Fiduciary Duties of LLC Organizers Argued Before New York's Highest Court
Last year the New York Appellate Division ruled that LLC organizers are fiduciaries of the investors they solicit to be members, and that as such they have a duty to disclose their self-dealing. Roni LLC v. Arfa, 903 N.Y.S.2d 352 (App. Div. 2010). I reported on the case, here.
The Roni decision was critiqued by New York lawyer Peter Mahler, who blogs on New York business law, here, and by law professor Larry Ribstein, here. To oversimplify a bit, the gist of the criticism is that the rule of the old corporate cases, on which the Roni court relied, (a) has been made unnecessary by the disclosure rules of federal and state securities laws, and (b) should not apply to LLCs because the contractual nature of the relationship between LLC members allows them to allocate risks and define duties inter se, which is not characteristic of corporations.
Roni has since been appealed to New York’s highest court, the New York Court of Appeals. Oral arguments in the case were heard by the court on November 15, 2011, and yesterday Peter Mahler blogged on the briefing and the oral arguments, here. His article is a fascinating review of the oral arguments before the high court. The judges’ questions apparently ranged widely from “Why should LLCs be treated differently?” to concerns over line-drawing and the reach of the Roni rule articulated by the Appellate Division.
So now we wait for the high court’s decision, which Peter Mahler predicts will likely be in the early months of next year. One can hope, if the Appellate Division ruling is upheld, that the court will provide some guidance on the scope of the Roni duty to disclose.
Virginia Limits the Assignability of LLC Member Control Rights
The transferability of an LLC member’s interest is determined by the terms of the LLC’s operating agreement and the requirements of the state’s LLC Act. State LLC statutes usually distinguish between transferability of a member’s economic interest and the member’s control rights, and generally make it easier to transfer the economic rights than the right to participate in management.
The Virginia Supreme Court recently analyzed the interplay between the transferability provisions of Virginia’s LLC Act and the LLC’s operating agreement in Ott v. Monroe, No. 101278, 2011 Va. LEXIS 214 (Va. Nov. 4, 2011). The court held that the death of an LLC member, and the transfer by will of his interest in the LLC, resulted in the transfer of the decedent’s economic rights but not his management rights.
Dewey Monroe, Jr. was an 80% member of L&J Holdings, LLC, a Virginia limited liability company. His wife Lou Ann was a 20% managing member. Dewey died in 2004, and his will bequeathed his LLC interest to his daughter Janet. Janet later called a meeting of the LLC and voted her 80% to remove Lou Ann and substitute herself as the managing member. Lou Ann objected that Janet had inherited only Dewey’s right to share in the LLC’s profits, losses, and distributions, and therefore had no right to vote as a member.
Janet then filed suit and asked for a declaration that she had inherited Dewey’s full membership in the LLC and that Lou Ann had been validly removed as a managing member. The trial court found that Janet had inherited only the economic rights and had no right to vote her interest or participate in the control of the LLC’s affairs, and that Janet therefore had no authority to remove Lou Ann from her position.
Virginia’s Supreme Court reviewed the history of Virginia’s LLC Act, and found the transferability of a member’s LLC interest to be analogous to the transferability of a partner’s interest in a partnership. Id. at *5-6. The Virginia Partnership Act recognizes that a partner’s interest comprises two components: a control interest and a financial or economic interest, and the court found this same division to be inherent in the LLC Act:
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.
Va. Code Ann. § 13.1-1039(A). The Act goes on to provide a way for an assignee to become a member: “Except as otherwise provided in writing in the articles of organization or an operating agreement, an assignee of an interest in a limited liability company may become a member only by the consent of” a majority of those members or member-managers. Va. Code Ann. § 13.1-1040(A).
The trial court had concluded that Dewey’s death resulted in his dissociation under Section 13.1-1040.1(7) (an individual member is dissociated upon his or her death), and that therefore his rights to participate in the LLC’s management terminated and only the economic rights survived to be inherited by Janet.
Janet argued that Section 2 of the LLC’s operating agreement, which permitted her to inherit Dewey’s rights, superseded Section 13.1-1040.1(7)(a) and that therefore Dewey was not dissociated. Section 2 of the operating agreement said:
[e]xcept 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.
