Manager Appoints an Attorney to Represent the LLC in the Manager's Lawsuit Against the LLC
The Democrats and the Republicans strive to control the appointment of federal judges because they believe that the choice of judge may be outcome-determinative in important cases. Apparently it was similar thinking that led two LLC managing members to each appoint an attorney to represent the LLC in settling a claim that one of the two members had against the LLC. This resulted in the two lawyers each claiming to represent the LLC and each asking the court to disqualify the other. Razin v. A Milestone, LLC, No. 2D10-5233, 2011 Fla. App. LEXIS 12309 (Fla. Dist. Ct. App. Aug. 5, 2011).
Background. Sheldon Razin and Ashwini Bahl, the two 50-50 managing members, organized the LLC to own and operate a shopping center. Razin loaned $1 million to the LLC. The loan was not repaid by the due date, and Razin filed a lawsuit against the LLC to collect the debt.
Razin called a meeting of the two managers shortly before the complaint was filed. Bahl did not attend, and Razin voted at the meeting to authorize the hiring of attorney Todd Norman to represent the LLC in Razin’s lawsuit. Bahl objected to Razin’s action in selecting the LLC’s attorney, but Razin based his authority on the LLC’s operating agreement.
Operating Agreement. Article VII, Section 1 of their operating agreement states: “Notwithstanding any other provision of this Agreement, during the period that any portion of the Razin loan is outstanding, in the event of a disagreement between the Managers regarding any matter affecting the Company, the decision of Razin shall control with respect to such matter ….”
Razin and the LLC (represented by Norman) then entered into settlement negotiations to resolve the debt-collection lawsuit, and prepared a written settlement agreement that was contingent on court approval. Bahl was not idle and retained attorney Michael McDermott, who filed an answer in the lawsuit on behalf of the LLC, raising defenses and asserting a counterclaim against Razin for breaching the operating agreement.
Mutual Disqualifications. Norman then filed a motion to disqualify McDermott, and McDermott filed a motion to disqualify Norman. The trial court held a hearing and ruled that a majority of the managers was required to appoint legal counsel and that therefore neither Norman nor McDermott was validly appointed to represent the LLC. The court appointed a custodian to select and retain legal counsel for the LLC, and to take other steps as necessary to break tie votes between Razin and Bahl. Razin and Bahl could not agree on who should be custodian, so the court selected and appointed one. Razin and Bahl both appealed the trial court’s orders.
The Court’s Analysis. The District Court of Appeal found that the operating agreement “clearly indicates that as long as the Razin loan remains outstanding, Razin had controlling authority over any decision affecting Milestone in the event of a disagreement.” Razin, 2011 Fla. App. LEXIS 12309, at *8. It was undisputed that the loan was outstanding and that Razin was a manager. The court found that the provision was unambiguous and that the parties were bound by it.
Duty of Loyalty. Bahl contended that, notwithstanding the control provision in the operating agreement, Razin had a conflict of interest in retaining counsel to represent the LLC in its defense of Razin’s suit. The court found otherwise, reasoning as follows.
The Florida LLC Act establishes an LLC manager’s or member’s duty of loyalty, and in this case the LLC’s operating agreement neither restricted nor enlarged the mangers’ duty of loyalty. Id. at *10. The Act states: “Subject to s. 608.4226, the duty of loyalty is limited to: … 2. Refraining from dealing with the limited liability company in the conduct or winding up of the limited liability company business as or on behalf of a party having an interest adverse to the limited liability company.” Fla. Stat. § 608.4225(1)(a). Razin was not dealing with the LLC when he hired Norman to represent it. Rather, he was acting on its behalf to hire an unaffiliated service provider. The statutory duty of loyalty was not implicated.
The court recognized that Razin’s retention of counsel for the LLC was furthering his own interest, since it was a step in the process of realizing on the debt from the LLC. That alone does not violate the duty of loyalty, because Section 608.4225(1)(d) provides that “[a] manager or managing member does not violate a duty or obligation under this chapter or under the articles of organization or operating agreement merely because the manager’s or managing member’s conduct furthers such manager’s or managing member’s own interest.”
The Florida LLC Act recognizes that it is often appropriate for an LLC manager to enter into a transaction with the LLC. The Act’s statement of the duty of loyalty is subject to Section 608.4226, and that section permits transactions between an LLC and its member or manager if there is full disclosure and a vote of the members or managers, or if the contract or transaction is “fair and reasonable as to the limited liability company at the time it is authorized.” So even if Razin’s retention of an attorney for the LLC constituted a conflict of interest, the court upheld it on the ground that it was “fair and reasonable.” There was nothing in the record to indicate that Norman was working to protect Razin’s interests. 2011 Fla. App. LEXIS 12309, at *11-12.
