District Court Finds Common Law Fiduciary Duties Applicable to Wisconsin LLCs
LLCs are sufficiently new that issues of first impression continue to come up in various states. One of those issues is whether common law fiduciary duties apply to LLCs, when the state statute is silent or unclear. That was the situation in Wisconsin, when the defendants in a case before the U.S. District Court for the Eastern District of Wisconsin contended that common law fiduciary duties do not apply to Wisconsin LLCs and that they therefore owed no fiduciary duties to the plaintiff. Executive Ctr. III, LLC v. Meieran, No. 10-CV-263-JPS, 2011 WL 4704274 (E.D. Wis. Oct. 4, 2011).
The dispute arose out of the plaintiff’s $1.2 million purchase of an office building from BRIC Executive, LLC. In connection with the sale, BRIC agreed to lease office space back from the plaintiff (Executive Center). But BRIC defaulted on its lease obligations almost immediately and made no rent payments. Executive Center sued BRIC on the lease and obtained a judgment for $152,000, but BRIC was insolvent and never paid on the judgment.
Executive Center then investigated and learned that the defendants, part owners of BRIC, had been paid $400,000 by BRIC immediately after the closing of the real estate sale. BRIC paid the $400,000 to the defendants in order to redeem their part ownership in BRIC, under an agreement made by BRIC and the defendants 11 months before Executive Center’s real estate purchase.
Executive Center next sued the defendants in federal court, challenging the $400,000 transfer from BRIC to the defendants and seeking an award of damages. (The case was filed in federal court on the basis of diversity jurisdiction; no federal law issues were involved.) Executive Center claimed that by accepting the $400,000, the defendants (1) violated portions of Wisconsin’s Uniform Fraudulent Transfer Act; (2) breached a fiduciary duty they owed to the plaintiff; and (3) benefited from an inequitable preference. Id. at *2.
After pretrial discovery the defendants moved for summary judgment on all of Executive Center’s claims. The court granted summary judgment to the defendants on the fraudulent transfer claim and on the inequitable preference claim, but denied summary judgment on the fiduciary duty claim.
The gist of Executive Center’s fiduciary duty claim was that the defendants breached fiduciary duties they owed to Executive Center, a BRIC creditor, when they accepted BRIC’s payment of $400,000 at a time when BRIC was insolvent. The defendants argued that “common law fiduciary duties do not apply to Wisconsin LLCs because LLCs are purely statutory creatures that have their duties defined entirely by statute.” Id. at *7 (citing Gottsacker v. Monnier, 697 N.W.2d 436, 447 (Wis. 2005)). The defendants also pointed out that Wisconsin’s LLC Act does not expressly state that common law fiduciary duties apply to LLCs, other than referring to the Act’s incorporation of veil-piercing principles. Id.
The District Court distinguished Gottsacker, however, pointing out that its only discussion of the applicability of common law fiduciary duties to LLCs was in one Justice’s concurring opinion. The court then examined precedent from other jurisdictions, finding it persuasive: “In fact, there is growing consensus that common law fiduciary duties should apply to the operations of LLCs.” Id. at *8 (citing seven cases from Indiana, Kentucky, California, Connecticut, and Idaho). The court also looked to the policy supported by fiduciary duty rules. “Fiduciary duties exist to protect people who are affected by the actions of those who control businesses. Therefore, it would not make any sense if the expectation for a business to act fairly were to be different simply due to the business owners’ choice of form – an LLC, in this case.” Id. at *9 (citation omitted). The court concluded that common law fiduciary duties apply to Wisconsin LLCs. Id.
The court next considered whether any duties were owed to Executive Center in particular. (Executive Center was a creditor of BRIC, not a member.) Under Wisconsin case law, the defendants would owe a fiduciary duty to Executive Center if (a) BRIC was insolvent at the time of the $400,000 transfer, and (b) BRIC had ceased to act as a going concern. The court had already found that BRIC was insolvent at the time of the transfer, and defendants had conceded that there was an issue of fact regarding whether BRIC was no longer a going concern at the time of the transfer. The court therefore found that genuine issues of material fact remained, and denied defendants’ summary judgment motion on the fiduciary duty claim, which meant that the issue could go to trial.
This case is a nice example of a court resolving a question left unanswered by the state’s LLC Act. (I have written about this issue before, in connection with the Idaho case cited by the Executive Center opinion, here.) It’s also not a surprising result – it’s difficult to imagine a court finding that fiduciary duties do not in general apply to LLCs.
