De Facto Dissolution of California LLC Allows LLC’s Creditor to Reach Assets Distributed to Members

An LLC sells its assets and distributes the proceeds to its members. It then goes out of business and leaves creditors holding the bag, unpaid. A creditor has a valid claim against the LLC, but can it assert its claim against the members who received the sale proceeds? That was the question before the court in a decision handed down by the California Court of Appeal last month, in CB Richard Ellis, Inc. v. Terra Nostra Consultants, 178 Cal.Rptr.3d 640 (Cal. Ct. App. Oct. 7, 2014). The court allowed the creditor to assert its claim against the members that received distributions, but only after finding that a de facto dissolution of the LLC had occurred.

The facts of the case were straightforward. CB Richard Ellis, Inc., a real estate broker (CBRE), signed a listing agreement with Jefferson 38, LLC to sell the LLC’s 38-acre real estate parcel. A dispute between CBRE and the LLC over the duration of the listing agreement and CBRE’s performance developed, and the LLC sold the real estate for $11.8 million without help from CBRE. One day after its receipt of the net sale proceeds, the LLC transferred essentially all of the proceeds to its members, without paying any commission to CBRE. Seven months later the LLC filed a certificate of cancellation with the California Secretary of State, indicating that it had been dissolved by a vote of its members.

CBRE arbitrated the dispute in accordance with the listing agreement and obtained a $960,000 judgment against the LLC for its commission, interest, and attorneys’ fees. The LLC had essentially no assets and could not pay, so CBRE later sued the LLC’s members.

CBRE alleged that the LLC had been dissolved, that the members had received distributions of the sale proceeds upon dissolution, and that in accordance with the LLC Act each member was therefore liable to CBRE for the LLC’s commission obligation, up to the amount of the distribution received by each member. A jury trial resulted in a verdict and judgment in favor of CBRE, against each member up to the amount of the member’s distribution. The members appealed on grounds that the jury had been improperly instructed on the law regarding the LLC’s dissolution.

Court of Appeal.  The Court of Appeal first had to determine which version of the California LLC Act to apply. (California adopted the Revised Uniform Limited Liability Company Act, effective January 1, 2014.) The court determined that it would apply the earlier version of the LLC Act, because it was in force at the time the dispute arose. Id. at 644.

CBRE based its claim on Section 17355 of the prior LLC Act, which provides that a cause of action against a dissolved LLC may be enforced, “[i]f any of the assets of the dissolved limited liability company have been distributed to members, against members of the dissolved limited liability company to the extent of the limited liability company assets distributed to them upon dissolution of the limited liability company.” Cal. Corp. Code § 17355(a)(1)(B) (repealed 2014). (Section 17707.07(a)(1) of the new LLC Act is nearly identical.)

The defendants objected to the jury instructions, which in relevant part stated:

Dissolution of a limited liability company occurs when it ceases operating in the ordinary course of its business, with the intention, on the part of its members, not to resume the ordinary course of its business….A limited liability company may continue to do business after it has dissolved for the purpose of winding up its affairs, paying its creditors and distributing its remaining assets. In determining whether a dissolution of Jefferson… occurred, you may consider all evidence bearing on that issue, including; for example, the ordinary business of the limited liability company, the assets of the limited liability company both before and after a distribution, the continuation of the ordinary business and the cessation of its ordinary business activities.

CB Richard Ellis, 178 Cal.Rptr.3d at 645. The Court of Appeal noted that the instruction uses the concept of a “de facto” dissolution, based on all the facts and circumstances rather than the formal dissolution steps taken under the statute.

The defendants contended that the jury instruction was incorrect because dissolution could occur only upon compliance with former Section 17350, which says that an LLC is dissolved upon the first to occur of (a) events specified in the articles of organization or operating agreement; (b) a majority vote of the members; or (c) a judicial decree of dissolution. Cal. Corp. Code § 17350 (repealed 2014). The defendants argued that because the LLC had not been formally dissolved when they received their distributions, former Section 17355 did not apply to the members and CBRE could not assert its claim against them.

The court, however, did not read Section 17350 to say that there are no other potential causes of dissolution, or that the three listed causes of dissolution are the exclusive grounds for dissolution. Finding no relevant legislative history, the court looked to the policy of the statute, which it saw as preventing unjust enrichment of LLC members when the members have received assets the dissolved LLC needs to pay its creditors. The court noted that if the members’ interpretation of the statute were correct, LLCs and their members could avoid the Section 17355 clawback “by the simple expedient of transferring assets out of the company the day before voting to dissolve.” CB Richard Ellis, 178 Cal.Rptr.3d at 647.

The court accordingly held that the jury was correctly instructed. “‘De facto’ dissolution is an acceptable predicate to a claim under former section 17355, subdivision (a)(1)(B).” Id.

Comment.  CB Richard Ellis stands out – most states do not recognize de facto dissolutions of LLCs. The issue doesn’t come up frequently because most states have a prohibition in their LLC laws on distributions to a member at a time when the LLC is insolvent or would be rendered insolvent by the distributions, regardless of whether the LLC has been dissolved. E.g., Cal. Corp. Code § 17704.05; Wash. Rev. Code § 25.15.235; Del. Code Ann. tit. 6, § 18-607. And many, including California, Washington, and Delaware, also require that a member who receives a distribution with knowledge that the LLC was insolvent must return the distribution to the LLC, without reference to whether the LLC is dissolved.

The LLC in CB Richard Ellis was presumably rendered insolvent by the distributions, given that CBRE had asserted a large claim against it. A creditor considering using that provision would have to establish the members’ knowledge of the LLC’s insolvency, of course, and that may be why CBRE did not pursue that avenue.

Washington LLC Member’s Bankruptcy Filing Dissociates the Member and Precludes Its Standing to Maintain Derivative Suit in the Name of the LLC

LLC businesses sometimes fail. When the failure is claimed to have resulted from mismanagement or self-dealing, the LLC’s minority members may want to bring a derivative suit against the manager for breach of fiduciary duties. But there may also be collateral damage – an LLC’s failure will sometimes drag the minority members into financial ruin, in which case they may need to file for bankruptcy protection. (For example, they may have guaranteed the LLC’s bank debt.)

A member’s bankruptcy filing may under state law cause the member’s dissociation, however, and that in turn may eliminate the member’s standing to bring a derivative suit for breaches of fiduciary duty. That was the result in a recent Washington case, Northwest Wholesale, Inc. v. Pac Organic Fruit, LLC, 334 P.3d 63 (Wash. Ct. App. Sept. 4, 2014).

