Utah Court Says Exception from Derivative Suit Requirements for Closely Held Corporations Applies to LLCs
LLC minority members who want to sue the majority members or managers for breaches of fiduciary duty are sometimes frustrated by a catch-22 – if the LLC was the injured party then the member’s complaint must be brought on behalf of the LLC as a derivative suit, but the procedural requirements for derivative suits may bar the minority member’s lawsuit. Utah has previously recognized an exception to the derivative suit requirements for closely held corporations, and recently applied that same exception to LLCs. Banyan Inv. Co. v. Evans, No. 20100899-CA, 2012 WL 5950664 (Utah Ct. App. Nov. 29, 2012).
Banyan was a 20% member of Aspen Press Company, LLC. The other five members managed the company and Banyan was not involved in its management. Banyan filed a lawsuit against the other members for breaches of their fiduciary duties and for unjust enrichment.
The defendants asked the court to dismiss Banyan’s lawsuit on the grounds that its claims were derivative and therefore could not be brought directly against the members. The defendants argued that Banyan should have filed the claims derivatively and should have complied with Rule 23A of the Utah Rules of Civil Procedure, which requires certain procedures for a derivative suit.
Rule 23A (and comparable rules from most other states) addresses the following problem. When a corporate director or LLC manager breaches its fiduciary duties, it directly harms the company. The shareholders or members are only harmed indirectly, so normally only the company would have standing to bring the lawsuit. But if those in charge of the company are themselves the wrongdoers, it’s unlikely that they’ll cause the company to sue themselves. That difficulty has led to the derivative suit, a procedural device by which a shareholder of a corporation or a member of an LLC can assert a claim on behalf of the company against a director or manager that is breaching its duties to the company.
A company’s decision to initiate a lawsuit is normally up to its management, so a derivative suit by its nature interferes with management’s authority. The rules for derivative suits therefore require, among other things, that before filing suit the complaining shareholder or member must first make demand on the company to take action against the wrongdoer, or explain why making the demand would be futile. E.g., Utah R. Civ. P. 23A.
Banyan’s lawsuit made claims for breaches of fiduciary duties directly against the other members. Its lawsuit was not a derivative suit and did not comply with Rule 23A. Banyan’s defense against the defendants’ motion to dismiss was that its suit was permitted under an exception for closely held corporations (referred to in this post as the Exception) that the Utah Supreme Court had recognized in Aurora Credit Services, Inc. v. Liberty West Development, Inc., 970 P.2d 1273, 1281 (Utah 1998) (“We therefore hold that a court may allow a minority shareholder in a closely held corporation to proceed directly against corporate officers.”).
The trial court ruled that the Aurora Credit Exception did not apply to LLCs and dismissed Banyan’s complaint. Banyan appealed. The defendants argued on appeal that the Exception does not apply to LLCs, and that even if it did apply, Banyan did not meet its requirements. Banyan Inv. Co., 2012 WL 5950664, at *4.
The Court of Appeals briskly disposed of the argument that the Exception did not apply to LLCs. The court pointed out that the Utah Supreme Court had previously decided that the corporate principles governing derivative actions apply to LLCs, and that Rule 23A governs derivative actions brought on behalf of LLCs as well as corporations. Id. (citing Angel Investors, LLC v. Garrity, 216 P.3d 944 (Utah 2009)). The court also found that the rationale for the decisions in Aurora Credit and Angel Investors was as applicable to LLCs as to corporations – the majority owners of closely held companies usually are the management, and management is usually not independent. The court concluded that “the trial court erred by dismissing Banyan’s direct claims solely on the basis of its conclusion that the [Exception] does not apply to LLCs.” Id. at *5.
The defendants also argued that Banyan could not maintain a direct action because it could not show that it was injured in a way that was distinct from any injury to the LLC. The court said no, that rule applied only to traditional direct actions by a shareholder or member, not to actions that would otherwise be derivative were it not for the Exception. Id.