New York High Court Punts on Fiduciary Duties of LLC Promoters
Last month New York’s highest court, the Court of Appeals, affirmed a 2010 ruling by the Appellate Division that LLC promoters were fiduciaries of the investors they solicited, prior to the LLC’s formation, to become members. Roni LLC v. Arfa, 2011 WL 6338906 (N.Y. Dec. 20, 2011). The top court’s ruling was a surprisingly short memorandum opinion, given the significance of the issue presented.
The Appellate Division had applied the corporate rule on pre-formation activities to LLCs. “It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders…. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Roni LLC v. Arfa, 74 A.D.3d 442, 444 (N.Y. App. Div. 2010). I wrote about the Appellate Division’s ruling here, and about last month’s oral argument before the Court of Appeals, here.
The Appellate Division’s ruling had also garnered attention from New York lawyer Peter Mahler, here and here, and from the late Professor Larry Ribstein, who passed away recently, here. Professor Ribstein also filed an amicus brief on the case with the Court of Appeals. The major criticisms of the 2010 ruling have been that the rule of the old corporate cases is no longer necessary because of the disclosure requirements of the federal and state securities laws, and that the corporate rule should not be applied to LLCs because their contractual nature distinguishes them from corporations.
The Court of Appeals put off the question, however, whether mere status as a pre-formation LLC promoter is adequate to create a fiduciary relationship. “Based on the foregoing analysis, we need not decide the question of whether the promoter defendants’ status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship.” Roni LLC v. Arfa, 2011 WL 6338906, at *4 n.2.
The court instead began by citing prior case law to the effect that a fiduciary relationship exists “when confidence is reposed on one side and there is resulting superiority and influence on the other,” id. at *2. The court then reviewed the complaint’s allegations that (1) the promoters planned the business venture, organized the LLC, and controlled the invested funds; (2) the promoters were in the best position to disclose material facts to the investors; (3) the promoters represented to the foreign investors that they had particular experience and expertise in the New York real estate market; and (4) the promoters played upon the cultural identities and friendship of the investors. The court found that the complaint’s allegations showed confidence by the investors and resulting superiority and influence by the promoters, and therefore adequately pled a fiduciary relationship. Id. at *3.
The Court of Appeals ignored the Appellate Division’s holding that the complaint’s allegations are inadequate to establish a fiduciary relationship, which suggests that the Court of Appeals went out of its way to affirm without ruling on the “LLC-promoter-status-equals-a-fiduciary” issue. But if so, it’s slightly puzzling that the court also saw no distinction between LLCs and corporations for the issues in this case:
Certainly there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case: a potential exists regardless of corporate form for “conscienceless promoters [to] accumulate property at a low price under a well-devised scheme to unload it upon others at a high price.
Id. at *4 n.1.
Although the court’s opinion leaves open the “LLC-promoter-status-equals-fiduciary” issue, I suspect that most plaintiff’s attorneys will conclude that the court left them with enough to work with when pleading pre-formation fiduciary duty claims against LLC promoters. For one thing, the first three of the four factual points in Roni referred to by the court and summarized above are likely to apply to most promoter situations.
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.
Manager Appoints an Attorney to Represent the LLC in the Manager's Lawsuit Against the LLC
The Democrats and the Republicans strive to control the appointment of federal judges because they believe that the choice of judge may be outcome-determinative in important cases. Apparently it was similar thinking that led two LLC managing members to each appoint an attorney to represent the LLC in settling a claim that one of the two members had against the LLC. This resulted in the two lawyers each claiming to represent the LLC and each asking the court to disqualify the other. Razin v. A Milestone, LLC, No. 2D10-5233, 2011 Fla. App. LEXIS 12309 (Fla. Dist. Ct. App. Aug. 5, 2011).
Background. Sheldon Razin and Ashwini Bahl, the two 50-50 managing members, organized the LLC to own and operate a shopping center. Razin loaned $1 million to the LLC. The loan was not repaid by the due date, and Razin filed a lawsuit against the LLC to collect the debt.
Razin called a meeting of the two managers shortly before the complaint was filed. Bahl did not attend, and Razin voted at the meeting to authorize the hiring of attorney Todd Norman to represent the LLC in Razin’s lawsuit. Bahl objected to Razin’s action in selecting the LLC’s attorney, but Razin based his authority on the LLC’s operating agreement.