Background.  Harold and Shirley Ostenson and Greg Holzman, Inc. (GHI) formed Pac Organic Fruit, LLC in 1998, to operate a Grant County orchard packing facility. The LLC was owned 49% by the Ostensons and 51% by GHI, which was the sole manager. The Ostensons worked at the plant, which the LLC leased from them. The Ostensons and Greg Holzman guaranteed a million-dollar loan to the LLC.

The parties commenced operating the business, but in 2005 the LLC defaulted on its operating line of credit and on its lease payments to the Ostensons. The Ostensons were fired, and the LLC’s bank foreclosed on the packing facility and the Ostensons’ orchard. In January 2007 the Ostensons filed a chapter 11 bankruptcy.

In May 2007 Northwest Wholesale, Inc., a creditor of the LLC, filed suit in Chelan County against the LLC, GHI, and the Ostensons.  The Ostensons then filed cross-claims against the LLC and derivative claims against GHI, Greg Holzman, and Total Organic, Inc., another Greg Holzman company. The Ostensons’ derivative claims alleged that Holzman and the Holzman entities mismanaged the LLC.

Northwest Wholesale was later dismissed from the lawsuit as the result of a settlement, and trial on the Ostensons’ claims commenced in Chelan County in July 2011. The Holzman defendants argued at trial that the Ostensons’ bankruptcy dissociated the Ostensons as members from the LLC under Wash. Rev. Code § 25.15.130(1)(d), and that because they were no longer members they lacked standing to bring the derivative action, under Wash. Rev. Code § 25.15.375. The Ostensons contended that the Holzman defendants consented in the bankruptcy proceeding to the Ostensons’ membership in the LLC and to their derivative action.

The trial court dismissed the Ostensons’ derivative claims against the Holzman defendants, ruling that the Ostensons’ bankruptcy dissociated them as members of the LLC and that under Wash. Rev. Code § 25.15.370 they were therefore precluded from bringing a derivative action. Pac Organic, 334 P.3d at 67.

Court of Appeals.  The court’s analysis of the Ostensons’ standing began with the LLC Act. The LLC Act says that a member may bring an action in the right of an LLC if its managers or managing members have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed.  Wash. Rev. Code § 25.15370.

The court was willing to assume that GHI, the LLC’s manager, would not authorize suit against itself, its owner, or its related company. Pac Organic, 334 P.3d at 73. But the LLC Act also requires that the plaintiff in a derivative action must be a member of the LLC when the suit is filed, and must have been a member of the LLC at the time of the transaction which is the subject of the complaint. Wash. Rev. Code § 25.15.375.

The court noted that the Ostensons were not members when they filed the derivative action, because they had previously filed for bankruptcy and had thereby become dissociated as members. Under Section 25.15.130(1)(d) of the LLC Act, a member is dissociated if the member files a voluntary petition in bankruptcy, unless the LLC agreement provides otherwise or the other members consent in writing. Upon dissociation, the member ceases to be a member and instead is treated as an assignee, i.e., it holds only the economic rights to share in profits, losses, and distributions associated with its interest in the LLC.  Wash. Rev. Code § 25.15.130(1).

The Ostensons pointed to a written stipulation that the parties had entered into in connection with the Ostensons’ bankruptcy. They contended that the stipulation was a consent by Holzman to the Ostensons’ continued membership in the LLC and to their right to sue derivatively on behalf of the LLC. The stipulation included a general release between the parties but preserved some claims, including claims by the LLC against the Holzman defendants for conversion of the LLC’s assets. The language of the stipulation did not address whether the Ostensons could assert the LLC’s claims, though, and the court found no such consent in the language of the stipulation.

Bankruptcy.  The Ostensons contended that federal bankruptcy law preempted the LLC Act from dissociating them because of their bankruptcy filing. They relied on Bankruptcy Code Section 541(c)(1), which provides that the debtor’s interests in property become part of the bankruptcy estate notwithstanding provisions in nonbankruptcy law that restrict transfer of the interest by the debtor. 11 U.S.C. § 541(c)(1).

The court did not agree. Referring to the principle that a debtor’s property rights are defined by state law, and citing In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000), the court found that although the bankruptcy estate acquired all the Ostensons’ interest in the LLC, the bankruptcy estate was itself dissociated by the LLC Act. Pac Organic, 334 P.3d at 77. 

The Ostensons also asserted that Bankruptcy Code Section 365(e) prevented them from being dissociated because of their bankruptcy filing. That section says that the debtor’s rights under an executory contract may not be terminated or modified because of a provision under applicable law or under the contract that is conditioned on the debtor’s commencement of a bankruptcy case. 11 U.S.C. 365(e). This section is often called the anti-ipso facto clause rule.

The court looked to an earlier Washington case concerning the effects on a partnership of a partner’s bankruptcy filing, and found that Section 365(e)’s invalidation of ipso facto provisions did not apply and that the LLC Act’s dissociation of the Ostensons was therefore not preempted. Id. at 79 (citing Finkelstein v. Sec. Props., Inc., 76 Wash.App. 733 (1995)).

The Court of Appeals accordingly affirmed the trial court’s dismissal of the Ostensons’ derivative action on behalf of the LLC.

Comment. The interaction between bankruptcy law and LLCs is complex and sometimes inconsistent from court to court. My description of the court’s bankruptcy analysis hits only the highlights. As the court said: “In resolving this question [of the effect of bankruptcy law] we stumble into an esoteric discussion of partnership law, limited liability company law, the nature of dissociation of a member or partner, economic and noneconomic interests in partnerships and LLCs, and executory contracts. We bounce to and from federal and state law.” Id. at 75.

Washington Court of Appeals Again Rules on 2010 Change to LLC Act’s Three-Year Post-Dissolution Limitations Period

For the second time this year the Washington Court of Appeals has ruled on the Washington LLC Act’s three-year post-dissolution statute of limitations. In both cases there was a dispute over whether a 2010 amendment to the LLC Act should be applied retroactively. The court in the more recent case ruled that the plaintiff’s lawsuit was not time-barred even though more than three years had passed since the defendant LLC’s administrative dissolution, because the LLC had not filed a certificate of dissolution as required by the 2010 change to the LLC Act. Zacks v. Arden Drywall & Texture, Inc., No. 70322-6-I, 2014 WL 3843784 (Wash. Ct. App. Aug. 4, 2014) (unpublished).

Background.  Adam Zacks sued Arden Drywall & Texture LLC on September 17, 2012, for breach of contract and negligence in connection with construction work on a home purchased by Zacks. Arden responded by filing a motion for summary judgment.

Arden had been administratively dissolved by the Washington Secretary of State on September 2, 2008, for failing to file its annual report and pay licensing fees. In its motion Arden contended that the claims against it were time-barred under former Wash. Rev. Code § 25.15.303 (2006). (Prior to 2010, Washington’s LLC Act provided that no lawsuit could be filed against a dissolved LLC after three years from the effective date of dissolution. Former Wash. Rev. Code § 25.15.303 (2006).)

