Last fall the Delaware Supreme Court surprised many corporate lawyers when it declared that whether the Delaware LLC Act imposes fiduciary duties on LLC managers is an open question. Gatz Props., LLC v. Auriga Capital Corp., 59 A.3d 1206, 1218 n.62 (Del. 2012).
Prior to Gatz, most Delaware lawyers believed that Delaware LLC managers were subject to fiduciary duties, absent contrary provisions in the LLC agreement. The Delaware LLC Act does not explicitly say that, but it’s implied in Section 18-1101(c):
To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement ….
(Emphasis added.) There was also case law from the Court of Chancery, most notably the Chancery opinion in the Gatz case: Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 839 (Del. Ch. 2012). The Chancery opinion comprehensively explained how and why the Delaware LLC Act applies fiduciary duties to LLC managers. I discussed that decision here.
The Supreme Court affirmed the judgment of the Court of Chancery, but it did so by relying only on the LLC agreement’s contractual provisions for fiduciary duties. The court rebuked the Court of Chancery for unnecessarily expounding on the statute’s interpretation, since deciding whether the LLC Act imposed fiduciary duties was not necessary to resolve the dispute. The Supreme Court declared that Chancery’s “statutory pronouncements must be regarded as dictum without any precedential value.” Gatz, 59 A.3d at 1218.
The Supreme Court’s opinion in Gatz was startling and generated a lot of commentary. I discussed it here. Not only did it reveal a gaping hole in Delaware’s LLC law, it also reflected some tension in the relationship between the Supreme Court and the Court of Chancery.
The Fix. Recognizing that the LLC Act may be ambiguous on whether fiduciary duties apply to LLC managers, the Supreme Court suggested that the Delaware State Bar Association “may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.” Id. at 1219.
And lo, it is happening. The Corporation Law Section of the Delaware State Bar Association has approved proposed legislation which is now awaiting the Bar Association’s final approval. Approval is expected by the end of this month, after which the proposal presumably will be introduced as a bill in the Delaware General Assembly. It would then proceed through the legislative process, and if all goes well will be passed by the legislature and signed into law by Governor Markell. Given the importance of predictable rules to Delaware’s prominence in the world of corporate law, I think it likely that this proposal will be adopted relatively soon.
The proposed amendment would add 11 words to the LLC Act. Section 18-1104 would be modified to read as follows (the new language is underscored):
In any case not provided for in the chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.
The Synopsis to the proposed bill elaborates on the amendment:
Section 8. The amendment to Section 18-1104 confirms that in some circumstances fiduciary duties not explicitly provided for in the limited liability company agreement apply. For example, a manager of a manager-managed limited liability company would ordinarily have fiduciary duties even in the absence of a provision in the limited liability company agreement establishing such duties. Section 18-1101(c) continues to provide that such duties may be expanded, restricted or eliminated by the limited liability company agreement.
Comment. This is an intriguingly short insert to the statute. In one sense it says nothing, because the current language – “the rules of law and equity” – would normally be read to mean all the rules of law and equity. If the rules of law and equity include the rules relating to fiduciary duties, then why the insertion?
Sometimes lawyers will use a phrase in contracts – “including, for the avoidance of doubt” – as a way of clarifying the purpose of an “including” clause. That thinking may be behind the proposed revision, i.e., it may be intended to eliminate any doubt whether fiduciary duties are included in the statute’s reference to “the rules of law and equity.”
Chancery’s opinion in Auriga Capital characterized fiduciary duties as originating in equity, and the proposed amendment’s emphasis on equitable rules can be viewed as a nod to the Chancery Court analysis.
A contract that limits a corporate director’s vote is generally invalid, but not so for LLC managers. The guiding principle for LLCs is freedom of contract, unlike corporations, but that principle can clash with the principles undergirding an LLC manager’s fiduciary duties. For example, what’s the result if an LLC’s operating agreement requires that one of the LLC’s managers vote as directed by a designated member? Does that manager have any fiduciary duties? The Delaware Court of Chancery recently held that such a manager was not without fiduciary duties, even though he had no power to vote. Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. C.A. 4113-VCN, 2013 WL 764688 (Del. Ch. Feb. 28, 2013).
