LLC Law Monitor : Northwest Limited Liability Company Lawyer & Attorney : Doug Batey : Stoel Rives Law Firm : LLC Formation, Tax Liability

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A recent U.S. District Court ruling shows why LLC derivative suits by LLC members against other members cannot normally be successfully removed from state court to federal court on diversity grounds. Price v. Smith, No. 11-C-0763, 2012 WL 336169 (E.D. Wis. Feb. 2, 2012).

Background. Sarah Price and Chris Smith were members of Bluemark Productions, LLC, a Wisconsin limited liability company. Bluemark is noteworthy for producing the film American Movie, which won the 1999 Grand Jury Prize for the best documentary at the Sundance Film Festival in Park City, Utah. Price was a co-director of American Movie, but Smith refused to acknowledge her and the director credit went solely to Smith. Price, 2012 WL 336169 at *1.

As part of his work for Bluemark, Smith then began directing commercial advertisements. Bluemark was paid for this work, and Price alleged that Smith wrongfully caused Bluemark to distribute the income from Smith’s work solely to himself, even though Price was also a Bluemark member and entitled to at least 10% of Bluemark’s profits. Price claimed that Smith had also hidden and withheld significant amounts of Bluemark’s revenue from her. Id.

In 2011 Price and Bluemark filed suit in Wisconsin state court against Smith, raising individual claims on Price’s behalf and derivative claims on behalf of Bluemark. The claims included breach of contract, fraud, and breach of fiduciary duty.

Shortly thereafter Smith removed the case to the U.S. District Court on the grounds of diversity, contending that the action is between citizens of different states and that the amount in controversy exceeds $75,000. See 28 U.S.C. § 1332; 28 U.S.C. § 1441(a).

Court’s Analysis. Smith and Bluemark then moved to remand the case back to state court, contending that the federal court lacked jurisdiction because there was not complete diversity between the parties. The court found Price to be a citizen of California and Smith to be a citizen of Wisconsin. But the court found Bluemark’s citizenship for diversity purposes to be that of its members, citing Cosgrove v. Bartolotta, F.3d 729, 731 (7th Cir. 1998). And if so, there would not be diversity of citizenship between the plaintiffs and the defendant, and the case would have to go back to the state court.

Price and Smith disputed whether Price was a member of Bluemark, but it was agreed that Smith was a member. The court therefore found Bluemark to be a Wisconsin citizen, and because Smith was also a Wisconsin citizen, diversity was lacking.

Smith contended, however, that Bluemark’s joinder as a plaintiff was unnecessary because Price’s derivative claims were really direct, individual claims on behalf of Smith, and that Bluemark’s presence in the case as a plaintiff was therefore superfluous and intended only to prevent removal of the case to federal court. Price, 2012 WL 336169 at *2, *3.

The court found that Smith’s argument ignored Wisconsin’s LLC Act, which states that a member who assents to a distribution in violation of the LLC’s operating agreement “is personally liable to the limited liability company for the amount of the distribution that exceeds what could have been distributed without violating … the operating agreement.” Id. at *3 (emphasis added by the court) (quoting Wis. Stat. § 183.0608(1)). The court also referred to a member’s statutory duty to account to theLLC and hold as a trustee for it any improper personal profit derived by that member from transactions connected with the conduct of the LLC or from use of the LLC’s property. Id. at *3; see Wis. Stat. § 183.0402(2). The court therefore found that the claims raised by Smith belong to Bluemark, Bluemark was a proper party to the suit, and Bluemark’s presence therefore defeated complete diversity.

Smith also argued as an alternative theory that Bluemark had been fraudulently joined to the suit. The court pointed out that the cases cited by Smith to support dismissal of Bluemark all involved fraudulent joinder of an in-state defendant in order to defeat removal to federal court. Smith’s claim, in contrast, was that Bluemark was fraudulently joined as a plaintiff. Price, 2012 WL 336169 at *2. Smith provided no authority indicating that the doctrine of fraudulent joinder applies to plaintiffs, and the court concluded that “[f]raudulent joinder does not provide a basis for dismissal of Bluemark.” Id.

The court concluded by granting Price and Bluemark’s motion to remand the case to the Wisconsin state court. Id. at *4.

Comment. The court’s analysis and ruling demonstrate the unavailability of the federal courts as a forum to resolve disputes between LLC members when the complaint is based on a member’s breach of the operating agreement, breach of fiduciary duty, or other wrong against the LLC. In a derivative suit the LLC is a necessary party as a plaintiff and is considered a citizen of the states where its members are citizens, including the defendant member. The defendant and the plaintiff LLC will therefore inevitably be citizens of the same state, resulting in a failure of diversity.

Even if the parties all desire the case to be in federal court, the court on its own initiative may remand the case back to state court. “A district court may raise the issue of subject matter jurisdiction sua sponte, and due to the constitutionally limited jurisdiction of the Federal Courts, is obligated so to do if it lacks jurisdiction.” Bartfield v. Murphy, 578 F. Supp. 2d 638, 644 (S.D.N.Y. 2008).

It’s also worth noting that the rule is decidedly different for corporations. “In the case of a regular corporation, the owners’ state of citizenship is irrelevant to whether there is the required complete diversity . . . .” Cosgrove v. Bartolotta, F.3d 729, 731 (7th Cir. 1998). For partnerships, whether general or limited, the rule is the same as for LLCs. Id.