Operating Agreement. Article VII, Section 1 of their operating agreement states: “Notwithstanding any other provision of this Agreement, during the period that any portion of the Razin loan is outstanding, in the event of a disagreement between the Managers regarding any matter affecting the Company, the decision of Razin shall control with respect to such matter ….”
Razin and the LLC (represented by Norman) then entered into settlement negotiations to resolve the debt-collection lawsuit, and prepared a written settlement agreement that was contingent on court approval. Bahl was not idle and retained attorney Michael McDermott, who filed an answer in the lawsuit on behalf of the LLC, raising defenses and asserting a counterclaim against Razin for breaching the operating agreement.
Mutual Disqualifications. Norman then filed a motion to disqualify McDermott, and McDermott filed a motion to disqualify Norman. The trial court held a hearing and ruled that a majority of the managers was required to appoint legal counsel and that therefore neither Norman nor McDermott was validly appointed to represent the LLC. The court appointed a custodian to select and retain legal counsel for the LLC, and to take other steps as necessary to break tie votes between Razin and Bahl. Razin and Bahl could not agree on who should be custodian, so the court selected and appointed one. Razin and Bahl both appealed the trial court’s orders.
The Court’s Analysis. The District Court of Appeal found that the operating agreement “clearly indicates that as long as the Razin loan remains outstanding, Razin had controlling authority over any decision affecting Milestone in the event of a disagreement.” Razin, 2011 Fla. App. LEXIS 12309, at *8. It was undisputed that the loan was outstanding and that Razin was a manager. The court found that the provision was unambiguous and that the parties were bound by it.
Duty of Loyalty. Bahl contended that, notwithstanding the control provision in the operating agreement, Razin had a conflict of interest in retaining counsel to represent the LLC in its defense of Razin’s suit. The court found otherwise, reasoning as follows.
The Florida LLC Act establishes an LLC manager’s or member’s duty of loyalty, and in this case the LLC’s operating agreement neither restricted nor enlarged the mangers’ duty of loyalty. Id. at *10. The Act states: “Subject to s. 608.4226, the duty of loyalty is limited to: … 2. Refraining from dealing with the limited liability company in the conduct or winding up of the limited liability company business as or on behalf of a party having an interest adverse to the limited liability company.” Fla. Stat. § 608.4225(1)(a). Razin was not dealing with the LLC when he hired Norman to represent it. Rather, he was acting on its behalf to hire an unaffiliated service provider. The statutory duty of loyalty was not implicated.
The court recognized that Razin’s retention of counsel for the LLC was furthering his own interest, since it was a step in the process of realizing on the debt from the LLC. That alone does not violate the duty of loyalty, because Section 608.4225(1)(d) provides that “[a] manager or managing member does not violate a duty or obligation under this chapter or under the articles of organization or operating agreement merely because the manager’s or managing member’s conduct furthers such manager’s or managing member’s own interest.”
The Florida LLC Act recognizes that it is often appropriate for an LLC manager to enter into a transaction with the LLC. The Act’s statement of the duty of loyalty is subject to Section 608.4226, and that section permits transactions between an LLC and its member or manager if there is full disclosure and a vote of the members or managers, or if the contract or transaction is “fair and reasonable as to the limited liability company at the time it is authorized.” So even if Razin’s retention of an attorney for the LLC constituted a conflict of interest, the court upheld it on the ground that it was “fair and reasonable.” There was nothing in the record to indicate that Norman was working to protect Razin’s interests. 2011 Fla. App. LEXIS 12309, at *11-12.
The court concluded that Razin’s appointment of Norman as LLC counsel did not run afoul of Razin’s duty of loyalty to the LLC. After considering and upholding the adequacy of Razin’s notice to Bahl of the managers’ meeting, the court upheld Razin’s appointment of Norman and found that Bahl lacked authority to appoint McDermott.
Further Thoughts. On the face of it the result appears straightforward: the attorney appointed by Razin was allowed to represent the LLC, and the attorney appointed by Bahl was disqualified. The trial court’s order appointing a custodian was reversed.