The plaintiffs owned units in Advance Realty Group, LLC, a Delaware LLC. Several of the plaintiffs were individuals who were executives of the LLC until their termination in 2007, and the other plaintiffs were entities owned by the individual plaintiffs. The plaintiffs raised a number of claims after their termination, but the most noteworthy was their contention that defendant Ronald Rayevich, a manager of the LLC, had breached his fiduciary duties to the LLC.
Rayevich was a member of the LLC’s managing board, which had the duty to manage the business and affairs of the LLC. He had no discretion in how to vote as a member, however, because he was required by the LLC’s Operating Agreement to follow the voting instructions of one of the LLC’s members.
The defendants moved for partial summary judgment on several of the plaintiffs’ claims, including the claim against Rayevich.
The Claim. The plaintiffs’ claim against Rayevich centered on his involvement in the managing board’s approval in 2008 of the LLC’s Conversion and Exchange Agreement (Agreement), which the plaintiffs contended negatively affected their LLC interests. The plaintiffs argued that although Rayevich had no choice in voting for the Agreement, he nonetheless violated his fiduciary duties because he failed (1) to evaluate whether the terms of the Agreement were in the best interests of the members, (2) to voice his opposition in light of the conflicts of interests involving his fellow board members, or (3) to take any steps to prevent the self-dealing of the insider defendants. Id. at *3.
Rayevich contended that he was entitled to summary judgment because (a) the plaintiffs had not overcome the presumption that he acted in good faith, and (b) even if he did breach his fiduciary duties, he was not acting willfully or in bad faith and therefore was exculpated from liability under the provisions of the LLC agreement.
The court pointed out that Rayevich is presumed to have acted on an informed basis in good faith, but said that he could not avoid liability simply by pointing out that he had no discretion to vote as a board member. Even though he could not vote, he had an obligation to consider the interests of the members and to take action to protect their interests. “[F]iduciary duties extend beyond voting. They may involve, for example, studying the proposed action, determining the appropriateness of the proposed action, setting forth a dissenting view to fellow board members, and, in the proper circumstances, informing unit holders about the potential adverse affects of a proposed action.” Id.
Procedural Posture. The court’s opinion is a ruling on the defendants’ motion for summary judgment. To prevail on a summary judgment motion the moving party must demonstrate that there is no material question of fact, and that on the undisputed facts it is entitled to judgment as a matter of law. Id. at *1. The party resisting a summary judgment motion does so either by showing that the moving party is not entitled to judgment under the law, or that the relevant facts are disputed. The parties establish the facts through affidavits submitted to the court, and there is no live testimony. A summary judgment motion can be an efficient way to resolve issues before trial.
The plaintiffs’ claim against Rayevich failed because they did not establish the facts necessary to resist his summary judgment motion. “Specific facts, as contrasted with mere allegations, are needed to resist a motion for summary judgment.” Id. at *3. The plaintiffs did not put forth facts to show Rayevich’s lack of good faith, that he was not independent and disinterested, that he was not informed about or had not considered the Agreement, or that his conduct was willful or in bad faith. Rayevich was therefore presumed to have acted in good faith and was entitled to exculpation under the LLC’s Operating Agreement, and the court ordered summary judgment in his favor on the plaintiffs’ claims.
Comment. Ross Holding points out the need for LLC managers to be proactive, and that fiduciary duties extend beyond mere voting. In the context of a multi-manager board, a manager who either has no vote or who is outvoted must be informed and give independent consideration to the proposal, and must consider expressing a dissenting view when appropriate and possibly informing the members about the potential adverse impact of a proposed action.
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.