The correct rule, said the court, is that for a plaintiff’s claims to come under the Exception, the plaintiff must be able to show that its injury is distinct from that suffered by the other owners: “The closely-held corporation exception applies where a minority shareholder suffers uniquely as a result of majority shareholders engaging in the type of wrongdoing that would ordinarily give rise only to a derivative claim.” Id. at *6 (emphasis added).
The court also stated that an LLC member may proceed directly under the Exception only if (i) the defendants will not be unfairly exposed to a multiplicity of actions, (ii) the interests of the LLC’s creditors will not be materially prejudiced, and (iii) the direct suit will not interfere with a fair distribution of the recovery among all interested persons. Id. (citing GLFP, Ltd. v. CL Mgmt., Ltd., 163 P.3d 636 (Utah Ct. App. 2007)).
The court held that the allegations in Banyan’s complaint satisfied these requirements and that Banyan could bring its derivative claims directly under the Exception. Id. at *7.
Comment. The Banyan court’s application of the Exception to LLCs is sensible and is consistent with the prior Utah case law. The Exception itself is a minority rule but appears to be gaining wider acceptance.
The Exception has been recommended by the American Law Institute. 2 American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 7.01(d) (1994). The American Law Institute indicates that its recommendation in § 7.01(d) is supported by decisions from nine states: Arizona, California, Georgia, Idaho, Maryland, Massachusetts, North Carolina, Ohio, and West Virginia. Id., Reporter’s Note 4, at 31-32.
When a Connecticut LLC filed suit to collect rent from its tenant, the tenant defended on grounds that the LLC members who approved the lawsuit owned only 50% of the LLC and therefore lacked the requisite majority vote. The LLC riposted that under the Connecticut LLC Act, the vote of its member who voted against the lawsuit had to be disregarded because her husband owned 20% of the tenant, and the Connecticut Supreme Court agreed. 418 Meadow St. Assocs., LLC v. Clean Air Partners, LLC, 43 A.3d 607 (Conn. 2012).
Background. State LLC statutes differ on how and to what extent members may bring lawsuits on behalf of LLCs. Some states allow derivative suits, in which one member can bring a suit on behalf of the LLC, subject to a number of restrictions. E.g. Delaware, Washington, and Illinois. The restrictions on LLC derivative suits are similar to those imposed on corporations. For example, the member must have been a member at the time of the alleged wrongdoing and at the time of filing the derivative suit, the member must make a prior demand of the LLC’s management (unless excused because it would be futile), and disinterested members or management may later terminate the suit.
Connecticut takes a different tack. Members holding a majority interest in an LLC may authorize a lawsuit on behalf of the LLC, whether or not the LLC is manager managed, unless the LLC’s operating agreement provides otherwise. Conn. Gen. Stat. § 34-187. Other states with similar provisions include Massachusetts and Wisconsin.
Connecticut’s section 34-187 and the other similar state LLC acts appear to have been based on Section 1102 of the Prototype Limited Liability Company Act (the “Prototype”), which was published in 1992 by the American Bar Association’s Committee on LLCs, Partnerships and Unincorporated Entities. The Prototype is reproduced at 3 Larry E. Ribstein & Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies, App. C (2d ed. 2012). The Prototype’s comment to Section 1102 discusses the differences between the derivative suit approach and Section 1102’s approach, and makes clear that Section 1102 replaces the derivative action.
Section 34-187 addresses conflicts of interest among the members when voting to approve a lawsuit. In determining the member vote on a lawsuit, the vote of any member “who has an interest in the outcome of the suit that is adverse to the interest of the limited liability company” is excluded. The Prototype’s comment to Section 1102 makes clear that interested members are excluded both as votes and in determining the number of votes necessary for a majority. Without the exclusion, a member that is or has an interest in the prospective defendant could vote against and block the LLC’s lawsuit.