The court concluded that Razin’s appointment of Norman as LLC counsel did not run afoul of Razin’s duty of loyalty to the LLC. After considering and upholding the adequacy of Razin’s notice to Bahl of the managers’ meeting, the court upheld Razin’s appointment of Norman and found that Bahl lacked authority to appoint McDermott.
Further Thoughts. On the face of it the result appears straightforward: the attorney appointed by Razin was allowed to represent the LLC, and the attorney appointed by Bahl was disqualified. The trial court’s order appointing a custodian was reversed.
But consider: Razin (on behalf of himself) and Norman (on behalf of his client the LLC) had entered into settlement negotiations and drafted a settlement agreement, to resolve Razin’s claim on his $1 million loan to the LLC. The reference to a settlement suggests that there was some compromise by both the LLC and Razin. In those negotiations, as the court noted, “Norman was hired to represent [the LLC], he had no duty to either Razin or Bahl individually; Norman’s duty ran only to [the LLC].” Id. at *12 n.4 (citing Fla. Rule of Prof’l Conduct 4-1.13).
The court did not discuss Florida Rule of Professional Conduct 4-1.2(a):
[A] lawyer shall abide by a client’s decisions concerning the objectives of representation, and, as required by rule 4-1.4, shall reasonably consult with the client as to the means by which they are to be pursued. . . . A lawyer shall abide by a client’s decision whether to settle a matter.
This rule makes it clear that the attorney is the agent of the client and must consult with the client about the attorney’s task. So, how did attorney Norman determine the objectives of the LLC in the settlement negotiations? How did he consult with the LLC to determine the means by which those objectives were to be pursued? How did his client, the LLC, determine whether to settle the matter?
Norman couldn’t rely on anything Razin told him that purported to be instructions from the LLC. That would be a blatant conflict that Norman couldn’t ignore. The provision in the operating agreement that gives Razin control would not help, since Razin would then in effect be negotiating with himself.
Norman couldn’t rely on instructions from Bahl, either, because the two managers would have to agree in order to authorize action by the LLC. The only way Norman could comply with the Rules of Professional Conduct would be to rely on joint instructions from Bahl and Razin, as managers of the LLC. That seems unlikely, given the parties’ acrimonious relationship.
Set aside the issue of how Norman could represent the LLC and at the same time satisfy his ethical obligations. Razin might purport to resolve the matter by executing a settlement agreement on behalf of the LLC, approved only by him (under the control provision of the operating agreement) and not by Bahl. Under Section 608.4226(1)(c), that would be valid if it is “fair and reasonable as to the limited liability company.” That would likely be a high hurdle to surmount and would presumably have to take into account the merits of the counterclaim that Bahl attempted to assert at the trial court level.
The decision of the Florida District Court of Appeal may be technically correct as far as it goes, but it looks like it is a long way from resolving the dispute between the parties.
An LLC's Single Member Cannot Represent It in a Washington Court - An Attorney Is Required
The common-law rule is that a corporation appearing in court must be represented by an attorney. That’s the rule in Washington and all federal courts. Not surprisingly, earlier this year Washington applied that rule to limited liability companies. Marina Condo. Homeowner’s Ass’n v. Stratford at the Marina, LLC, 161 Wn. App. 249, 263, 254 P.3d 827 (2011).
One might have thought that the Marina decision would have foreclosed the issue, but the plaintiff in Dutch Village Mall, LLC v. Pelletti, 162 Wn. App. 531, 256 P.3d 1251 (July 5, 2011), an LLC with a single member, contended that its sole member should be able to represent it in court.
The Dutch Village LLC owned a shopping mall and sued a tenant. The LLC’s complaint was signed by its sole member, Jay Lei. The defendant moved to strike the complaint on the grounds that it had to be signed by an attorney. The trial court granted the motion and the Court of Appeals accepted review. Lei argued for an exception:
Lei contends the right to appear pro se belongs to a single-person LLC as much as a person because the single owner is likewise acting solely on his own behalf, making all the decisions and taking all the risks, much like a sole proprietor. Lei contends the separate legal entity status of a single member LLC is a technicality that the court should disregard.
Id. at 536.