Two weeks ago the Delaware Supreme Court confounded the conventional wisdom and rebuked the Court of Chancery, by ruling that whether fiduciary duties apply to LLC managers is an open question in Delaware law. Gatz Properties, LLC v. Auriga Capital Corp., No. 148, 2012, 2012 WL 5425227 (Del. Nov. 7, 2012). Most Delaware corporate lawyers have assumed that LLC managers are subject to fiduciary duties unless limited by the LLC agreement, and the lower court in Gatz had interpreted Delaware’s LLC Act to impose fiduciary duties on LLC managers.
The Trial Court. The Court of Chancery ruled earlier this year on Gatz in Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012). The court found that an LLC’s manager and majority owner breached his fiduciary duties by taking steps to squeeze out the minority investors at an unfair price in order to obtain ownership of the LLC’s valuable golf course.
Chancellor Strine, the author of the trial court opinion, held that the terms of the parties’ LLC agreement, and the Delaware LLC Act, imposed fiduciary duties on the LLC’s manager. The court analyzed the Delaware LLC Act and its history, reviewed precedential cases, analogized the LLC Act to Delaware’s General Corporation Law in its treatment of fiduciary duties, and concluded that the LLC Act applies fiduciary duties to LLC managers and controllers unless the parties’ LLC agreement limits those duties. Commentators hailed the Chancellor’s opinion as a comprehensive and detailed explanation of how and why the Delaware Act applies fiduciary duties to LLC managers. I discussed that decision, here.
Supreme Court’s Ruling. The Supreme Court affirmed the judgment of the Court of Chancery and its award of damages and attorneys’ fees, but it did so by relying only on the LLC agreement’s contractual imposition of fiduciary duties. That was sufficient to decide the case, said the court, and therefore the Court of Chancery should not have expounded on whether the LLC Act imposed fiduciary duties on the manager.
Where, as here, the dispute over whether fiduciary standards apply could be decided solely by reference to the LLC Agreement, it was improvident and unnecessary for the trial court to reach out and decide, sua sponte, the default fiduciary duty issue as a matter of statutory construction. The trial court did so despite expressly acknowledging that the existence of fiduciary duties under the LLC Agreement was “no longer contested by the parties.” For the reasons next discussed, that court’s statutory pronouncements must be regarded as dictum without any precedential value.
Gatz, 2012 WL 5425227, at *9 (footnote omitted). In its footnote the court said it felt compelled to “address this dictum” so in future cases it would not be misinterpreted as a correct rule of law when “in fact the question remains open.” Id., at *9 n.62.
The court elaborated on why the lower court’s discussion should be regarded as dictum. First, the LLC Agreement in Gatz addressed the issue that controlled the dispute. Second, the parties had not asked the court to decide whether the LLC Act imposed fiduciary duties. Third, it was wrong for the trial court to imply that once practitioners have relied on repeated decisions of the Court of Chancery on an issue, the Supreme Court should not change the rule relied on by those decisions. Fourth, reasonable minds can differ on whether DLLCA Section 18-1102’s provision that to the extent a manager has fiduciary duties, they can be limited by the LLC agreement, is “consciously ambiguous.” Fifth, “the court’s excursus on this issue strayed beyond the proper purview and function of a judicial opinion,” which is to “resolve the issues that the parties present in a clear and concise manner.” Id. at *10.
The court also discussed the proper role of the trial court: “We remind Delaware judges that the obligation to write judicial opinions on the issues presented is not a license to use those opinions as a platform from which to propagate their individual world views on issues not presented. A judge's duty is to resolve the issues that the parties present in a clear and concise manner.” Id.
After admonishing the trial court not to go beyond the issues presented, the Supreme Court then pontificated that the appropriate committee of the Delaware State Bar Association “may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.” Id.
Comment. This case has generated a tremendous amount of commentary by bloggers and the press, including an article in The New York Times, here, and an alert from the American Bar Association’s Committee on LLCs and Partnerships, here. Besides undoing what many corporate lawyers thought was a settled legal principle, the opinion also admonished the highly respected chief judge of the Delaware Court of Chancery, Chancellor Leo Strine, that it was “improvident and unnecessary” to reach out and decide the fiduciary duty issue.