Ott, 2011 Va. LEXIS 214, at *1-2. But the court did not detect any intent in the operating agreement to supersede Section 13.1-1040.1(7)(a), pointing out that Section 2 of the agreement does not explicitly address statutory dissociation.
The court concluded: “Dewey thus was dissociated from the Company upon 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. at *10. The result was that Janet inherited the economic rights but was not admitted as a member, and therefore had no ability to vote her interest or otherwise participate in management. The court affirmed the trial court’s dismissal of Janet’s claims to management rights.
Not content to resolve the dispute before it, the court went further and opined that “it is not possible for a member unilaterally to alienate his personal control interest in a limited liability company. Code § 13.1-1039(A).” Id. The court pointed out that the phrase “[u]nless otherwise provided in the articles of organization or an operating agreement” modifies only the first sentence of Section 13.1-1039(A), and not the third sentence, which says: “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.” (The entirety of Section 13.1-1039(A) is quoted above.) The court concluded that the operating agreement could not confer the power on Dewey to unilaterally convey to Janet his control interest. Ott, 2011 Va. LEXIS 214, at *11.
The court ignored Section 13.1-1040, however. That Section 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. This allows the operating agreement to limit or expand how an assignee can become a member. For example, the operating agreement could say that no consent of any member is required for an assignee (or certain classes of assignees) to become a member, and that any such assignee becomes a voting member upon the effectiveness of the assignment. This counterexample shows the risk in a court giving opinions beyond the dispute immediately before it.
The court also ignored Section 13.1-1001.1(C), which states: “This chapter shall be construed in furtherance of the policies of giving maximum effect to the principle of freedom of contract and of enforcing operating agreements.” That’s surprising, given its direct relevance to the court’s task of interpreting the Act’s strictures on the LLC’s operating agreement.
New York LLC Derivative Suit Fails for So Many Reasons
Judge Karas thoroughly dissects the plaintiff’s derivative and other claims in Cordts-Auth v. Crunk, LLC, No. 09-CV-8017, 2011 U.S. Dist. LEXIS 109600 (S.D.N.Y. Sept. 27, 2011). The opinion usefully sheds light on some of the corners of New York law on LLC derivative suits.
Plaintiff Renate Cordts-Auth filed suit on September 18, 2009, asserting:
● derivative claims for breach of fiduciary duty, tortious interference with contract, and legal malpractice;
● a direct claim for breach of contract; and
● equitable claims for an accounting, access to records, and a declaratory judgment that she was a member of Crunk, LLC at the time of the claimed wrongdoing.
The defendants moved to dismiss the lawsuit, and for purposes of the dismissal motions the court assumed the truth of the following facts, as asserted in the complaint.
Background. Cordts-Auth was a long-time employee of Sidney Frank Importing Company (SFIC), and also assisted its owner Sidney Frank in the operation of Crunk, LLC, a New York limited liability company. In 2005 Cordts-Auth was granted Performance Units in Crunk as consideration for her services. Her interest in the Performance Units was limited to the company’s post-grant-date appreciation, based on an appraisal at the time of grant.
Sidney Frank, the CEO of SFIC and Crunk, died in 2006. His daughter Catherine Halstead (Halstead) became Chairwoman of SFIC and manager and principal executive of Crunk. Her husband, Peter Halstead, became an advisor to Crunk’s management, including Cordts-Auth. Two months later, Peter informed Cordts-Auth that Halstead intended to devalue Crunk’s Performance Units and issue new units, to restructure Crunk and re-launch the company with new investors, and to defraud Crunk’s existing investors.
Cordts-Auth informed Halstead of her objections to the restructuring in February, 2007. Shortly thereafter she was removed by Halstead from her positions at SFIC and Crunk. A month later Cordts-Auth, SFIC, and Crunk entered into a separation agreement, under which Cordts-Auth agreed to resign from her positions with the companies and was paid $2 million.
Three weeks after execution of the separation agreement, Halstead wrote to Cordts-Auth. Halstead informed her that Crunk had lost $1.5 million in 2006, that Crunk had been projected to lose its remaining cash investments during the upcoming fiscal year, and that Crunk had been sold to Solvi Brands, LLC as of February 28, 2007, nine days before the date of the separation agreement. Cordts-Auth was informed that she would receive nothing for her Performance Units because the Crunk sale proceeds were less than the minimum required for the Performance Units to have any value. Two months later Crunk was dissolved.