Amended in 2010, the LLC Act now authorizes a dissolved LLC to file an optional certificate of dissolution, and provides that a lawsuit cannot be filed against a dissolved LLC after three years from the date of filing of its certificate of dissolution. Wash. Rev. Code § 25.15.273, 25.15.303. There is no three-year bar on lawsuits against a dissolved LLC if it does not file a certificate of dissolution.

Relying on the 2010 amendment, Zacks argued that because Arden had not filed a certificate of dissolution, the three-year period had not commenced and the lawsuit was not time-barred. Arden riposted that the 2010 amendment to RCW 25.15.303 did not apply retroactively to it. 2014 WL 3843784, at *2. The trial court ruled that Zacks’ claims against Arden were barred, granted Arden’s summary judgment motion, and dismissed Zacks’ claims.

Court of Appeals.  Division 1 of the Court of Appeals reasoned that because a dissolved LLC continues to exist, Arden was still an existing legal entity when the 2010 amendments to the LLC Act took effect. Id. at *4. And when the 2010 amendments took effect, less than two years had passed since Arden’s administrative dissolution. The three-year bar under the old statute therefore had not yet applied to Arden, and when the statutory amendments became effective on June 10, 2010, their new rules became applicable.

The 2010 amendments required that a dissolved LLC file a certificate of dissolution in order to commence a three-year limitations period. Arden had not filed a certificate of dissolution, so the court ruled that Zacks’ lawsuit was not barred and could proceed, reversing the trial court. Id.

Comment.  The Zacks court did not need to address whether the 2010 amendments were retroactive, because it simply applied the amendments to Arden commencing when the amendments became effective. (Even if the amendments had been given retroactive effect, though, it would not have changed the result.)

A different division of the Court of Appeals (Division 3) ruled on a similar case earlier this year, which I wrote about, here. Houk v. Best Dev. & Constr. Co., 179 Wash. App. 908, 322 P.3d 29 (Mar. 13, 2014). The court in Houk reached the opposite conclusion, i.e., that a plaintiff’s lawsuit against an administratively dissolved LLC was barred by the three year post-dissolution statute of limitations. But the different results were driven by different chronologies of the relevant events, and the two opinions are consistent in their reasoning.

In Houk the LLC was administratively dissolved in 2006. More than three years passed before the 2010 amendments to the LLC Act became effective, and the plaintiff filed his lawsuit after the 2010 amendments. The LLC never filed a certificate of dissolution. (Note that in Zacks the LLC’s administrative dissolution occurred only two years before the 2010 amendments became effective.)

Houk found that the 2010 amendments were not retroactive, so claims against the LLC became time-barred on the third anniversary of its dissolution, before the 2010 amendments were effective.

Zacks is another reminder of the importance of filing certificates of dissolution for dissolved Washington LLCs. The three-year statute of limitations in Wash. Rev. Code § 25.15.303 can be hugely useful in cutting off claims as part of a dissolved LLC’s winding up. The benefits of the three-year statute of limitations for all claims are so significant that the certificate of dissolution should almost always be filed. The certificate of dissolution is a simple one-page document, Wash. Rev. Code § 25.15.273, and there is no filing fee, Wash. Admin. Code § 434-130-090(11).

New York LLC Manager’s Apparent Authority Makes LLC’s Real Estate Contract Enforceable in the Absence of Manager’s Actual Authority

A New York LLC entered into a contract to sell real estate and accepted a cash deposit. But shortly before closing the LLC asserted that its manager had no authority to sign the sale contract, tendered back the deposit, and refused to sign the closing documents. The buyers sued to enforce the contract, and the court ruled that the manager had sufficient apparent authority that his signature bound the LLC. Pasquarella v. 1525 William St., LLC, 120 A.D.3d 982 (N.Y. App. Div. Aug. 8, 2014).

Background.  The parties negotiated off and on for two years over the plaintiffs’ purchase of real estate from 1525 William Street, LLC, a New York LLC. The LLC was represented in the negotiations by Zvi Sultan, who indicated he was the sole member and President of the LLC. The LLC was also represented by legal counsel, who acted throughout the negotiations as if Sultan had authority to negotiate on behalf of the LLC. Eventually the sale contract was executed, with Sultan signing on behalf of the LLC as its manager. The LLC’s attorney accepted the plaintiffs’ deposit.

Later the LLC refused to sign the closing documents and attempted to return the deposit, on grounds that Sultan had no authority to sign the sale contract on its behalf. The LLC contended that Sultan sold a controlling interest in the LLC to his son shortly before the sale contract was signed, and that the LLC’s operating agreement provided that a sale of corporate property must be approved by all members. The son had not approved the sale.

The plaintiffs sued to enforce the sale contract and the trial court granted their motion for summary judgment. The LLC appealed on grounds that there was a triable issue of fact whether Sultan lacked apparent authority to contractually bind the LLC. Id. at 983.

Apparent authority exists when (a) a third party reasonably believes, based on the principal’s actions, that the supposed agent has authority to act on the principal’s behalf, (b) the third party relies on the appearance of authority, and (c) the third party will suffer loss if an agency relationship is not found. E.g., Zions Gate R.V. Resort, LLC v. Oliphant, 326 P.3d 118, 122 (Utah Ct. App. 2014).

Appellate Division.  The court emphasized that apparent authority can only be created by words or deeds of the principal. “The agent cannot by his own acts imbue himself with apparent authority.” Pasquarella, 120 A.D.3d at 983 (quoting Hallock v. State, 474 N.E.2d 1178, 1181 (N.Y. 1984)).

Examining the history of the parties’ interactions, the court concluded that the plaintiffs reasonably relied on sufficient actions of the LLC and its authorized agents to establish Sultan’s apparent authority:

  • the prior course of dealing with Sultan in his capacity as President of the LLC,
  • the fact that the LLC’s authorized attorney acted in a manner consistent with Sultan’s authority, and
  • the LLC’s acceptance of the plaintiffs’ deposit.

Id. at 984.

The court found an alternative basis to support Sultan’s statutory apparent authority, under the New York Limited Liability Company Law:

Unless the articles of organization of a limited liability company provide that management shall be vested in a manager or managers, every member is an agent of the limited liability company for the purpose of its business, and the act of every member, including the execution in the name of the limited liability company of any instrument, for apparently carrying on in the usual way the business of the limited liability company, binds the limited liability company, unless (i) the member so acting has in fact no authority to act for the limited liability company in the particular matter and (ii) the person with whom he or she is dealing has knowledge of the fact that the member has no such authority.