What can lawyers take away from this case? The moral for lawyers forming Delaware LLCs is clear: use language in the LLC agreement that clearly defines the fiduciary duties applicable to the managers and the limits of those duties.
But in other contexts the court’s ruling raises questions. For example, members of existing Delaware LLCs may be relying on LLC agreements that were written under the assumption that fiduciary duties implicitly apply to the managers. Such an agreement may yield unexpected results in the event of a dispute, if the Delaware Supreme Court ultimately holds that fiduciary duties do not apply to LLCs. Perhaps those members’ lawyers should be thinking about amendments to clarify explicitly what the parties intended.
In the case of existing disputes involving allegations of breach of fiduciary duties, Gatz has suddenly shifted the landscape. Now the parties don’t know what the Delaware law on LLC fiduciary duties is. Presumably the Court of Chancery will continue to rule as it has in the past, i.e., that LLC managers are subject to fiduciary duties unless those duties are explicitly limited in the LLC agreement. But we won’t know definitively what the law is until either a case comes up to the Supreme Court that squarely presents the issue, or the Delaware legislature clarifies the issue by amending the LLC Act.
Under the long-established corporate opportunity doctrine, a limited liability company manager that takes advantage of an opportunity that under the circumstances should have belonged to the LLC will be in breach of its fiduciary obligations. In a recent Maryland case the manager of a real estate development LLC caused the LLC to participate in a pooled line of credit. The LLC’s real estate was pledged to secure the borrowings not only of the LLC but also of the two other companies participating in the line of credit. The LLC received its portion of the loan proceeds, proceeded with its development, and obtained lien releases as each of its lots was sold.
When the LLC’s principal investor later learned of the pooled line of credit it sued the LLC’s manager. The investor claimed that the pooled line of credit showed that the manager usurped the LLC’s corporate opportunity by developing the second development. The trial court ruled that the manager had not usurped the LLC’s corporate opportunity and had not breached its fiduciary obligations, and the Court of Special Appeals affirmed. Ebenezer United Methodist Church v. Riverwalk Dev. Phase II, LLC, 45 A.3d 883 (Md. Ct. Spec. App. 2012).
Background. Synvest Real Estate Investment Trust formed River Walk Development, LLC (Riverwalk One) in 2001 and contributed undeveloped real estate to it. In 2002 Ebenezer United Methodist Church purchased a 50% interest in Riverwalk One for $250,000. Before completing its investment in Riverwalk One, Ebenezer United learned that Synvest owned a 32-acre parcel and other lots elsewhere in the county.
In 2003 Synvest formed River Walk Development Phase Two, LLC (Riverwalk Two), which acquired the 32-acre parcel. William Green, Synvest’s president and part owner, then caused Riverwalk One, Riverwalk Two, and a third entity known as Green Spring Valley Overlook to collectively enter into a $2.1 million loan agreement with Regal Bank & Trust. Each of the three entities placed liens on its real estate by granting deeds of trust to Regal to secure the collective line of credit.
Riverwalk One developed and sold several units, conveyed the proceeds to Ebenezer United, and in 2006 repurchased Ebenezer United’s LLC interest. Ebenezer United’s profit on its $250,000 investment was between $30,000 and $35,000.
Ebenezer United later learned of the joint loan agreement and the liens that had encumbered the Riverwalk One properties. In 2009 Ebenezer United filed suit against Green, Synvest, Riverwalk Two, and Green’s family trust, claiming breach of fiduciary duties and usurpation of a corporate opportunity.
At trial Green testified that Riverwalk One had required debt financing to complete its construction, that Regal would not extend credit to Riverwalk One unless all its members guaranteed the loan, and that Ebenezer United was precluded from providing a guarantee because it was a non-profit. Riverwalk Two and Green Spring Valley already had a loan agreement in place with Regal, so Green arranged for Riverwalk One to draw on that loan, which required that Riverwalk One grant Regal a lien on its property to secure the three parties’ obligations on the collective line of credit.