An article published earlier this year examines (i) how the states that have adopted the Prototype’s Section 1102 have resolved member disputes, (ii) the differences between derivative suits and the direct suit approach of Section 1102, and (iii) the recommendations for member suits in the ABA’s Revised Prototype Limited Liability Company Act. James R. Burkhard, Resolving LLC Member Disputes in Connecticut, Massachusetts, Pennsylvania, Wisconsin, and the Other States that Enacted the Prototype LLC Act, 67 Bus. Law. 405 (2012). I wrote about the ABA’s publication last year of the Revised Prototype LLC Act, here.
The Lawsuit. Barbara Levine owned 50% of 418 Meadow Associates, LLC (Meadow), and Michael Weinshel and Mark Wynnick owned the other 50%. Meadow leased office space to Clean Air Partners, LLC (Clean Air).
A dispute arose between Meadow and Clean Air over the lease, and Weinshel and Wynnick brought suit in Meadow’s name to enforce the lease and collect rent from Clean Air. Barbara Levine’s husband, Steven Levine, owned 20% of Clean Air, however, and Barbara Levine objected to the lawsuit and did not vote to bring the action.
Clean Air defended the suit by claiming that Meadow lacked standing because member approval of the suit by majority vote was necessary, and Weinshel and Wynnick held only 50% of the member interest in Meadow and therefore lacked a majority. Meadow countered that Barbara Levine had an interest in the outcome of the lawsuit that was adverse to the LLC’s interest, because of her husband’s part ownership of Clean Air.
The trial court found that Barbara Levine’s indirect interest in Clean Air, through her husband’s part ownership of Clean Air, was insufficient to disqualify her as a voting member. With Barbara Levine voting against the lawsuit, the votes of Weinshel and Wynnick did not form a majority. The trial court therefore found that Meadow lacked standing and gave judgment for Clean Air. The Appellate Court affirmed and the Supreme Court accepted review.
The court began with the language of the statute, pointing out that “adverse interest” is not defined in Section 34-187 or elsewhere in the Connecticut LLC Act, and that therefore it should be construed according to its common usage. After reviewing a number of definitions, the court concluded that adverse interest should be construed broadly:
Simply put, the term “adverse” in § 34-187(b) encompasses any interest of a member that is contrary or opposed to the limited liability company’s interest in the outcome of the litigation. We therefore conclude, contrary to the trial court, that the statute’s application is not limited to circumstances in which a member’s adverse interest is a proprietary one.
43 A.3d. at 616.
The court therefore ruled that when LLC members desire to approve a lawsuit by the LLC and a spouse of one of the members is part owner of or maintains a position of control in a defendant company, then that member is considered to have an interest in the outcome of the suit that is adverse to the LLC’s interest and that member’s vote will be excluded. Id. The court viewed its broad interpretation of “adverse interest” as consistent with the overall approach of the LLC Act, which provides default rules for LLC governance but allows the members to depart from those rules in their operating agreement. Members desiring a different rule for initiating a lawsuit can specify that in the LLC’s operating agreement.
The decisions of the trial court and the Appellate Court were reversed and the case was remanded for further proceedings.
Comment. The members’ resort to Section 34-187 in 418 Meadow Street is unusual because the dispute did not involve a claim by one member against another member or manager. Most LLC lawsuits that are brought as derivative suits or as member-initiated direct actions (e.g., under Connecticut’s Section 34-187) involve disputes between members over breaches of fiduciary duty or breaches of the LLC’s operating agreement. Here the dispute was between the LLC and its tenant, and had it not been for one member’s spouse being part owner of the tenant it presumably would have been a routine business decision for the LLC to file suit to recover unpaid rent.
Georgia Court Dismisses LLC Derivative Suit, and Declines to Adopt Futility Exception to the Pre-Filing Demand Requirement
A derivative suit is a procedural device that can be used by a member of a limited liability company to assert a claim on behalf of the LLC against a manager or managing member of the LLC that is breaching its fiduciary or contractual obligations to the LLC. But an LLC’s decision to initiate a lawsuit is normally up to the managers, so a derivative suit by its nature interferes with the managers’ authority. For that reason a member is expected to exhaust its remedies within the LLC by first making a demand on the managers that they take action to resolve the wrongdoing. This “demand requirement” is reflected in many state statutes, rules of civil procedure, and case law.