But consider: Razin (on behalf of himself) and Norman (on behalf of his client the LLC) had entered into settlement negotiations and drafted a settlement agreement, to resolve Razin’s claim on his $1 million loan to the LLC. The reference to a settlement suggests that there was some compromise by both the LLC and Razin. In those negotiations, as the court noted, “Norman was hired to represent [the LLC], he had no duty to either Razin or Bahl individually; Norman’s duty ran only to [the LLC].” Id. at *12 n.4 (citing Fla. Rule of Prof’l Conduct 4-1.13).
The court did not discuss Florida Rule of Professional Conduct 4-1.2(a):
[A] lawyer shall abide by a client’s decisions concerning the objectives of representation, and, as required by rule 4-1.4, shall reasonably consult with the client as to the means by which they are to be pursued. . . . A lawyer shall abide by a client’s decision whether to settle a matter.
This rule makes it clear that the attorney is the agent of the client and must consult with the client about the attorney’s task. So, how did attorney Norman determine the objectives of the LLC in the settlement negotiations? How did he consult with the LLC to determine the means by which those objectives were to be pursued? How did his client, the LLC, determine whether to settle the matter?
Norman couldn’t rely on anything Razin told him that purported to be instructions from the LLC. That would be a blatant conflict that Norman couldn’t ignore. The provision in the operating agreement that gives Razin control would not help, since Razin would then in effect be negotiating with himself.
Norman couldn’t rely on instructions from Bahl, either, because the two managers would have to agree in order to authorize action by the LLC. The only way Norman could comply with the Rules of Professional Conduct would be to rely on joint instructions from Bahl and Razin, as managers of the LLC. That seems unlikely, given the parties’ acrimonious relationship.
Set aside the issue of how Norman could represent the LLC and at the same time satisfy his ethical obligations. Razin might purport to resolve the matter by executing a settlement agreement on behalf of the LLC, approved only by him (under the control provision of the operating agreement) and not by Bahl. Under Section 608.4226(1)(c), that would be valid if it is “fair and reasonable as to the limited liability company.” That would likely be a high hurdle to surmount and would presumably have to take into account the merits of the counterclaim that Bahl attempted to assert at the trial court level.
The decision of the Florida District Court of Appeal may be technically correct as far as it goes, but it looks like it is a long way from resolving the dispute between the parties.
LLC Managers on Both Sides of Transaction Breach Delaware's Entire Fairness Standard
LLC managers tempted by the old saw “no harm, no foul” should read William Penn Partnership v. Saliba, No. 362, 2010, 2011 Del. LEXIS 91 (Del. Feb. 9, 2011). The case shows that LLC managers having a conflict of interest in an LLC’s transaction must do more than ensure that the deal is economically fair to the LLC. They must also use fair procedures and comply with the LLC agreement.
The LLC managers in William Penn were members of the LLC, and they were also investors and directors of a corporation (Buyer) that wanted to purchase the LLC’s motel, its only substantial asset. Two of the other members did not want the motel sold, and if the sale could not be stopped they wanted to purchase the motel themselves. The mangers proceeded to manipulate the LLC’s sale and approval process through repeated material omissions and misrepresentations to the other members, and failed to hold a vote as required by the LLC agreement. The property was sold to Buyer, and the other members sued the managers for breach of fiduciary duties.
The LLC’s operating agreement was silent on the managers’ fiduciary duties, so the court found that they owed the traditional fiduciary duties of loyalty and care to the LLC’s members. William Penn, 2011 Del. LEXIS 91, at **14-15. Because of their financial interest in both the LLC and the Buyer, the managers bore the burden of demonstrating the entire fairness of the transaction. Id. at **15.
The entire fairness standard requires that the fiduciary demonstrate both fair dealing and a fair price in the transaction. Fair dealing involves aspects such as how the transaction was structured, timing, disclosures, and approvals. Fair price addresses the economic and financial aspects of the transaction. Id. at **15-16. The managers argued that the deal was entirely fair because the purchase price was more than the appraised value, but the court pointed out that both elements of the entire fairness test must be satisfied.
The Delaware Supreme Court found ample evidence in the record to support the Chancery Court’s conclusion that the managers breached their fiduciary duties. They prevented a fair and open process by a variety of machinations – withholding full information, providing misleading information, and imposing an artificial deadline on the transaction. Id. at **20.
In order to determine damages, the Chancellor ordered an appraisal of the property. The appraisal came in at $5.58 million, less than the $6.6 million the property had been sold for, leaving the plaintiffs with no conventional damages remedy.