In February 2009 Cordts-Auth requested from the re-launched Crunk an accounting of Crunk’s sale proceeds. In March 2009 she demanded a copy of the sale agreement between Crunk and Solvi, and the identities of all former interest-holders in Crunk and all current interest-holders in Solvi. Her requests were rejected and she filed the lawsuit several months later.
Analysis. The court began by reviewing Cordts-Auth’s claims to determine whether they were direct (made in her own right) or derivative (asserted on behalf of the LLC). The court applied New York law because Crunk was a New York LLC. Under New York law, a claim is considered to be derivative if the claim is for wrong done to the LLC. Id. at *15. The court viewed Cordts-Auth’s claims for breach of fiduciary duty, tortious interference, and legal malpractice as claims for injury to the LLC, and therefore characterized them as derivative claims.
Standing. The court next examined whether Cordts-Auth had standing to maintain the derivative claims. New York law requires that the plaintiff in an LLC derivative suit must have been a member of the LLC both at the time of the offending conduct and at the time the lawsuit is commenced, Id. at *17. (Many states, e.g. Delaware and Washington, have similar requirements.)
Crunk’s operating agreement set forth the requirements for an individual to be admitted as a member. The agreement required that Crunk’s Board determine the nature and amount of the Unit Consideration to be made by the individual, and the Unit Consideration must be received by the LLC. Unit Consideration is defined to be “cash or property” – services are not included. The Board made no such determination in Cordts-Auth’s case, and no Unit Consideration was paid by Cordts-Auth.
Crunk’s operating agreement also required that members holding two-thirds of Crunk’s Class A Units consent in writing to the admission of a member. That never happened. Cordts-Auth pointed out that she was listed on the operating agreement’s exhibit as a member, but the court found that the exhibit did not overcome the operating agreement’s clear membership requirements.
The court concluded that Cordts-Auth never became a member but instead was an assignee, a non-member holder of Performance Units. “Therefore, Plaintiff has failed to adequately plead that she ever attained membership in Crunk, and the Court dismisses her derivative claims on this ground alone.” Id. at *25-26.
Not content to rest on that branch of the analysis, the court also examined Cordts-Auth’s status at the time of filing the lawsuit. Cordts-Auth didn’t dispute the defendants’ contention that she was not a Crunk member when she filed suit, but she asserted that she fell within an equitable exception that applied where the transaction was fraudulent. The court found that although Delaware recognizes the equitable exception, no New York courts had applied a fraud exception to a New York LLC.
But even assuming that New York courts would apply an equitable exception to the continuous ownership requirement, the court found that Cordts-Auth did not fit into the exception. The fraud exception applies if the transaction was fraudulent and the transaction was done merely to eliminate derivative claims. Cordts-Auth alleged that the transaction was fraudulent, but not that its purpose was to eliminate derivative claims. She had no claims pending at the time of the Crunk sale, so eliminating a potential derivative suit was unlikely to have been the motivation for the transaction. Id. at *31.
Another equitable exception can apply if both the acquired company and the surviving company have engaged in wrongful or fraudulent conduct. The court found that Cordts-Auth did not allege any wrongful or fraudulent conduct by Solvi, the surviving company, so this exception did not apply. Cordts-Auth therefore lacked standing to pursue the derivative claims. Id. at *33.
Demand Requirement. Although the court found that Cordts-Auth did not have standing because she was not a member of Crunk at either of the required times (time of wrongdoing, and time of commencement of suit), it nonetheless proceeded to analyze whether Cordts-Auth had satisfied the demand requirements of a derivative lawsuit, and concluded that she had not.
There are two elements of the demand rule. The first component is procedural. Federal Rule of Civil Procedure 23.1 and the New York Business Corporation Law both require that a complaint which asserts a derivative claim must state with particularity the plaintiff’s efforts to obtain the desired action from the LLC’s managers, and the reasons for not obtaining the action or making the effort. The second component is substantive and addresses whether the demand was adequate to inform the managers of the potential cause of action so they could address the claim.
The defendants also contended that Cordts-Auth had a conflict of interest, because she was asserting on behalf of the LLC its claims against alleged wrongdoers, while at the same time pursuing her own personal claims directly against the LLC. The court dismissed that contention, because Cordts-Auth no longer held any interest in Crunk and would not receive any return as a member from the LLC’s claims.