The Court’s Analysis. The court began with the fundamental premise that an LLC’s managing member owes fiduciary duties to the LLC and to the other members, including the duty not to exclude the LLC from corporate opportunities. Id. at 886. Maryland analyzes claims of corporate opportunities under the “interest or reasonable expectancy test,” which focuses on whether the LLC could realistically expect to seize and develop the opportunity. Id. at 887.
Ebenezer United, however, did not plead nor discuss the interest or reasonable expectancy test, but instead argued that the collective security agreement automatically established a corporate opportunity. The court characterized Ebenezer United’s argument as conflating financial self-dealing with usurpation of a corporate opportunity. The court saw the question of whether the financing arrangement was self-dealing as independent of whether the defendants excluded Ebenezer United from a corporate opportunity. Because Ebenezer United had failed to argue or prove that there was self-dealing, the court focused on the interest or reasonable expectancy test for corporate opportunities. Id. at 887-88.
According to the court, “a corporate ‘interest or expectancy’ requires something more than the mere opportunity to develop a neighboring parcel of land.” Id. at 888 (citing Dixon v. Trinity Joint Venture, 431 A.2d 1364 (Md. Ct. Spec. App. 1981)). Fiduciaries do not owe their principals a general duty to offer participation in other real estate development opportunities – there must be something more than superficial similarity between the projects. Id.
There was no evidence, said the court, that Riverwalk Two had any effect on the value of the Riverwalk One project. The lien restriction on Riverwalk One’s property was not for the exclusive benefit of Riverwalk Two but was instead an efficient way to benefit the Riverwalk One project. The court concluded: “In short, a reasonable expectation or interest in a corporate opportunity requires something more than mere ‘proximity’ of geography and management, as in Dixon, or of finance, as in this case,” and affirmed the trial court’s conclusion that Green, Synvest, and Riverwalk One had not usurped a corporate opportunity. Id. at 889.
Comment. The court gave such short shrift to Ebenezer United’s argument that one can’t discern the underpinnings of Ebenezer United’s reasoning. But there are cases for the proposition that if a manager uses one LLC’s assets to support a second’s development, then the second development is a corporate opportunity of the LLC whose assets were used. In this case, granting a lien on Riverwalk One’s property to secure borrowings by Riverwalk Two appears to be a use of Riverwalk One’s assets to help develop the assets of Riverwalk Two.
For example, the Illinois Appellate Court, in support of a finding that corporate opportunities were misappropriated, said:
Therefore, when a corporation’s fiduciary uses corporate assets to develop a business opportunity, the fiduciary is estopped from denying that the resulting opportunity belongs to the corporation whose assets were misappropriated, even if it was not feasible for the corporation to pursue the opportunity or it had no expectancy in the project.
Graham v. Mimms, 444 N.E.2d 549, 557 (Ill. App. Ct. 1982) (emphasis added). Similarly, the Bankruptcy Court for the District of Delaware has said: “Thus, a business opportunity falling outside a corporation’s line of business and which would not otherwise be considered a corporate opportunity, nevertheless, will be deemed a corporate opportunity if developed or financed with corporate funds.” In re Trim-Lean Meat Prods, Inc., 4 B.R. 243, 247 (Bankr. D. Del. 1980).
But even so, I think the Ebenezer United facts still fall short of demonstrating a corporate opportunity. One reason is that, as the court pointed out, Riverwalk One’s grant of a lien on its property under the collective loan agreement was for its own benefit. And in fact Riverwalk One was benefited by the joint loan agreement. It was able to obtain its financing even though its 50% member, Ebenezer United, could not provide a guaranty as requested by the bank, and its properties were released from Regal’s lien as they were sold.
The other reason is the lack of direct benefit to Riverwalk Two, given the sequence of events. Riverwalk Two and Green Spring Valley already had a loan agreement in place with Regal when Green arranged for Riverwalk One to be added, so Riverwalk One’s security was irrelevant to Riverwalk Two’s obtaining the Regal credit line.