Not to be balked by the rule that litigants normally bear their own legal fees, the Chancery Court used its equitable power and awarded attorneys’ fees to the plaintiffs. The Supreme Court found that there was no abuse of discretion: “The Chancellor’s decision to award attorneys’ fees and costs was well within his discretion and is supported by Delaware law in order to discourage outright acts of disloyalty by fiduciaries.” Id. at **22.
“No harm, no foul” didn’t work – even though the managers’ breach of fiduciary duties did not result in damages to the other members, the court nonetheless stung them with an award of the members’ attorneys’ fees.
Concealment of Breach of Fiduciary Duty Tolls the Alabama Statute of Limitations
Here’s a case for you. Plaintiffs invest $2.5 million in an LLC formed to purchase real estate, and guarantee a $7.5 million loan to the LLC. The LLC buys the real estate for $10 million from Ray Jacobsen, an affiliate of the LLC’s managers and its original investors. No one informs the new-money investors that Jacobsen bought the real estate for $5 million just days before selling it to the LLC for $10 million.
The plaintiffs alleged (a) that the LLC’s managers and original investors (the defendants) were well aware of Jacobsen’s “flip” of the property, (b) that the defendants never disclosed this information to the plaintiffs, (c) that the plaintiffs justifiably relied on the defendants’ silence by forgoing independent investigation, and (d) that the plaintiffs learned of the fraud later by happenstance. DGB, LLC v. Hinds, No. 1081767, 2010 Ala. LEXIS 116 (Ala. June 30, 2010).
The investors sued for damages, claiming fraud and breach of fiduciary duty and asking for dissolution of the LLC. The defendants contended that the claims were barred by the statute of limitations. The trial court dismissed almost all of the investors’ claims, and the plaintiffs appealed.
The defendants argued that the claims were barred by Alabama’s two-year statutes of limitations, Ala. Code §§ 6-2-38(l), 8-6-19(f). The plaintiffs in turn invoked the fraud savings clause of Ala. Code § 6-2-3:
In actions seeking relief on the ground of fraud where the statute has created a bar, the claim must not be considered as having accrued until the discovery by the aggrieved party of the fact constituting the fraud, after which he must have two years within which to prosecute his action.
If applicable, this exception would save the plaintiffs’ claims of fraud and breach of fiduciary duty, because their lawsuit had been filed within two years of their discovery of Jacobsen’s double-dealing, although it was more than two years after the original real estate deal.
The court simply applied the savings clause to the fraud claims, but the fiduciary duty claims were examined more closely. The court ruled that fraudulent concealment of wrongful acts is enough to invoke the fraud savings clause, even if the cause of action was for something other than fraud. DGB, supra, at *15, 16. Since the plaintiffs had alleged concealment of the defendants’ real estate flip, their claims survived.
The court never explicitly discussed what is necessary to make the concealment “fraudulent.” Presumably it means that there was some degree of mens rea, i.e., a guilty mind or intent.
Statutes of limitation are more than mere technicalities. They prevent old, stale claims from popping up many years after the original event. Memories fade, evidence may be lost, and witnesses may die or be missing. But in this case the court’s application of the fraud rule, along with its extension of the time for bringing the lawsuit, was the right result. As the court said, “A party cannot profit by his own wrong in concealing a cause of action against himself until barred by limitation. The statute of limitations cannot be converted into an instrument of fraud.” DGB, supra, at 11, 12 (quoting Hudson v. Moore, 194 So. 147, 149 (Ala. 1940), overruled on other grounds by Ex parte Sonnier, 707 So. 2d 635 (Ala. 1997)).
The investors also asked the court to order the dissolution of the LLC. The Alabama LLC Act allows for judicial dissolution of an LLC “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Ala. Code § 10-12-38. This provision is similar to those of the Delaware LLC Act and the Washington LLC Act. Since dissolution can be granted “whenever” it is not reasonably practicable to carry out the business in conformance with the charter, the court found that there was no basis for applying the statute of limitations to a request for a dissolution. DGB, supra, at *10.