That’s all well and good, but what if the controlling manager is the one accused of wrongdoing? How likely is it that a manager accused of breaching its fiduciary obligations to the LLC will fairly consider causing the LLC to sue itself, just because of a member’s demand? This is such a common scenario that many statutes and case law recognize an exception to the demand requirement when the plaintiff can show that making a demand would be futile. Potential plaintiffs in a derivative action often resist making a demand because of fears that the managers will cloak their refusal to take action as a reasonable business decision, or take control and manage the lawsuit in a less than diligent manner.
The Decision. The Georgia Court of Appeals recently had to decide whether the plaintiff in an LLC derivative suit should be excused from making a demand of the LLC’s majority member before commencing a derivative suit in the name of the LLC. The plaintiff had not demanded that the LLC take action before filing the derivative action in Pinnacle Benning, LLC v. Clark Realty Capital, LLC, 724 S.E.2d 894 (Ga. Ct. App. March 6, 2012). The court declined to adopt a futility exception to the demand requirement and dismissed the derivative claims. Id. at 901.
The plaintiff was a 30% member and one of two managers of Clark Pinnacle Benning LLC (CPB). The two affiliated defendants controlled CPB – one was a 70% member and the other was the second manager. CPB in turn was the managing member of an LLC that operated a military housing project at Fort Benning, Georgia. The plaintiff claimed that the two affiliated defendants controlled CPB and through it the housing project, and that they had taken steps in bad faith to audit the plaintiff’s management operations at Fort Benning and to terminate its interests as the property manager, in violation of their fiduciary obligations. Id. at 896-97.
The trial court dismissed the derivative claims because the plaintiff had not demanded, prior to filing its lawsuit, that CPB initiate suit against the defendants. (Presumably the plaintiff thought that it would be an exercise in futility to demand that the two defendants cause CPB to sue themselves.)
The Court of Appeals began by examining Georgia’s LLC Act. The Act lists five conditions under which a member may commence a derivative action in the right of the LLC, one of which is: “The plaintiff has made written demand on those managers or those members with such authority requesting that such managers or such members take suitable action[.]” Ga. Code Ann. § 14-11-801(2). The Act makes no reference to any exception to the demand requirement.
The court noted that the Georgia Business Corporation Act requires a demand on the corporation prior to commencement of a derivative suit and makes no mention of any exception. The court pointed out that the Corporation Act had previously been interpreted by the Court of Appeals to allow for no exceptions to the demand requirement. Pinnacle Benning, 724 S.E.2d at 900.
Guided by the prior corporate ruling, the court found the legislature’s intent to be clear: The LLC Act’s procedures for LLC derivative suits contain a pre-filing demand requirement with no futility exception. Id. at 900-01. The plaintiff contended that it had cured any procedural defect by filing a demand letter with its response to the defendants’ motion to dismiss the complaint, but the court found that unavailing because the LLC Act requires that the derivative suit not be commenced until at least 90 days after the demand was made. Accordingly, the Court of Appeals affirmed the trial court’s dismissal of the derivative suit.
Dismissal of the suit may only be round one of this dispute, however. That’s because, as the Court of Appeals pointed out, “the trial court’s dismissal of Pinnacle’s action was actually due to a lack of subject-matter jurisdiction based upon Pinnacle’s failure to meet a procedural prerequisite prior to filing suit.” Id. at 902. The court accordingly remanded the case to the trial court for entry of an order dismissing the derivative claims, without prejudice. Id. A dismissal without prejudice is not an adjudication on the merits, and the plaintiff could therefore refile the complaint if the jurisdictional defect can be cured.
Georgia’s Minority Position. Georgia is not the only state to require a demand of management before an LLC derivative suit can be filed, with no futility exception. Arizona, for example, has a comparable provision in its LLC Act. Ariz. Rev. Stat. Ann. § 29-831. But this appears to be a distinctly minority view.