New Hampshire Governor John Lynch signed into law a comprehensive revision to New Hampshire’s limited liability company statute on June 18, 2012. The new act, the New Hampshire Revised Limited Liability Company Act, will be effective January 1, 2013 for LLCs formed thereafter. It will not be effective until January 1, 2014 for LLCs formed under the current statute, although they can elect to be covered by the new act beginning January 1, 2013. The current statute is here.
One of the new act’s major changes is the shift away from requiring an LLC agreement to be in writing, and to now allow LLC agreements to be oral or implied as well as written. The significance of this is that the current LLC act provides a framework of LLC default provisions that can only be modified by a written LLC agreement.
The current act defines a limited liability company agreement as “a written agreement of the members or a document adopted by the sole member as to the affairs of a limited liability company and the conduct of its business.” N.H. Rev. Stat. § 304-C:1(VI).The new act uses the term “operating agreement” and provides that it may be “written, oral, or implied by course of dealing or otherwise.” § 304-C:40. The new act thus allows the members’ oral agreement to override the statute’s default rules in almost all cases.
Allowing oral operating agreements provides more flexibility for the many organizers of LLCs that desire to avoid the expense of hiring a lawyer to prepare a written agreement. The downside is that if there is a dispute it may be more difficult to prove the terms of an oral agreement, which is why lawyers usually recommend putting the agreement in writing.
Another major change is that the new act comprehensively defines the members’ and managers’ fiduciary duties of loyalty and care. § 304-C:106. The current act, in contrast, has no fiduciary duty provisions. The new act’s description of members’ and managers’ fiduciary duties brings clarity to this important issue and is a big improvement.
The new act was drafted by an ad hoc committee of the New Hampshire Business and Industry Association that was chaired by John Cunningham. John is the co-author, with Vernon Proctor, of Drafting Delaware LLC Agreements, a treatise I have used frequently in creating Delaware LLCs. I note that the third edition is now available. John M. Cunningham, Drafting Limited Liability Company Operating Agreements (3d ed. 2012).
John has authored a June 30, 2012 article in the Union Leader on the practical significance of the new LLC act, here, and indicates that it is the first in a series. Stay tuned to the Union Leader for his subsequent articles. He has also written a more detailed article on the new act for the New Hampshire Business Review, here.
Delaware Court Awards Lost Future Earnings to LLC Investors Because of Promoter's Fraud and Breaches of Fiduciary Duty
Many new businesses fail, for a variety of reasons, and that usually means the investors lose their investment. But it’s a bitter pill for the investors when the venture fails because of the promoter’s fraud and breaches of fiduciary duties. In a Delaware Court of Chancery case decided this week, the plaintiffs alleged fraud and breaches of fiduciary duty, and claimed that they had not only lost their investment, but also that their reputations were so besmirched by their involvement in the company’s fraudulent futures-trading scheme that they were effectively unemployable and were therefore entitled to damages for their lost future earnings. Paron Capital Mgmt., LLC v. Crombie, C.A. No. 6380-VCP (Del. Ch. May 22, 2012)(slip op.). The court agreed.
Background. Peter McConnon and Timothy Lyons met James Crombie in 2010. McConnon was a principal of a multi-billion dollar hedge fund based in London, and Lyons had worked as a senior investment professional for a number of financial institutions. Crombie had developed a software-based trading program in futures contracts, and explained that his trading program had annual returns of 25% in 2007 and 38% in 2008. He asserted that he had $30 million in assets under management, and invited McConnon and Lyons to join him in a new company to manage a hedge fund product and to trade futures on behalf of client accounts.
Due Diligence. Before deciding to join Crombie and form the new company, McConnon and Lyons conducted extensive due diligence on Crombie, his history, and his software product. They reviewed marketing materials from Crombie, including an independent verification from accounting firm Yulish & Associates, which certified that the returns claimed by Crombie were actual returns, verified through a third-party clearing broker. They checked references from 10 of Crombie’s former clients and colleagues, including mutual acquaintances. They interviewed Crombie in person and observed the software operate. They searched industry databases, interviewed Crombie’s lawyer about a lawsuit Crombie was involved in, and hired Kroll, Inc., an international risk consulting firm, to conduct a comprehensive background search on Crombie. None of those efforts turned up any red flags.