N.Y. Ltd. Liab. Co. Law § 412(a) (emphasis added). Section 412(b) has a similar provision governing manager-managed LLCs, so the court found that under Section 412, Sultan had apparent authority whether he was acting as a member or as a manager.

The LLC failed to offer any evidence that plaintiffs had any knowledge of the limitation on Sultan’s authority resulting from the transfer of his member interest, so the court found that there was no issue of triable fact whether Sultan lacked apparent authority to enter into the sale contract, and affirmed the trial court’s ruling.

Comment.  The legal doctrine of apparent authority is hugely important in the world of business. Consumers and businesses routinely rely on the apparent authority of the other party to a contract, without inquiring into the details of the actual authority of the agent signing the contract.

It would be difficult to function in a modern economy for more than a few hours without interacting with an agent of some kind. The atmosphere is so thick with agents that most people rarely think about them; I willingly hand money to a stranger I meet in a store and carry away goods without questioning whether a sale has occurred.

Paula J. Dalley, A Theory of Agency Law, 72 U. Pitt. L. Rev. 495, 497 (2011).

Pasquarella is an example of a fairly routine application of apparent authority, so much so that it’s a little surprising that the LLC asserted Sultan’s lack of actual authority as a reason for not enforcing the sale contract. The doctrine of apparent authority is by its nature always fact-specific, but the facts here seemed to fairly clearly support Sultan’s apparent authority.

The court also relied on Sultan’s statutory apparent authority under Section 412 of the New York Limited Liability Company Law. If that section applies in a particular case, the court in theory need not even examine the facts supporting apparent authority, other than (a) was the purported agent a member or manager of the LLC, (b) was the action by the purported agent taken “for apparently carrying on in the usual way the business of the limited liability company,” and (c) did the other party have any knowledge that the member or manager in fact had no authority.

In one respect the Pasquarella court’s analysis was deficient, because it did not address whether the real estate sale contract was for the purpose of “apparently carrying on in the usual way” the business of the LLC. The LLC’s business is not described in the opinion, but a sale contract for a parcel of real property would usually be considered outside the ordinary course, unless the LLC routinely sold real estate.

 

Washington Court of Appeals Clarifies That Fraud Need Not Be Pleaded with Particularity to Support Veil-Piercing Claim

The Washington Court of Appeals had to decide earlier this year whether the plaintiff’s complaint in an LLC veil-piercing case was adequate, in Landstar Inway, Inc. v. Samrow, 181 Wn. App. 109, 325 P.3d 327 (May 6, 2014). The plaintiff alleged that the veil should be pierced because the LLC member used the LLC form to commit fraud. The LLC member moved to dismiss the claim against him on grounds that the complaint lacked sufficient detail. The court held that the strict pleading requirements for a fraud claim do not apply to a veil-piercing claim based on fraud allegations.

A brief review of the pleading requirements for a complaint is in order. A complaint is the document that a plaintiff files in court to begin a lawsuit. It must contain a statement of the plaintiff’s claim showing that the plaintiff is entitled to relief from the defendant, and a demand for judgment for the relief requested. In most cases the relief requested will be an award of damages, i.e., money from the defendant to compensate the plaintiff.

The rules of court govern the requirements for a complaint. Washington’s court rules for civil cases, like those of most states, are based on the Federal Rules of Civil Procedure. In most cases the complaint must provide only “a short and plain statement of the claim showing that the pleader is entitled to relief.” Wash. R. Civ. P. 8(a). This is often referred to as “notice pleading,” meaning that the complaint is only required to have sufficient detail to put the defendant on reasonable notice of the claim. The expectation is that the parties will be able to learn additional details, if necessary, during the discovery phase of the proceedings.

The pleading rules are stricter for some types of allegations, however, including claims of fraud:

“In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally.” Wash. R. Civ. P. 9(b) (emphasis added). A complaint that alleges fraud but fails to plead the elements of fraud and the detailed circumstances constituting the fraud may face dismissal.

Background. Frank Samrow and Terry Walker formed Oasis Pilot Car Service LLC to provide pilot car dispatching services to trucking companies. Truckers hauling tall cargo loads in Washington are required to have a pilot car escort. The pilot car has an attached, vertical survey pole, higher than the load, and precedes the truck to ensure safe passage under overpasses and bridges.

Oasis entered into a master agreement in 2009 with Landstar Inway, Inc. to provide pilot car services. Later that year Oasis responded to a request from Landstar by dispatching Phil Kent to escort a truck with a tall load from the Canadian border through Washington.

Kent’s pilot car passed under a freeway overpass near Lakewood that Kent believed had been safely cleared, but the truck’s load struck the bottom of the overpass, damaging both the load and the overpass. Landstar eventually paid the owner of the load and the Washington Department of transportation for their damages, and then tendered its indemnity claim to Oasis under the master agreement. The master agreement required Oasis to maintain vehicle liability insurance, but Samrow’s insurance company rejected Landstar’s claim because the insurance was on his personal vehicle.

Landstar then sued Oasis, Samrow, and Kent’s company, CJ Car Pilot, Inc., for negligence, breach of contract, and breach of indemnity. Samrow moved for summary judgment dismissing him from the lawsuit, on grounds that any liability ran to Oasis and not to Samrow personally. The trial court granted Samrow’s summary judgment motion, ruling that the undisputed facts did not justify piercing the LLC’s veil or imposing personal liability on Samrow, and Landstar appealed. Landstar, 181 Wn.App, at 119.

Court of Appeals. The court began its review of Washington’s LLC veil-piercing law by referring to Chadwick Farms Owners Association v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), and Section 25.15.060 of the Washington LLC Act. To succeed in piercing the veil of an LLC, a plaintiff must prove that the LLC form was used to violate or evade a duty and that the LLC form should be disregarded to prevent loss to an innocent party. Abuse of the corporate form must be shown to establish that the LLC was used to violate or evade a duty, and that typically involves some type of fraud, misrepresentation, or manipulation of the LLC to the member’s benefit and the creditor’s detriment. Landstar, 181 Wn.App. at 123.

Landstar alleged that Samrow abused the corporate form by fraudulently concealing the fact that Oasis dispatched pilot car operators instead of providing pilot car services of its own, and by fraudulently misrepresenting his own personal insurance as Oasis’, to satisfy Oasis’s insurance obligation under the master agreement. But Samrow argued that the court should reject Landstar’s veil-piercing claim because it was based on fraud, and Landstar failed to plead the elements of fraud and the factual circumstances with the particularity required by Civil Rule 9(b).

The court pointed out that it was faced with an issue of first impression: “There is no Washington case addressing whether a party must satisfy the pleading requirements of CR 9(b) in seeking to disregard a corporate form.” Id. at 125. The court looked to the federal courts because they have addressed the issue, but found no unanimity there.