I have checked the LLC Acts of 12 states chosen at random (including Georgia). My review showed that the LLC Acts of nine of the 12 had a futility exception from the demand requirement for an LLC derivative suit. I think this is a large enough sample to draw the general conclusion that most states include the futility exception in the derivative suit rules of their LLC Acts.
Two states of particular interest to me, Washington (where I practice) and Delaware (a leading state for LLC formations), have in their statutes a futility exception to the pre-filing demand requirement for LLC derivative suits. Washington’s LLC Act gives members the right to bring a derivative suit if either (a) the managers or managing members have refused to bring the action, or (b) “an effort to cause those managers or members to bring the action is not likely to succeed.” Wash. Rev. Code § 25.15.370. This is consistent with Washington’s limited partnership statute, which requires a pre-filing demand before a limited partner can bring a derivative suit, unless “[a] demand would be futile.” Wash. Rev. Code § 25.10.706.
The Delaware LLC Act excuses a pre-filing demand for LLC derivative suits in language similar to Washington’s. Del. Code Ann. tit. 6, § 18-1001. The same is true for the Delaware limited partnership statute, which excuses a pre-filing demand for limited partnership derivative suits if a demand is not likely to cause the general partners to bring the action. Del. Code Ann. tit. 6, § 17-1001.
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.
The ABA’s Revised Prototype Limited Liability Company Act has been published in the November 2011 Business Lawyer, copies of which were received at my firm last week. The Revised Prototype incorporates a number of welcome changes, and will likely become an even more widely used resource by states considering amendments to their LLC Acts.
Many state LLC Acts were first adopted in the early 1990s. In adopting and amending their LLC Acts, state legislatures have been able to look for guidance to several sources:
- The Uniform Limited Liability Company Act (“ULLCA”) promulgated by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) in 1994;
- The Prototype Limited Liability Company Act (the “Prototype”) published in 1992 by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities; and
Both the ULLCA and the Prototype were influential as the states drafted their LLC Acts, but neither fully occupied the field. As a result there is a lot of variation in LLC laws from state to state. According to NCCUSL, the revised ULLCA has been adopted by only the District of Columbia, Idaho, Iowa, Nebraska, Utah, and Wyoming. The Prototype also was used as the basis for several states’ LLC Acts, and has been used as a reference by other states in amending their Acts.
The Revised Prototype is a major revision and modernization of the Prototype. Changes include terminology, organization, and major points of law. The following is a partial list of the major changes.
Terminology. The name of the formation document has been changed from “articles of organization” to “certificate of formation,” and the principal contract that defines an LLC’s structure and the members’ rights has been renamed from “operating agreement” to “limited liability company agreement.” The latter change reflects the more common terminology, although it is cumbersome. E.g., Washington (RCW § 25.15.005), Delaware (DLLCA § 18-101).
Nonwaivable Provisions. Most state LLC statutes provide numerous default provisions that may be modified by an LLC agreement. Often each default rule will be preceded by language such as “except as otherwise provided in a limited liability company agreement.” Usually, however, some provisions of the statute will be nonmodifiable or nonwaivable by an LLC agreement, in which case the “except as otherwise provided …” language is not used to limit the statutory rule. This was the approach used in the 1992 Prototype.
The Revised Prototype instead simply states that the LLC agreement governs the LLC and its members, and that when the LLC agreement is silent the Act will govern, except that certain statutory provisions listed in Section 110 may not be modified by the LLC agreement. This approach eliminates the need to repeat variants of “except as otherwise provided [in an LLC agreement]” throughout the statute, as all of the default rules in the statute are subject to modification in an LLC agreement unless modification is barred by Section 110.
Manager-Managed vs. Member-Managed; Authority. Many state LLC Acts assume that management of the LLC will be vested either in the members or in one or more managers. Typically the statute will also describe the actual and apparent authority of the members or managers. Oregon and Washington both follow this approach, as did the Prototype.