Idaho LLC Member Owes No Fiduciary Duty to LLC's Manager
The Idaho Supreme Court has again examined the fiduciary duties of LLC members, in High Valley Concrete, L.L.C. v. Sargent, 2010 WL 2681188 (Idaho July 8, 2010). Last year the Idaho Supreme Court analyzed fiduciary duties between LLC members in Bushi v. Sage Health Care, PLLC, which I discussed here. In Bushi the court concluded that managing members of an LLC owe each other fiduciary duties.
In High Valley the LLC’s manager claimed that the sole member owed a fiduciary duty to the manager. High Valley was organized by Cary Sargent and Doyle Beck as an Idaho LLC. They initially planned for Beck to have a 51% interest and Sargent to have a 49% interest in the company. Ownership certificates for both were drawn up and signed, and each made his initial contribution to the LLC. Beck then requested that all of the LLC units be issued to him so that he could have the tax losses until the company became profitable – “then we’ll clear up - we’ll change the paperwork back.” High Valley, 2010 WL 2681188 at *1. Sargent agreed to the change, so Beck became the sole member and Sargent the manager.
Sargent was later fired, and the LLC sued Sargent for conversion, fraud, and breach of fiduciary duty. Sargent, the manager, in turn sued Beck, the sole member, for breach of fiduciary duty. Sargent claimed that he was damaged by the loss of his contributions to High Valley. At trial the LLC was awarded judgment on its claims against Sargent, and Sargent was awarded judgment on his fiduciary duty claim against Beck. Beck appealed.
The court began by noting that fiduciary relationships usually involve one party placing property or authority in the hands of another, or being authorized to act on behalf of the other. Id. at *4. The court described a fiduciary as one who is in a superior position to the other, where the other reposes special trust and confidence in the fiduciary. Examples include partners, principal and agent, attorney and client, and the executor and beneficiary of an estate. Id. at *5. Arm’s-length business transactions, standing alone, do not give rise to a fiduciary relationship.
The court had previously held in Bushi that LLC managing members owe each other fiduciary duties. But the High Valley court found that Sargent was not a member. Sargent had the opportunity to obtain a membership interest at the time of the LLC’s formation, but instead he allowed Beck to become the LLC’s only member. Bushi was therefore not applicable.
None of the other indicia of a fiduciary relationship were present. There was no indication that Sargent had any reason to believe that Beck was acting in Sargent’s interest. And although Beck had discussed reinstating Sargent’s 49%, Sargent testified that Beck was not holding Sargent’s 49% for him. Finding none of the control, property transfer, or “superior position” attributes of a fiduciary relationship to be present, the court held that no fiduciary relationship existed.
What is novel about this case is the role reversal. Usually members raise fiduciary duty claims against managers, not the other way round, as in High Valley. The managers, after all, are the ones in control of the LLC. It’s that control of the other party’s assets or business that lies at the heart of most fiduciary relationships.
It’s unclear from the court’s opinion what was the basis of the jury’s finding of a breach of fiduciary duty by Beck. The jury may have believed that Beck’s initial statements about later re-establishing Sargent’s 49% amounted to a sort of trust arrangement, a promise to hold the 49% for Sargent and to later restore the 49% to him. But the Idaho Supreme Court relied on the following bit of Sargent’s testimony:
Q. Did you understand that Beck was going to hold your 49 percent for you?
A. No. I understood that I – that the ownership would remain the same, that he was just doing it for his personal tax purposes or his business’ tax purposes.
Id. at *1. That “no” answer appears to have torpedoed Sargent’s case. I suspect that with further questioning by his counsel, Sargent could have made clear that there was more to the arrangement than his brief answer indicated. But that’s the thing about trial testimony – you don’t get a second crack at it after the trial is over.
New York Addresses Fiduciary Duties of LLC Organizers
The New York Appellate Division recently applied the fiduciary rules for corporate organizers to the organizers of LLCs, and found the LLC organizers to be fiduciaries of the investors they solicited to become members. Roni LLC v. Arfa, No. 1758, 601224/07, 2010 N.Y. App. Div. LEXIS 4613 (June 3, 2010).
The defendants were the promoters and organizers of several New York LLCs. The organizers entered into real estate purchase agreements, and then assigned the agreements to the LLCs after their formation. The organizers, who were the initial members of the LLCs, solicited outside investors to purchase member interests in the LLCs. The investors’ funds were then used by the LLCs to purchase the real properties.
Subsequently the investors sued the organizers, claiming that the organizers concealed brokerage commissions they received from property sellers and mortgage brokers. The investors alleged that the undisclosed commissions inflated the purchase prices of the real estate by at least $6.5 million.