Washington law is clear that piercing the veil is an equitable remedy and not a separate cause of action. If the veil of an LLC is pierced, a member may be held personally liable for the LLC’s underlying tort or breach of contract, but piercing the veil is not a freestanding claim for relief. Id. at 125-26 (citing Truckweld Equip. Co. v. Olson, 26 Wn.App. 638, 643, 618 P.2d 1017 (1980)). From that premise the court reasoned that CR 9(b)’s heightened pleading requirement for claims of fraud should not apply to claims seeking the remedy of piercing the veil, even if the veil-piercing claim is based on fraudulent conduct. The court also noted that its conclusion was consistent with Washington’s commitment to maintaining liberal pleading standards. Id. at 126.

Having rejected Samrow’s contention that Landstar’s complaint failed to satisfy the CR 9(b) heightened pleading requirement, the court went on to the merits of Samrow’s summary judgment motion. The court reversed the trial court’s grant of summary judgment on the veil-piercing claim because it found that material issues of fact remained to be resolved at trial.

Comment. Landstar is significant because it resolved an open question about the pleading requirements for a complaint that seeks to pierce the veil of an LLC, where the veil-piercing request is predicated on fraudulent acts or statements. The court made clear that the normal “notice pleading” rules apply in such a case, unlike the stricter requirements for pleading a direct claim of fraud.

South Carolina Supreme Court Invalidates LLC Operating Agreement’s Repurchase Right After Charging Order Foreclosure

Many LLC operating agreements contain transfer restrictions on LLC member interests. Those restrictions sometimes include the LLC’s right to repurchase the interest if a member makes a transfer in violation of the operating agreement. What’s the result if such a repurchase right applies to a transfer resulting from the foreclosure of a charging order by a member’s judgment creditor? The South Carolina Supreme Court earlier this month ruled that a foreclosure sale was valid and trumped the operating agreement’s repurchase right, and that the repurchase right could not be enforced. Levy v. Carolinian, LLC, No. 27442, 2014 WL 4347503 (S.C. Sept. 3, 2014).

Background. Shaul and Meir Levy obtained a $2.5 million judgment against Bhupendra Patel, a member of Carolinian, LLC, a South Carolina LLC. The Levys later obtained a charging order against Patel’s interest in the LLC, and subsequently foreclosed the lien of the charging order.

Following the foreclosure sale, the LLC asserted that it was entitled under the operating agreement to purchase Patel’s interest from the Levys. Section 11.1 barred the members from voluntarily or involuntarily selling, transferring, or otherwise conveying their interest without a two-thirds vote of the other members, and declared that any attempted conveyance of a member’s interest without the requisite consent would be null and void. Section 11.2 provided for the repurchase: “If a Member attempts to transfer all of a portion of his Membership Share without obtaining the other Members’ consent as required in Section 11.1, … such Member is deemed to have offered to the Company all of his Member Share….” Id. at *2.

The LLC contended that because Patel’s interest was conveyed without the members’ consent, the Levys were deemed to have offered their interest to the LLC and it was entitled to purchase the interest. The Levys objected that they were not parties to the operating agreement and were not required to obtain any consent to foreclose their statutory charging order.

The Levys filed suit for a declaratory judgment that they were the rightful owners of Patel’s interest. The trial court found that as transferees the Levys became subject to Article 11 of the operating agreement, and that the LLC could therefore force the Levys to sell Patel’s interest to the LLC. Id. 

Supreme Court. The court began by reviewing the South Carolina LLC Act, S.C. Code Ann. § 33-44-101 to -1208 (the Act). The Act provides at Section 504 that:

  • a judgment creditor of an LLC member may obtain from a court a charging order against the member’s distributional interest,
  • a charging order is a lien on the judgment debtor’s distributional interest,
  • the judgment creditor may foreclose its lien,
  • the member’s interest that is subject to the charging order may be redeemed at any time before foreclosure,
  • a purchaser at a foreclosure sale has the rights of a transferee, and
  • this is the exclusive remedy by which a member’s judgment creditor may satisfy a judgment out of the judgment debtor’s distributional interest in the LLC.

The court pointed out that while an LLC is generally free to modify the default provisions of the Act by its operating agreement, the agreement may not restrict the rights of a person “other than a manager, member, and transferee of a member’s distributional interest.” Levy, 2014 WL 4347503, at *3 (quoting S.C. Code Ann. § 33-44-103(b)).

But, said the court, the Levys did not become transferees until after the foreclosure sale, so the LLC’s operating agreement could not restrict their rights by requiring consent of the members before the foreclosure sale. At that time the Levys were merely judgment creditors. The LLC could not invoke the purchase right under Section 11.2 after the foreclosure, because that right was only applicable where consent was not obtained prior to the transfer. The Supreme Court accordingly reversed the trial court: “[W]e further find that Carolinian may not now invoke the provisions of Article 11 to compel the Levys to sell the distributional interest they acquired through the foreclosure sale.” Id. at *4.

Comment. Levy is not about an attempt to avoid a charging order or an attempt to prevent foreclosure of a charging order, and it’s not a dispute about a pre‑foreclosure redemption. (The operating agreement and the Act both allowed redemption of a member’s interest that is subject to a charging order, but the LLC was unwilling or unable to redeem Patel’s interest prior to the foreclosure.) Levy is about an attempt by an LLC to require in its operating agreement that unwanted acquirors of a member’s interest, on demand by the LLC, must sell back the interest to the LLC (presumably at a fair price, although the opinion never mentions the price that Article 11 apparently describes).

The operating agreement’s buyback is an aspect of the “pick your partner” principle – the idea that, like partners in a partnership, members in an LLC should not be forced to associate and do business with another member they don’t know and don’t want to be associated with. This principle is embodied in the distinction between an LLC member, who will have voting and management rights as well as economic rights, and an assignee (also called a “transferee”) that has only economic rights unless admitted as a member. Consistent with this principle, most LLC statutes only allow an assignee to be admitted as a member on the unanimous vote of the members, or as otherwise allowed by the operating agreement. E.g., S.C. Code Ann. § 33-44-503.

Of course the buyback provision of the Carolinian operating agreement goes further than merely keeping the purchaser at the foreclosure sale out of management. Buying back the purchaser’s interest completely ousts the purchaser from the LLC, so it would not even have economic rights, let alone management rights.

The court’s analysis, however, focused in a literalistic way on the language of the operating agreement. The court’s analysis ran as follows: the Levys did not become transferees until after the foreclosure, consent for the sale was required by the operating agreement before the foreclosure, and therefore the Levys were not bound by the need for consent. But a transferee of a member’s interest takes no less and no more than the economic rights of the transferor. If the transferor’s LLC interest was subject to a repurchase right under certain circumstances before the transfer, then it would continue to be subject to the repurchase right after the transfer. The court ignored this basic principle of property rights. The repurchase right did not affect the rights of a third party; it applied to a transferee, the purchaser at the foreclosure sale.