The Revised Prototype instead takes a more flexible approach by eliminating the need to pigeon-hole the LLC as member-managed or manager-managed. The default rule is that the activities of the LLC are under the direction and oversight of its members. Revised Prototype, § 406. That can be changed by the LLC agreement, which may establish managers, officers, or other decision-makers and define their authority.
The Revised Prototype does not define any actual or apparent authority for members or managers. Instead, the actual and apparent authority of the members or of any officers, managers, or other agents, will be established by the LLC agreement, the decisions of the members, any filed statement of authority, or the common law of agency. Revised Prototype, Article 3.
Power. Most if not all state LLC Acts explicitly state that an LLC formed under the Act has adequate power. The statutes typically refer to LLCs having the powers that are “necessary or convenient” for their activities, or to comparable language. E.g. Delaware (DLLCA § 18-106(b), Washington (RCW § 25.15.030(2)), Oregon (ORS 63.077). Entity power is a fundamental attribute. For example, if an entity lacks power to form a contract and purports to do so, the contract will not be enforceable.
The importance of this issue is shown by legal opinion-letter practice. Lawyers for parties in major transactions are often required as a condition of the transaction to provide a legal opinion to the other party covering, among other things, the power of the lawyer’s client to enter into and carry out the transaction. The TriBar Opinion Committee’s 2006 Report on LLC closing opinions states that a lawyer’s opinion that an LLC has the power to enter into and perform its obligations under an agreement means that the LLC “has that power under … the statute under which it was formed.” TriBar Opinion Committee, Third-Party Closing Opinions: Limited Liability Companies, 61 Bus. Law. 679, 687 (2006) (emphasis added).
The Prototype intentionally did not include any language dealing with the LLC’s power to carry out its activities, apparently relying on the contractual aspect of LLCs. See Prototype, § 106, Commentary. The Revised Prototype, however, has included a statement that an LLC will have the powers “necessary or convenient to the conduct, promotion, or attainment of the business, purposes, or activities” of the LLC. Revised Prototype, § 105(b).
The Revised Prototype explicitly recognizes the entity nature of LLCs, defining an LLC as “an entity formed or existing under this Act.” Revised Prototype, § 102(13) (emphasis added). The Prototype, in contrast, defines an LLC as “an organization formed under this Act.” Prototype, § 102(F) (emphasis added).
It seems odd that the summary of major changes in the introduction to the Revised Prototype makes no mention of the addition of a powers clause, which I think most practicing lawyers would consider major, and the comment to Section 105 of the Revised Prototype makes no mention of the change.
Fiduciary Duties. The Revised Prototype does not provide for fiduciary duties and allows broad latitude to the LLC agreement to expand, restrict, or eliminate fiduciary duties. The implied contractual covenant of good faith and fair dealing may not be eliminated. Revised Prototype, § 110. Note that the absence of a default specification of fiduciary duties does not mean that the applicable state’s common law would necessarily hold that managers of LLCs have no fiduciary obligations. See Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012), which I wrote about, here.
Charging Orders. The Prototype provided that a court may issue a charging order, which gives an LLC member’s judgment creditor the right to receive any distributions the member would otherwise receive. The Prototype left unclear whether a charging order was a judgment creditor’s exclusive remedy. I wrote about the exclusivity of charging orders last year, here.
The Revised Prototype makes clear that a judgment creditor’s charging order is its exclusive remedy against an LLC member’s interest in the LLC. This change brings desirable clarity, but many would argue that there is a policy issue left unaddressed by the Revised Prototype, i.e. whether the charging order should be exclusive even in the case of a single-member LLC.
The new provision provides additional detail about the exercise of the charging order, and also makes clear that a charging order may be obtained against an assignee’s LLC interest.
Derivative Suits. The Prototype did not provide a default rule for derivative suits, although nothing in the Prototype prevented an LLC agreement from authorizing derivative suits. The Revised Prototype authorizes derivative suits for members as a default rule, although not for assignees (unlike Delaware, which allows members and assignees to bring a derivative suit, DLLCA § 18-1001).