The court rejected Lei’s argument. First, said the court, allowing nonlawyers to conduct litigation creates burdens for the other party and for the court, resulting in poorly drafted pleadings, inadequate presentations of motions, and proceedings that are unduly prolonged and numerous. Id. at 538. (This does seem to reflect a hostility to pro se litigants, even when the litigant is an individual and therefore fully entitled to represent him- or herself.) Additionally, said the court, a lay litigant lacks many of an attorney’s ethical responsibilities. The court referred to the “elaborate and inappropriate claims pleaded by Lei in this case and his refusal to withdraw a moot and pointless motion for default.” Id.
Second, the court was troubled by the inconsistency between disregarding the entity for the member’s convenience (thereby obviating the need for a lawyer in court), and respecting it for other issues (the LLC’s liability shield). For example, if the defendant successfully counterclaimed against the LLC, Lei presumably would be unwilling to disregard the LLC and accept personal liability.
The court also pointed out that a rule allowing single-member LLCs to appear in court without an attorney would likely result in disputes over the LLC’s claim to have only one owner. What if the LLC’s ownership changed in the middle of a lawsuit? Could a plaintiff assign its claim to a single-member LLC, thereby eliminating the need to hire a lawyer to represent it in court?
The court’s refusal to allow the LLC to be represented in court by its single member is unexceptional and consistent with the rules on corporations. It is also consistent with the lawyer licensing system and the body of rules that protect lawyers’ monopoly on legal services. The system is usually justified by the need to protect the public from incompetent or unethical legal representation, but the Dutch Village case shows that the convenience of the courts is also a factor in supporting the rule.
Rhode Island Becomes the Newest State to Authorize Low-Profit LLCs - What's Going On Here?
Rhode Island passed legislation in June to authorize low-profit limited liability companies (L3Cs). The bill was signed by the Governor on June 20, 2011, and will take effect on July 1, 2012. With the passage of this legislation, Rhode Island becomes the ninth state to authorize L3Cs, joining Illinois, Louisiana, Maine, Michigan, North Carolina, Utah, Vermont, and Wyoming.
An L3C is a specific type of limited liability company, one whose primary purpose is not to earn a profit but rather to “significantly further the accomplishment of one or more charitable or educational purposes.” 2011 R.I. Pub. Laws ch. 79 (H. B. 5279A). I have previously written about L3Cs, here and here.
The promoters and advocates of L3Cs say that private foundations, as well as commercial investors, will be encouraged to invest in L3C enterprises. The state legislatures seem to be jumping on the bandwagon: L3C bills were introduced in at least nine states this year in addition to Rhode Island, which I wrote about in March, here.
These L3C bills are being pushed because the non-profit community is strongly interested in collaboration between the not-for-profit world and the for-profit-world, and wants to leverage the financial strength of the for-profit, investment-oriented community into charitable and educational activities. Arthur Wood, Transcript: New Legal Structure to Address the Social Capital Famine, 35 Vt. L. Rev. 45 (2010).
The fly in the ointment is that commentators – business lawyers and professors – have written at length about perceived defects in the L3C structure. For example, Bill Callison, a partner at Faegre and Benson, and Allan Vestal, Dean and Professor of Law at Drake University, have written about what they call the L3C illusion. J. William Callison & Allan Vestal, The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 273 (2010).
Another: Daniel Kleinberger, Professor of Law at William Mitchell College of Law, published an article last year that analyzes a number of L3C issues. Daniel S. Kleinberger, A Myth Deconstructed: The “Emperor’s New Clothes” on the Low-Profit Limited Liability Company, 35 Del. J. Corp. L. 879 (2010). If the title of his piece doesn’t give you its thesis, let me list the titles of the sections covered in Part Vof his article, The L3C Concept Debunked: (A) The L3C is Unnecessary, (B) The L3C “Brand” is Unwise, (C) The L3C Construct is Inherently Misleading, and (D) Current L3C Legislation is Nonsensical and Useless. I refer you to his article for Professor Kleinberger’s lengthy and detailed analysis.
With serious questions being raised by academics and business lawyers, one has to wonder why the states are rushing to adopt L3C legislation.
To quote Paul Newman in Cool Hand Luke: “What we’ve got here is a failure to communicate.” The business lawyers and professors are analyzing and criticizing the L3C structure, the non-profit community and other promoters are pushing the L3C law hard at a local level, and state legislatures are passing the laws. But the issues raised by the commentators are apparently being ignored. This is not a good way to make public policy.