Dissolution of Connecticut LLC Does Not Automatically Transfer Assets to LLC’s Members

Lawyers sometimes misunderstand the consequences of an LLC’s dissolution. Dissolution does not terminate the existence of an LLC. A dissolved LLC’s members and managers continue to be its members and managers, and must wind up the LLC’s business. The dissolved LLC continues to own its property until it is sold or distributed to the members.

A claim by an LLC’s managing member that the LLC’s dissolution automatically transferred its property was a central issue in a recent accounting malpractice case. Mukon v. Gollnick, 92 A.3d 1052 (Conn. App. Ct. June 24, 2014) (per curiam).

Background. Mark Mukon was the managing member of Sea Pearl Marine, LLC, a Connecticut limited liability company. The LLC purchased a ship’s hull in 2007 in order to construct a complete vessel, and paid Connecticut sales tax on the hull.

Connecticut LLCs must pay an annual $250 filing fee to the state, and in 2009 Mukon asked his accountant how he could avoid paying the annual fee. His accountant advised him that he could avoid the fee by dissolving the LLC, and that the only tax consequences would be capital gains taxes when the vessel was sold. Mukon accordingly dissolved the LLC, and his accountant assisted in filing the dissolution paperwork with the state.

After the dissolution Mukon re-registered the vessel in his own name with the Connecticut Department of Motor Vehicles. Shortly thereafter the Department of Revenue Services audited the transaction, determined that there was no exemption, and assessed use taxes, penalties, and interest, which Mukon paid. (The use tax is complementary to the sales tax, and is assessed when sales tax is not collected.)

Mukon later sued his accountant for malpractice. He claimed that the tax became payable when the vessel was automatically transferred upon the LLC’s dissolution, contrary to the accountant’s advice that the dissolution would not result in any tax liability other than capital gains upon the vessel’s sale. The trial court accepted Mukon’s theory, found that the accountant had committed professional malpractice, and awarded damages to Mukon. The accountant appealed.

Appellate Court. The court’s analysis turned on its review of the Connecticut LLC Act’s dissolution provisions. A dissolved LLC continues to exist but must be wound up. Its managers or managing members must, in the name of the LLC, settle and close the LLC’s business, dispose of and transfer the LLC’s property, discharge its liabilities, and distribute any remaining assets to the LLC’s members. Conn. Gen. Stat. §§ 34-206, 34-208. The court found the statute to be clear: the LLC’s dissolution started a winding-up process, but dissolution alone did not transfer any assets.

The dissolution of a limited liability company does not … result in an automatic transfer of the limited liability company’s assets to one of the individual members. Instead, the dissolution necessitates a prescribed winding-up process, and a member receives the limited liability company’s property if, and only if, the member or manager winding-up the limited liability company has completed the applicable steps established by § 34-208(b) and the assets are distributed in accordance with § 34-210.

Mukon, 92 A.3d at 1055.

Mukon’s malpractice cause of action was predicated on his theory that the use tax became due and payable when the vessel was automatically transferred upon the LLC’s dissolution. The court rejected his theory and therefore reversed the trial court’s malpractice award.

Comment. It seems odd that Mukon hung his whole case on the theory that the LLC’s dissolution transferred the LLC’s property. After all, an LLC’s dissolution initiates the winding-up process, and the statute requires that the LLC’s assets be sold or distributed to the members after all debts and liabilities have been satisfied. In other words, dissolution made the transfer of the boat inevitable, and the transfer resulted in the use tax being assessed. So the accountant’s advice that the dissolution would not result in sales or use taxes appears to have been incorrect.

In any event, the case is a good review of the rules for dissolving and winding up an LLC. It’s also an example of the adage, “penny wise and pound foolish.” $250 a year seems like a modest price to pay to keep an LLC in existence.

Three Short Takes: (1) Exclusive Nature of Florida Charging Order Precludes Garnishment; (2) Tricky Signature Block on Contract Personally Obligates Georgia LLC’s Manager; (3) Idaho Clarifies That Veil-Piercing Claims Are Equitable

We have a roundup this week of three recent LLC cases.

1.   Charging Order. A dispute between two members of a Florida LLC resulted in litigation, in which the trial court ultimately awarded one member a $41,409 judgment against the other member. After an appeal that affirmed the judgment, and on the prevailing member’s motion, the trial court issued a writ of garnishment in favor of the prevailing member. The LLC as garnishee indicated that it was indebted to the losing member in an amount in excess of the judgment, and that it had funds in that amount in its possession. The court then ordered the LLC to pay the judgment amount to the prevailing member, under the writ of garnishment against the member’s distributions from the LLC.

The losing member appealed the garnishment order, contending that the Florida LLC Act’s charging order provisions barred the garnishment. Young v. Levy, 140 So.3d 1109 (Fla. Dist. Ct. App. June 18, 2014).

Florida’s LLC charging order statute states:

Except as provided in subsections (6) and (7), a charging order is the sole and exclusive remedy by which a judgment creditor of a member or member’s assignee may satisfy a judgment from the judgment debtor’s interest in a limited liability company or rights to distributions from the limited liability company.

Fla. Stat. § 608.433(5). The member that won the garnishment order argued that the LLC’s distributions were “profits” or “dividends” subject to a writ of garnishment and thus exempt from Section 608.433(5). However, Section 608.433(5) refers to the judgment debtor’s “interest” in the LLC, and the Florida LLC Act defines a member’s interest to include the profits and losses of the LLC. Fla. Stat. § 608.402(23). The court accordingly relied on the “sole and exclusive remedy” language of Section 608.433(5) and reversed the garnishment order. Young, 140 So.3d at 1112.

This is not a surprising result, but it’s always good to see an appellate court interpret a statute in a straightforward way. Exclusive does mean exclusive.

2.  Personal Liability. A Georgia LLC entered into four written contracts with an advertising agency, for print and Internet advertising. The LLC did not pay the full amount of the agency’s invoices, and the agency sued both the LLC and its manager for the balance. The trial court found in favor of the agency and awarded judgment against the LLC, and against its manager, for damages, attorneys’ fees, and interest.

The manager appealed, contending that he was not a party to the contracts and signed them only in his representative capacity. Buffa v. Yellowbook Sales & Distrib. Co., No. A14A0209, 2014 WL 2766746 (Ga. Ct. App. June 19, 2014).

The four agreements showed that they were with the LLC, but they also had language that implicated the manager. Clause 15F of each agreement stated: “The signer of this agreement does, by his execution personally and individually undertake and assume the full performance thereof including payments of amounts due thereunder.” Id. at *1.

