It was faced with a square conflict between Section 57C-5-06 (a member may withdraw only if allowed by the articles of organization or a written operating agreement) and Section 57C-5-02 (except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of its membership interest).
Joseph assigned all of his interest. Under the statute he therefore ceased to be a member, but he was also barred from withdrawing as a member. The court sliced the Gordian knot by holding that Joseph did continue as a member and retained the control rights associated with the interest assigned, until his assignee is admitted as a member.
The court’s decision resolved the conflict for Joseph’s assignment, but the court ignored the same conflict inherent in HBI’s assignment of all of its interest to Rob Bell and Virginia Bell. Because the Bells were already members they received control rights as well as economic rights for the interests they received from HBI. The court made no mention of the fact that HBI’s assignment and the associated transfer of the control rights to the Bells amounted to a withdrawal by HBI, in conflict with the LLC Act’s bar on withdrawal.
An alternative approach would have been for the court to simply enforce Section 57C-5-02’s requirement that a member ceases to be a member upon assignment of all of its membership interest. If such an assignment amounts to a prohibited withdrawal, then the other members could assert a cause of action for that violation of the statute and sue for damages.
Other Statutes. The statutory provisions that the Blythe court wrestled with are not an anomaly. Delaware and Washington both have essentially the same rules as North Carolina regarding assignments and withdrawal, including the same conflict between the assignment rules and the “no withdrawal” rule. And it appears that neither has a reported opinion dealing with a similar fact pattern where there is no LLC agreement.
Solution. These statutes should be amended to eliminate this conflict. One approach that would do minimal violence to the existing rules would be to recognize that the prohibition on withdrawal is not as important for most LLCs as it is to partnerships. By simply changing the default rule so that withdrawal is allowed unless prohibited by the LLC agreement or certificate of formation, the statutory conflict that Blythe dealt with would be eliminated. LLCs would still be able to limit withdrawal in their LLC agreements if desired.
The Oregon LLC Act is a good example of that approach. Oregon’s rules on LLC assignments are essentially the same as those of Washington, Delaware, and North Carolina, except that a member may voluntarily withdraw from an LLC on six months’ notice unless prohibited by the LLC’s articles of organization or operating agreement. Or. Rev. Stat. § 63.205.
An LLC is a legal entity that is separate and distinct from its members, and an injury to an LLC is not the same as an injury to its members. Failure to take that distinction into account when commencing a lawsuit can lead to the dismissal of claims. An example of this unfortunate (at least from the plaintiff’s point of view) result is O’Reilly v. Valletta, 55 A.3d 583 (Conn. App. Ct. Nov. 20, 2012).
Background. HUB Associates, LLC and its sole member, John O’Reilly, sued Robert Pformer for violations of the Connecticut Unfair Trade Practices Act (CUTPA). HUB had leased real estate for a restaurant, and Pformer was a board member of the condominium association that managed the leased premises. The suit claimed that Pformer interfered with HUB’s efforts to advertise its business on the leased premises.
The trial court dismissed the CUTPA claims against Pformer on grounds that Pformer’s alleged conduct involved the management of a condominium and did not constitute “acts or practices in the conduct of any trade or commerce,” as is required to prove a violation of CUTPA. Id. at 586. O’Reilly appealed, but HUB did not appeal. Id. at 584 n.1.
The Appeal. Pformer argued on appeal that the trial court’s ruling in his favor was correct. But he went further and argued on appeal, for the first time, that O’Reilly lacked standing to bring the claim against him and that O’Reilly’s claim should therefore be dismissed for lack of subject matter jurisdiction.
Standing and subject matter jurisdiction sound technical, but they address fundamental issues of the court’s power and who may bring a lawsuit. Subject matter jurisdiction is the authority of a court to adjudicate the type of controversy presented. Courts have no power to decide cases over which they lack jurisdiction. Subject matter jurisdiction may not be waived by a party, and it may be raised by any party or by the court at any stage of the proceedings, including on appeal. Id. at 586.
One aspect of subject matter jurisdiction is standing. A court has no jurisdiction over a claim if the claimant does not have standing to assert the claim. Normally a party will have standing if it alleges direct injury to itself – the claimant’s injury must not be indirect or remote. Id. at 587.
The court considered O’Reilly’s claim and his status as the sole member of HUB. (HUB’s claim was not before the Appellate Court because the trial court had ruled against it and it had not appealed.) The court noted that an LLC is a distinct legal entity, with separate existence from its members. Therefore, “[a] member or manager … may not sue in an individual capacity to recover for an injury based on a wrong to the limited liability company.” Id.
O’Reilly’s CUTPA claim against Pformer was based entirely on allegations of Pformer’s violations of HUB’s rights and expectations that arose from HUB’s status as lessee of the premises and operator of the restaurant. Id. As sole owner of HUB, O’Reilly may have been harmed indirectly by Pformer’s alleged injuries to HUB, but the only direct harm was to HUB. The court therefore concluded that O’Reilly lacked standing, that the trial court lacked subject matter jurisdiction over the claim, and that the trial court improperly rendered judgment for Pformer on the merits of O’Reilly’s CUTPA claim. The case was remanded to the trial court to dismiss for lack of subject matter jurisdiction.
Comment. O’Reilly addresses basic issues that are sometimes taken for granted. The key to the court’s ruling is the separate nature of LLCs, their status as distinct legal entities. They can sue and be sued, own property, and enter into binding contracts. If an LLC is injured by a breach of contract, for example, it can sue the other party for breach of that contract. But its members, even a sole member, would not have standing to sue for breach of the contract because only the LLC was directly injured.
O’Reilly is also instructive about the power in litigation of the issue of subject matter jurisdiction. New legal issues cannot generally be brought up on appeal, but subject matter jurisdiction cannot be waived and can be brought up at any stage of litigation, including on appeal. If there is no subject matter jurisdiction, the claim is dismissed.