The court found that Cordts-Auth’s complaint satisfied the particularity requirement, because it had adequate details about her demands and included copies of two demand letters she had sent to the defendants. But the substance of her demand was inadequate because it did not clearly relate to the derivative claims she was seeking to assert. She had demanded documents and information about the Crunk sale but had not mentioned potential causes of action or damages.
Cordts-Auth argued that demand would have been futile, which can excuse a failure to make demand. The court rejected this argument because Cordts-Auth did not fail to make a demand, but rather had made an inadequate demand that was refused by management. “Accordingly, the Court finds that Plaintiff has not satisfied the demand requirement, as required under New York law, and that she therefore may not pursue her derivative claims.” Cordts-Auth, 2011 U.S. Dist. LEXIS 109600, at *48.
Substance of Claims. After holding that Cordts-Auth’s derivative claims failed both because she lacked standing and because she had not satisfied either of the demand requirements (particularity and adequacy), the court then discussed the substance of some of her derivative claims in a long footnote 14. Id. at *48-53. The court didn’t rule on those issues, but expressed its skepticism about their viability.
Cordts-Auth claimed that both Crunk and Solvi breached fiduciary duties that they owed to her. Under New York law, corporations do not owe fiduciary duties to shareholders. Apparently no New York court has addressed the analogous issue for LLCs, but the court found it reasonable to extend the corporate rule to LLCs. Neither Crunk nor Solvi owed fiduciary duties to Cordts-Auth, so there could be no breach of fiduciary duties.
Cordts-Auth claimed that Solvi and the Solvi investors had tortiously interfered with her Crunk operating agreement, by inducing Crunk to sell its assets to Solvi in violation of the operating agreement. The court found it doubtful that Cordts-Auth could demonstrate that the Solvi investors induced the sale of Crunk to Solvi merely by investing in Solvi, and questioned whether the sale constituted a breach of the Crunk operating agreement.
Cordts-Auth also asserted a constructive trust claim, on the theory that her Performance Units were wrongfully transferred, but the court rejected that claim because the Performance Units were not transferred but were canceled when Crunk was dissolved.
Breach of Contract. Cordts-Auth asserted a direct claim, in her own right, for breach of contract against Crunk and Halstead. She alleged that their failure to give her notice of Crunk’s impending sale to Solvi violated Crunk’s operating agreement.
The court dismissed Cordts-Auth’s breach of contract claim against Crunk because Crunk was not a party to its operating agreement, which is an agreement between the Crunk members. “The plain language of the Crunk Agreement, and common sense, make clear that Crunk was not a party to the Crunk Agreement, and therefore could not have breached it.” Id. at *54.
(A Delaware LLC, in contrast, is bound by its operating agreement and therefore could be in breach of its own operating agreement. “A limited liability company is bound by its limited liability company agreement whether or not the limited liability company executes the limited liability company agreement.” Del. Code Ann. tit. 6 § 18-101(7).)
The court also dismissed Cordts-Auth’s breach of contract claim against Halstead. Cordts-Auth claimed that Halstead was obligated to give a “Drag Along Notice” of the impending Crunk sale. The Drag Along Notice only applied, however, if a majority of the selling Crunk members wished to force a minority to participate in a sale of their member interests. The Crunk sale was an asset sale and not a sale of member interests, so the Drag Along Notice did not apply. Further, Halstead had an optional right, but not an obligation, to give a Drag Along Notice. (No notice was required if Halstead did not exercise her Drag Along Right.) The court dismissed Cordts-Auth’s claim: the Drag Along Notice did not apply to Crunk’s asset sale and Halstead was not obligated to give the notice in any event, so there was no breach.
Accounting, Books and Records, and Declaratory Relief. Cordts-Auth asked for an accounting of the proceeds from Crunk’s sale. The court dismissed that claim, because a party seeking an accounting must establish the existence of a fiduciary relationship, and Cordts-Auth was not ever a member of Crunk and therefore failed to establish the existence of a fiduciary relationship. Additionally, her accounting claim named only Solvi and Crunk, and as the court previously noted, a New York LLC owes no fiduciary duties to its members.