Additionally, the signature block of each contract stated: “This Is an Advertising Contract Between Yellow Book and [printed company name] and [signature] Authorized Signature Individually and for the Company (Read Clause 15F on reverse side).” The court reviewed the language and signature blocks and concluded that the manager was clearly a party to the contracts and therefore liable to pay amounts owing. Id. at *2.

The court also rejected the manager’s argument that he was at most obligated as a guarantor of the LLC’s obligations and therefore was not liable because his guaranty did not satisfy the Statute of Frauds. “Since the language employed in the Yellowbook advertising contracts reflects that Buffa agreed to undertake a primary obligation to perform under the contract, we need not address his arguments regarding the Statute of Frauds.” Id. at *3 n.3. The Court of Appeals therefore affirmed the trial court.

We often hear the maxim, caveat emptor, or buyer beware. This case illustrates the maxim that signers of contracts, even when signing for an LLC, must beware of language in the contract or in the signature block that may unexpectedly saddle the manager with personal liability for the LLC’s obligations.

3.   Equity and Veil-Piercing Claims.  The Idaho Supreme Court ruled earlier this summer on a breach of contract lawsuit that involved multiple claims, including several veil-piercing claims. Wandering Trails, LLC v. Big Bite Excavation, Inc., 329 P.3d 368 (Idaho June 18, 2014). The court’s discussion of the issues and the facts is lengthy, but one part of the opinion stands out because it resolves an unclear issue in Idaho law.

Idaho law is fairly clear on the basic rule: To pierce the veil of an Idaho LLC and impose personal liability on the LLC’s members or managers, the claimant must show that the LLC is the alter ego of the members, i.e., that there is a unity of interest and ownership to a degree that separate personalities of the LLC and members do not exist, and that if the acts complained of were to be treated as only the acts of the LLC, an inequitable result would follow. Id. at 376.

The court pointed out, however, that Idaho law is not clear whether veil-piercing claims are issues at law or at equity. Id. at 373. The significance is that if veil piercing is an equitable claim, then the trial judge must decide whether to pierce the veil. If it is not an equitable claim, the jury will decide whether the veil is to be pierced. “This Court’s opinions have been unclear regarding whether veil-piercing claims present a question for the jury or whether they are equitable issues to be tried by the court.” Id.

The court reviewed prior decisions, pointed out the inconsistencies, and concluded: “To clarify, we hold that issues of alter ego and veil-piercing claims are equitable questions….In these cases, the trial court is responsible for determining factual issues that exist with respect to this equitable remedy and for fashioning the equitable remedy.” Id. The court noted that a court may empanel an advisory jury on factual questions relevant to piercing the veil, but is not required to do so.

The court’s ruling on this issue is not surprising, because piercing the veil is universally recognized as an equitable remedy. “The doctrine of piercing the corporate veil is equitable in nature.” 1 William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 41.25, at 162 (rev. vol. 2006) (footnote omitted). What is perhaps surprising was the confusion in prior Idaho law, which Wandering Trails has now straightened out.

Massachusetts Court Pierces the Veil of Single-Member LLC Because of Its Failure to Maintain Business Records

Piercing the veil is a long-standing equitable remedy that can allow a claimant against a corporation to also assert the claim against a shareholder, under limited circumstances that usually involve some degree of wrongdoing or abuse of the corporate form. With the advent of LLCs, most states have also applied their existing law about veil piercing to LLCs. State laws about veil piercing vary quite a bit from state to state, and anomalous decisions crop up from time to time.

An outlier decision on veil-piercing was handed down earlier this year by the Massachusetts Appellate Division, in Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014). The court pierced the veil of a single-member LLC based on only one factor: the LLC’s failure to maintain business records.

Background. Milan Kosanovich entered into a purchase agreement to buy a condominium from 80 Worcester Street Associates, LLC (WSA). Jeffrey Feuerman was WSA’s manager and sole member, and signed the purchase agreement and a supplemental contract on behalf of WSA. One of the agreements required WSA to repair any defects in the condominium for up to one year after closing.

During the following year Kosanovich complained of numerous defects, and Feuerman responded to some but not all of the complaints. Kosanovich was not satisfied and later sued WSA and Feuerman for breach of contract, breach of an implied warranty of habitability, and violations of the Massachusetts Consumer Protection Act. A jury was waived, and at trial the judge ruled in favor of Kosanovich on his claims for breach of contract and breach of an implied warranty of habitability, and awarded him $9,000 in damages. The judge pierced WSA’s LLC veil and found Feuerman personally liable for the damages award. Id. at *2.

Appellate Division. The court first reviewed the basic veil-piercing rule: the corporate or LLC  veil should only be pierced in rare situations, and only “for the defeat of fraud or wrong, or the remedying of injustice.” Id. at *2 (quoting Hanson v. Bradley, 10 N.E.2d 259, 264 (Mass. 1937)). The court should examine 12 factors in light of all the circumstances to determine if veil piercing is justified:

(1) common ownership,

(2) pervasive control,

(3) confused intermingling of business assets,

(4) thin capitalization,

(5) nonobservance of corporate formalities,

(6) absence of corporate or LLC records,

(7) no payment of dividends or distributions,

(8) insolvency at the time of the litigated transaction,

(9) siphoning away of corporation’s funds by dominant shareholder or member,

(10) nonfunctioning of managers, or officers and directors,

(11) use of the corporation or LLC for transactions of the dominant shareholders or members, and  

(12) use of the corporation or LLC in promoting fraud.

Feuerman did not dispute that he had sole ownership and pervasive control of WSA, which according to the court is not enough to pierce the veil, standing alone. But the trial judge had also found that WSA’s records did not exist or were improperly kept. The only document submitted by Feuerman at trial was WSA’s certificate of formation. Feuerman admitted that he ran the business out of his house and his car and that he had no bookkeeping records, tax records or returns, checkbook, or records of payments to subcontractors. As he said, “it was a bit informal.” Id.

That was enough to pierce the veil, said the court. “Feuerman’s failure to maintain or produce records hindered the court’s ability to establish the twelve factors, including intermingling of assets, thin capitalization, and insolvency…. Feuerman’s failure to maintain business records coupled with his sole ownership and pervasive control of WSA supported the [trial] judge’s decision to pierce the corporate veil.” Id. at *3.

Comment.  The court’s decision seems inconsistent with the basic rules the court itself cited. As the court said, piercing the veil is intended to remedy fraud, wrong, or injustice. But there was no evidence of any of those. One would have thought the burden of proof would have been on the party claiming that the LLC’s veil should be pierced. The court’s reliance on Feuerman’s inadequate record-keeping effectively placed on his shoulders the burden to prove that he was innocent of violating any of the other 12 factors.