Series LLCs. Series LLC provisions were added to the Revised Prototype. A series LLC is an LLC that is split into separate series, each having its own members and managers, owning its own assets separate from the assets of the LLC or any other series, and incurring obligations enforceable only against its own assets. At least eight states have authorized series LLCs (see my blog post, here).
Evergreen. The Revised Prototype has been published by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities. The Committee deserves praise for this comprehensive revision and the thoughtful comments.
The Committee stated in the overview to the Revised Prototype that it will be revised on an ongoing basis, to anticipate and respond to legal and business changes affecting LLCs. This will be especially useful if the Committee can make such revisions publicly available on the Internet (once released), with clear delineation of the changes from one version to another and with adequate comments explaining the changes.
Comments. The Committee has encouraged interested parties to submit suggestions and comments on the Revised Prototype. The Committee can be reached through the ABA’s website, here.
To prevent forum-shopping by plaintiffs in shareholder derivative suits, some Delaware corporations in the last couple of years have amended their bylaws to lock in the Delaware Court of Chancery as the exclusive forum for derivative suits. One study showed that as of the end of 2011, 195 Delaware corporations have adopted or proposed exclusive forum provisions in their bylaws or articles.
At least nine lawsuits have been filed this month by shareholders challenging the new bylaw provisions. The lawsuits seek to have the bylaw provisions declared invalid on grounds that (a) the forum of a derivative suit is an external matter and not a matter of internal corporate governance, (b) there was no mutual shareholder consent to the new forum rule, and (c) the new bylaws are overly broad and violate due process. The corporations have apparently threatened to sue any shareholders daring to bring a derivative suit outside of Delaware in violation of the new bylaw provisions.
Francis Pileggi and Professor Stephen Bainbridge have commented on these lawsuits, and I refer you to their reports for more details and commentary. Alison Frankel has also written about the lawsuits and includes links to some of the complaints, here.
What about limited liability companies? LLC managers observing the forum restrictions that many corporations have adopted might well consider implementing similar restrictions.
The concern would not be unfounded – derivative suits are available to members of LLCs. Delaware allows a member or an assignee of an LLC interest to bring a derivative action in the right of an LLC. DLLCA, § 18-1001. Washington has a similar provision in its statute, except that Washington only allows members, and not assignees, to bring the action. RCW 25.15.370.
Forum restrictions are contemplated by the Delaware LLC Act. A written LLC agreement can provide that its members consent to the exclusive jurisdiction of the Delaware courts. DLLCA § 18-109(d). (This is one of the few sections in the Delaware LLC Act where a provision of an LLC agreement must be in writing to be enforceable.)
Changing the rules for an existing LLC is not as easy as a corporate board’s amendment of the corporation’s bylaws. An LLC agreement is a contract between the members and can only be changed with their consent, so member consents would be required for an LLC to add a forum-limiting provision to its LLC agreement.
Whether or not the consent of all the members would be required depends on the terms of the LLC agreement, which may or may not allow amendments on the approval of less than all members. The Delaware LLC Act authorizes an LLC agreement to limit the voting or approval rights of any member or group of members. DLLCA, § 18-302(a). For example, an LLC could have two classes of members, voting and non-voting. The non-voting members would be presumed to have known their rights when they became parties to the LLC agreement, and under the policy in the Delaware statute of giving maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements, a forum-limiting amendment to the LLC agreement, approved by only the voting members, should be enforceable. DLLCA, § 18-1101(b).
If the LLC agreement is silent on the subject of its amendment, unanimous approval of the members will be required for any change to the agreement, as with any other multi-party contract.
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.
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.
The Delaware Court of Chancery decided earlier this month 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. CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220 (Del. Ch. Nov. 3, 2010). The court’s lengthy opinion is nicely summarized by Francis Pileggi, here.