The investors asserted claims for waste, breach of fiduciary duty, actual fraud, constructive fraud and an accounting. The organizers moved to dismiss for failure to state a cause of action and for failure to plead actual fraud and breach of fiduciary duty with specificity. The trial court denied the motion and upheld all claims, other than the claim for waste. The organizers appealed the dismissal of the motion, contending that the investors had not alleged adequate facts to establish that the organizers were their fiduciaries.
The key to the court’s decision was its extension of the corporate rule to LLCs. The court noted that “[i]t is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.” Id. at **5. From there it was a short jump to LLCs: “By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Id. at **5-6. As fiduciaries, the organizers were obligated to fully disclose the organizers’ interests that might affect the LLC and its members, including the organizers’ profits from organizing the LLC. Id. at **6. The court held that the investors had therefore stated a cause of action by alleging that the defendant organizers had failed to disclose the commissions they received from sellers and mortgage brokers, which inflated the purchase prices of the LLCs’ real estate. Id.
The organizers also defended on grounds that the investors had failed to allege that the undisclosed commissions were material, that the investors justifiably relied on the organizers’ silence, and that the investors were damaged. The court made short work of those defenses. Damages had been alleged, said the court. And because the case was an appeal of the trial court’s denial of the plaintiffs’ motion to dismiss, the issues of materiality and reliance could not be resolved as a matter of law, but would have to be resolved at trial. Id. at **7-8.
The Roni court’s resolution of the fiduciary duties of LLC organizers is an example of legal reasoning by analogy. The court looked at the rule that applied to organizers of corporations, and apparently deciding that LLCs are similar enough to corporations, applied the corporate rule to LLCs.
As the law of LLCs develops, state courts are frequently called upon to decide novel LLC issues. In doing so the courts often look to the law applicable in the analogous corporate context. Examples that I have written on previously include New York (de facto corporations, here), Colorado (creditors’ claims against directors, here), Oregon (requirements for derivative suits, here), and Michigan (officer liability for corporate torts, here).
The Roni court did not explain the principles underlying the corporate rule that it relied upon, but simply applied it “[b]y extension.” Id. at **5-6. The court’s implicit recognition of a close analogy between corporations and LLCs was presumably based on the entity nature of each and the similar roles played by the organizers of each type of entity.
LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Idaho's First Case on LLC Fiduciary Duties
The law of fiduciary duties in LLCs is not well settled. For example, less than half of the states have reported opinions on fiduciary duties in LLCs. Cases of first impression on basic fiduciary duty issues in LLCs will be arising for a long time to come.
State courts, when first faced with a claim of breach of fiduciary duty by an LLC manager or member, normally look initially to the state’s LLC Act. Many state LLC Acts have provisions setting fiduciary standards. For example, Ohio’s LLC Act requires managers to act in good faith, in (or not opposed to) the best interests of the company, and with the care of an ordinarily prudent person.
The Idaho Supreme Court recently addressed member fiduciary duties for the first time, in Bushi v. Sage Health Care, PLLC (March 4, 2009). Applying Idaho’s pre-RULLCA LLC Act, the court found no prescribed fiduciary duties in the Act. (In 2008 Idaho enacted RULLCA into law, which does contain express fiduciary duty language, but it does not become effective until July 1, 2010.)
Looking further afield, the justices found that the majority of courts considering the issue have concluded that LLC members owe one another the fiduciary duties of trust and loyalty. In the cases referred to in the Idaho opinion, the courts analogized LLCs to partnerships. The court concluded that under Idaho’s LLC Act, managing members of an LLC owe each other fiduciary duties.
This is not a surprising result. In fact, it’s hard to imagine a state court finding that LLC members with managing authority, or nonmember managers, do not have fiduciary duties of good faith, loyalty, and care akin to those of partners in a partnership or directors in a corporation. But the Idaho case is a good example of a court looking first to its statute, and upon not finding an answer, looking to persuasive precedent and the reasoning used by other courts.
We can anticipate later, more difficult questions involving matters such as the scope of a member’s or manager’s fiduciary duties, the extent to which the members can agree by contract to limit or exclude each other’s fiduciary duties, and whether claims for breach of fiduciary duties can be brought by a member or only derivatively in the name of the LLC. But those are discussions for a later date.