Lawyers of course routinely advise their clients to adhere to the various formalities of running a business in the form of a corporation or LLC, and to maintain and keep adequate business and organizational records. This decision drastically underscores the need to follow the formalities and keep good records.

Kentucky Court Says Member Has Standing for Some but Not All Claims Against Other LLC Members

Standing is a legal doctrine that focuses on, among other things, whether a potential plaintiff is the right party to bring a lawsuit. The claimant must be the real party in interest, i.e., it must benefit directly if the action is successful.

A trial court’s dismissal for lack of standing of an LLC member’s claims against the other members was recently reversed in part by the Kentucky Court of Appeals. The Court of Appeals’ examination of the claims nicely contrasts those that gave the plaintiff standing with other claims where standing was lacking. Chou v. Chilton, No. 2009-CA-002198-MR, 2014 WL 2154087 (Ky. Ct. App. May 23, 2014).

Background. Ram.Chou Construction, LLC (RC LLC) was formed by Li An Chou and Richard, Mark, and William Chilton. The Chiltons owned and operated a separate company focused on large-scale public construction projects. Chou, born in China and raised in Taiwan, had operated several import and export businesses but was unfamiliar with the construction industry.

RC LLC was formed to qualify as a Minority Business Enterprise (MBE), so that it could obtain preferences when bidding on public construction projects. Chou had a 51% member interest in order to qualify the LLC as an MBE. Chou was responsible for obtaining MBE certification, and the Chiltons promised to teach Chou the construction business.

RC LLC had some success bidding on construction projects, but problems arose. According to Chou’s complaint, the Chiltons caused RC LLC to use the employees, equipment, accounting department, and payroll services of the Chiltons’ other construction company. The Chiltons also transferred funds between the two companies without authorization or documentation.

Eventually RC LLC lost its MBE certification because it lacked documentation to show that it was a separate entity and not merely a conduit for the Chiltons’ other construction company. At that point the Chiltons terminated Chou and moved RC LLC’s funds to their main construction company.

Chou then filed a lawsuit in his own name against the Chiltons, claiming fraud, breach of fiduciary duty, breach of the duty of good faith and fair dealing, and misappropriation of funds. He also asked the court for a dissolution of RC LLC and an accounting, and for an award of punitive damages. The trial court determined that RC LLC was the real party in interest and that Chou as an individual lacked standing, and accordingly dismissed his complaint.

Court of Appeals. Referring to court rules and prior case law, the court summarized the standing rule as follows: a lawsuit must be prosecuted in the name of the real party in interest, which is the party that will be entitled to the benefits of the suit if successful, i.e., to “the fruits of the litigation.” Id. at *3 (quoting Taylor v. Hurst, 216 S.W. 95 (Ky. Ct. App. 1919)). The court then reviewed each of Chou’s claims.

Dissolution – Standing. The Kentucky LLC Act authorizes the court to dissolve an LLC “in a proceeding by a member if it is established that it is not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement.” Ky. Rev. Stat. Ann. § 275.290(1) (emphasis added). Chou was a member and was authorized by the statute to seek the LLC’s dissolution, so he was therefore the real party in interest and had standing. Chou, 2014 WL 2154087, at *3.

Accounting – Standing. A dissolved LLC must be wound up and liquidated, and its net assets must be collected and either liquidated or distributed in kind. Ky. Rev. Stat. Ann. § 275.300(2). Thus an accounting would be “the natural next required step in the dissolution of the company.” Chou, 2014 WL 2154087, at *3. Because Chou had standing to seek a dissolution, he had standing to seek an accounting as well.

Breach of Fiduciary Duty – No Standing. Earlier Kentucky case law established that managing members of an LLC owe a fiduciary duty to the other LLC members. Patmon v. Hobbs, 280 S.W.3d 589, 595 (Ky. Ct. App. 2009). But the Chiltons were not RC LLC’s managing members – the operating agreement established Chou as the only managing member. Because the Chiltons were not managing members they owed no fiduciary duties to Chou, so he had no standing to assert the fiduciary duty claim. Chou, 2014 WL 2154087, at *4.

Misappropriation – No Standing. The funds and business opportunities that Chou claimed were misappropriated belonged to RC LLC, not to Chou. Any recovery for their misappropriation would belong to the LLC and not to Chou, so he had no standing to assert this claim. The fact that he might benefit indirectly from a recovery by the LLC was not adequate to give him standing to assert the claim. Id.

Fraud and Breach of the Covenant of Good Faith and Fair Dealing – Standing. Under earlier Kentucky case law, there is an implied covenant of good faith and fair dealing in every contract. Chou claimed that the Chiltons breached the implied covenant in the LLC’s operating agreement. As a party to the contract, Chou would be entitled to any recovery for the Chiltons’ breach of the contract. The operating agreement also provided that any member could sue the other members for fraud, so Chou would be entitled to any recovery on his fraud claim. He was therefore the real party in interest and had standing to assert claims for fraud and for breach of the implied covenant of good faith and fair dealing. Id.

Punitive Damages – Standing. The court referenced earlier Kentucky case law for the rule that a claim for punitive damages cannot survive if there is no underlying claim for compensatory damages. The court had already held that Chou had standing for his claims for compensation for fraud and for breach of the implied covenant of good faith and fair dealing, so he also had standing to seek punitive damages. Id.  

The Dissent. Judge Thompson’s dissent from the majority’s holding that Chou had no standing for his fiduciary duty claims points out three problems with the majority opinion.

First, Chou’s complaint alleged that Chou’s appointment as managing member of RC LLC was only a formality done for qualifying RC LLC as an MBE, and that in reality the Chiltons managed the LLC and acted on its behalf. As the majority noted, “[a] breach of fiduciary duty generally occurs between a principle [sic] and an agent.” Id. at *4. The Chiltons acted as agents for RC LLC and so owed the members fiduciary duties.

Second, the majority ignored Section 275.170 of the Kentucky LLC Act, which extends fiduciary duties to members as well as managers:

 (2)     The duty of loyalty applicable to each member and manager shall be to account to the limited liability company and hold as trustee for it any profit or benefit derived by that person without the consent of more than one-half (1/2) by number of the disinterested managers, or a majority-in-interest of the members from:

   .…

 (b)        Any use by the member or manager of its property, including, but not limited to, confidential or proprietary information of the limited liability company or other matters entrusted to the person as a result of his or her status as manager or member.

Ky. Rev. Stat. Ann. § 275.170(2) (emphasis added).

Third, the dissent pointed out that the Patmon opinion, which the majority relied on, referred to the duties of managing members because the defendant was the managing member of the LLC, but Patmon did not exclude members from fiduciary duties.

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