This blog post focuses on only one aspect of the opinion – its treatment of the interplay between the LLC Act’s statutory provisions and the judicially-created, derivative-suit remedy available to the courts under their general equity jurisdiction. My thesis is that the court gave unduly short shrift to the equitable underpinnings of the derivative suit.
The CML ruling is in contrast to the rule for corporations. Creditors of an insolvent corporation do have standing in Delaware to bring derivative claims. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).
The CML conclusion surprised many practitioners. The court itself admitted the “awkward fact” that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing [a derivative] suit.” CML, 2010 Del. Ch. LEXIS 220, at *12.
The result is surprising because it is inconsistent with the corporate rule and with the policy behind that rule. The policy of the corporate rule was noted by the court: “When a corporation is insolvent, the creditors become ‘the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’” Id. at *6 (quoting Gheewalla, 930 A.2d at 102).
That policy applies as much to an insolvent LLC as it does to an insolvent corporation. If the entity is insolvent, the members’ or shareholders’ economic interest in the LLC or corporation has been wiped out. The creditors then in effect stand in the shoes of the members or shareholders.
The CML 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.
(Emphasis added.) The court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as mandating that the plaintiff must be a member or an assignee of a member. CML, 2010 Del. Ch. LEXIS 220, at *7-8.
The court did not discuss Section 18-1002’s references to “a member or an assignee.” Creditors of an insolvent LLC, like assignees of member interests in a solvent LLC, hold the economic interest in the LLC and become the principal constituency injured by fiduciary breaches. It’s hard to see why such a creditor should not be treated like an assignee of the members’ interests. And assignees are explicitly granted standing in Section 18-1001 to initiate a derivative suit.
The court also did not discuss in any detail the equity-court origins of the derivative-suit remedy. The court’s disregard of the history of the derivative suit led it to conclude that Sections 18-1001 and 18-1002 are the sole source of authority for an LLC derivative suit. CML, 2010 Del. Ch. LEXIS 220, at *8-9.
That analysis contrasts with the court’s view of Section 327 of the Delaware General Corporation Law (DGCL). Section 327 states: “In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law.” The CML court characterized Section 327 as not creating the right to sue derivatively and as not saying that only stockholders can sue derivatively. CML, 2010 Del. Ch. LEXIS 220, at *10 (citing Schoon v. Smith, 953 A.2d 196, 204 (Del. 2008)).
The reason why Section 327 does not create the right to sue is that the derivative-suit remedy was a judicial creation. Schoon describes at length how the right of shareholders to sue derivatively originated in the equity courts in order to prevent a failure of justice, and how the shareholder derivative suit was later restricted by Section 327 to prevent strike suits. Schoon, 953 A.2d at 201-03.
Delaware courts have applied equitable remedies to LLCs even when the remedy is not set forth in the LLC Act, pursuant to the courts’ general equity powers. E.g., Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113-VCN, 2010 Del. Ch. LEXIS 184 (Del. Ch. Sept. 2, 2010) (appointment of a receiver). Consistent with those cases, Delaware presumably would have applied the derivative-suit remedy to LLCs even if Delaware’s LLC Act made no mention of derivative suits.
The long history of the derivative-suit remedy and the courts’ willingness in general to assert equitable remedies imply that the LLC Act should not be viewed as the sole authority for LLC member derivative suits. And if so, one should read Sections 18-1001 and 18-1002 together, interpreting them much as DGCL Section 372 has been interpreted. Under that reading, the “must” in Section 18-1002 is seen as applying the contemporaneous ownership requirement to the subset of derivative suits instituted by an LLC member, and Section 18-1002 does not close the courthouse doors to a creditor bringing a derivative suit in the name of an insolvent LLC.
The CML court was troubled by the fact that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” CML, 2010 Del. Ch. LEXIS 220, at *12. The court never answered the obvious question – why is that? The answer is that the court’s perfunctory treatment of the history of the derivative-suit remedy and its disregard of its own general equity jurisdiction resulted in an outré and anomalous conclusion.
The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.
The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.)
The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.
Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).
The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.
The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.
Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.
The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.
The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.
The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.