Cordts-Auth also asked for access to Crunk’s books and records, and a declaratory judgment that she was a member of Crunk at the time of sale. Those claims were dismissed because only LLC members have rights to the LLCs books and records, and the court had already determined that Cordts-Auth had not been and was not a member of Crunk.
Conclusion. All of Cordts-Auth’s claims were dismissed, and her derivative claims were dismissed on several grounds. The opinion will bear study by any New York practitioner analyzing a client’s potential LLC derivative suit.
Pennsylvania LLC Member Personally Liable on Lease With Incorrect Signature
Business people use LLCs when starting a new business venture so they can be shielded from personal liability for the venture’s obligations. Limited liability for members is a fundamental part of the states’ LLC laws. The Pennsylvania LLC Act, for example, states:
Except as provided in subsection (e), the members of a limited liability company shall not be liable, solely by reason of being a member, under an order of a court or in any other manner for a debt, obligation or liability of the company of any kind or for the acts of any member, manager, agent or employee of the company.
15 Pa. Cons. Stat. § 8922(a). (Subsection (e) is only applicable if the LLC’s certificate of organization provides that some or all of the members are personally liable for the debts or liabilities of the LLCs. That is almost never done.)
The members can of course give up their liability shield, either intentionally in a contract or sometimes by mistake. One part of a contract that can be a pitfall for LLC members is the signature block, the place at the end of the contract where the parties sign it. (I assume the contract is in writing.)
The standard way to indicate that an LLC (and none of its members) is a party to a contract is to use the LLC’s name and the title of the signing member (or manager if it is manager-managed). Unfortunately this detail is sometimes overlooked or mishandled.
In Hazer v. Zabala, 26 A.3d 1166, 2011 Pa. Super. LEXIS 2227 (Pa. Super. Ct. Aug. 11, 2011), Juan Zabala signed his name to a lease, and underneath printed “DBA/ZABALA BROKER, LLC.” Hazer, 26 A.3d at 1170. (The lease did not otherwise recite the name of the tenant.) The landlord sued Zabala when the rent was not paid, and Zabala defended on the ground that the LLC, not Zabala, was the party to the lease.
The court disagreed. It recognized “DBA” as an abbreviation for “doing business as,” and saw the acronym as an indication that Zabala Broker, LLC was simply another name for Juan Zabala. “‘DBA’ identifies an equivalency or single identity between the appellations.” Id. at 1170.
Zabala’s signature did not identify himself as an officer, member or agent of the LLC, and the court found that the corporate rule applied to LLCs: “Corporations necessarily act through agents and if one so acting is to escape personal liability for what he intends to be a corporate obligation, the limitation of his responsibility should be made to appear on the face of the instrument.” Id. (internal quotation marks and citations omitted). Zabala’s failure to use any title such as “member” or “managing member” doomed his appeal.
The court was also unswayed by the fact that rent checks from an account in the name of Zabala Broker, LLC were accepted by the landlord. The court affirmed the trial court’s finding that the landlord was justified in accepting the checks in the belief that they were simply paid on behalf of Mr. Zabala.
The court’s analysis focused on the notion that “DBA” is used to indicate an alternative name for an individual or entity. It usually is, and the court’s analysis would have made perfect sense if Juan Zabala had used “Zabala Broker” as a DBA. What is odd is that he included “LLC” in the DBA, i.e., “Zabala Broker, LLC.” That indicates that he was holding himself out as a limited liability company, which doesn’t make sense. An individual is not an entity. It would seem more logical to view the use of “DBA Zabala Broker, LLC” as an awkward attempt to indicate that he was signing on behalf of the LLC, in a representative capacity.
However, the court also pointed out in a footnote that Zabala Broker, LLC was not formed until December 15, 2008, two and a half months after the lease was signed. Id. Although the court didn’t discuss the fact that the LLC did not exist at the time of signing the lease, that nonexistence supports the court’s conclusion that Zabala had not clearly indicated that he was signing in a representative capacity.
Lawyers routinely and reflexively write contractual signature blocks using the entity’s name and the title of the signing individual. In most cases where an incorrect signature block is used the signer is inexperienced or rushed, without an attorney to review and catch the mistake. In the song The End of the Innocence, Don Henley sings “The lawyers dwell on small details.” But sometimes those small details can cause large problems, and that’s what happened in Hazer v. Zabala.