What should happen here? There are clearly substantial problems and issues with the current form of L3C law that the states are adopting. The existing L3C laws should either be taken off the books or changed to address the problems, and new laws in the current L3C form should not be passed. Conceivably a form of L3C that addresses the problematic issues could be promulgated for consideration by the states.
I think one of the national bodies with expertise and a broad constituency, such as the National Conference of Commissioners on Uniform State Laws, the American Law Institute, or the Business Law Section or Tax Law Section of the American Bar Association, should take this issue in hand, study it, and make recommendations after thoroughly analyzing the issue and considering input from the various groups and experts. Such a process would result in recommendations and possibly a model statute that would be persuasive to state legislatures.
If you are an NCCUSL commissioner, an ALI member, or a member of the ABA’s Business Law Section or Tax Law Section, think about getting your organization involved in taking a hard look at L3Cs.
Delaware Supreme Court Upholds Bar on Derivative Suits by Creditors of Insolvent LLCs
During the past two months I have been on an extended vacation – very nice. Thanks to my colleagues Janet Jacobs and John Laney for guest-authoring posts, here and here.
Last week the Delaware Supreme Court ruled on the appeal of CML V, LLC v. Bax, in which the Court of Chancery held last year that a creditor of an insolvent LLC does not have standing to maintain a derivative suit in the name of the LLC against its managers. I wrote about that surprising result here – surprising because it is inconsistent with the corporate rule.
Delaware’s Supreme Court affirmed the Court of Chancery decision, holding that “Section 18-1002 of the LLC Act, by its plain language, limits LLC derivative standing to ‘member[s]’ or ‘assignee[s],’ and thereby denies derivative standing to LLC creditors.” CML V, LLC v. Bax, No. 735,2010, 2011 Del. LEXIS 480, at *24 (Del. Sept. 2, 2011) (brackets in the original).
The Court’s conclusion turned on its analysis of Sections 18-1001 and 18-1002 of the Delaware LLC Act:
§ 18-1001. Right to bring action. A member or an assignee of a limited liability company interest may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if managers or members with authority to do so 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.
§ 18-1002. Proper plaintiff. In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:
(1) At the time of the transaction of which the plaintiff complains; or
(2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction.
The Court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as requiring that the plaintiff be an LLC member or an assignee of a member. The Court emphasized the mandatory language in Section 18-1002: “must be a member or assignee,” and found Sections 18-1002 and 18-1002 to be unambiguous. CML, 2011 Del. LEXIS 480, at *11.
CML argued that (i) Section 18-1001 authorizes derivative standing to members or assignees but is not by its language exclusive, (ii) Section 18-1002 addresses only the chronology of such a member’s or assignee’s status, and (iii) when the two sections are read together they are similar in their effect to the comparable provisions of the Delaware General Corporation Law, Del. Code Ann. tit. 8, § 327, which has long been interpreted as allowing derivative standing for creditors of insolvent corporations.
CML’s position is buttressed by what the Court of Chancery characterized as an awkward fact:
[V]irtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit. Particularly in light of Production Resources and Gheewalla, an exclusive reading of Section 18-1002 would cause LLC derivative actions to differ markedly from their corporate cousins. If practitioners widely understood the derivative standing provisions to have this effect, one would expect treatises, articles, and commentaries to call attention to that fact. … [O]ne also would expect courts to have encountered parties raising the statutory provisions as a defense. Yet the universe of authorities favoring the no-standing position consists of (i) a single sentence at the end of a footnote in one Delaware treatise, see Symonds & O’Toole, supra, § 9.09, at 9-61 n.270, and (ii) abbreviated treatment in an unreported district court decision, see Magten, 2007 WL 129003, at *3.
Many commentators, by contrast, have assumed that creditors of an insolvent LLC can sue derivatively. In light of this assumption, they have debated vigorously whether an LLC agreement can limit the fiduciary duties that the creditors would invoke. That question never arises if creditors lack standing to sue under Section 18-1002.
CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220, at *12-13 (Del. Ch. Nov. 3, 2010) (footnote omitted).
This widespread reading of Sections 18-1001 and 18-1002 significantly undercuts the Court’s assertion that these two sections are unambiguous.
Nonetheless, the Court has spoken and the rule is now clear, at least until changed by legislative action. Given the gulf between the Court’s reading of the statute and the widespread past interpretations by commentators and practicing lawyers, it would not be surprising to see legislative action on this point. As the Court said, “The General Assembly is well suited to make that policy choice and we must honor that choice.” CML, 2011 Del. LEXIS 480, at *13.