The New Company. Satisfied with their investigation, McConnon and Lyons entered into business with Crombie. They formed Paron Capital Management, LLC, a Delaware limited liability company, on June 2, 2010. Crombie had a 75% interest and was the initial manager, McConnon had a 20% interest, and Lyons a 5% interest. They commissioned an updated, independent verification of Crombie’s track record from Rothstein, Kass & Company, a national accounting firm, and used its report to begin marketing Paron to potential clients. Paron’s marketing materials were sent to over a hundred of McConnon’s and Lyons’ client contacts.
Fraud Revealed. On March 10, 2011, Paron received an audit request from its regulator, the National Futures Association (NFA). Numerous documents about Paron’s operations and Crombie’s predecessor company, JDC Ventures, LLC, were provided to the NFA. The NFA detected discrepancies and requested additional information. McConnon and Lyons began to investigate and learned that documents provided by Crombie to the NFA and to the accounting firm that had verified Crombie’s track record were false and had been forged by Crombie. After further investigation, McConnon and Lyons removed Crombie as a manager and member of the LLC, and the NFA issued a notice prohibiting Crombie and Paron from accessing, disbursing, or transferring any funds in Crombie’s name or a client’s name without prior NFA approval.
Lawsuits. On April 13 and 14, 2011, McConnon and Lyons filed two lawsuits against Crombie. Crombie entered into a stipulated judgment in the first lawsuit, in which he admitted that he was properly removed as a manager and member of the LLC, and agreed to a permanent injunction against using Paron assets or holding himself out as being affiliated with Paron.
In the second lawsuit, the plaintiffs sought damages for Crombie’s fraud and breach of fiduciary duty. A three-day trial was held in October 2011. Crombie failed to appear and presented no evidence, claiming financial hardship. Crombie filed for bankruptcy in February 2012, and the lawsuit was stayed. Later in February the stay was lifted.
Fraud. The court’s findings of Crombie’s fraud are damning. “[M]any of the representations Crombie made about his track record, employment history, and personal financial situation were outright lies.” Paron Capital Mgmt., slip op. at 10. Crombie forged account statements from multiple sources. Id. at 11. Crombie misrepresented his relationship with a prior employer and his personal financial situation. He failed to disclose another lawsuit against him and numerous personal debts he owed. The court found the plaintiffs’ reliance on Crombie’s representations to be justifiable, which isn’t surprising given their extensive due diligence.
Fiduciary Duties. The LLC’s operating agreement did not limit or exclude Crombie’s fiduciary duties as the manager, so Crombie owed the plaintiffs the traditional fiduciary duties of loyalty and care. Id. Those duties were breached both by Crombie’s preparation of fraudulent marketing materials for the LLC and by his continued concealment of material information about his track record, employment history, and personal finances. The court noted that under Delaware law, a fiduciary who remains silent about false, earlier communications that are relied upon by the beneficiary breaches his duty of loyalty. Id. at 16.
Damages. The court awarded McConnon reliance damages and mitigation costs totaling about $1.5 million. Those consisted of his loans and costs advanced to Crombie and to Paron in reliance on Crombie’s misrepresentations, and legal fees incurred in regulatory proceedings against Crombie and Paron and in foreclosing on collateral pledged by Crombie for the loan.
The vast majority of the damages claimed by McConnon and Lyons were for lost future earnings. “Specifically, Plaintiffs claim that their association with Crombie and Paron damaged their relationships with clients and effectively made them unemployable because they would be required to disclose their association with Paron to future employers, who, in turn, would have to disclose it to investors.” Id. at 20.
McConnon and Lyons provided trial testimony from two expert witnesses, an executive search professional with the financial services industry and a CPA certified in fraud examination and financial forensics. The executive recruiter testified that in his opinion, the clients he represents would not hire McConnon because of his association with Paron. The recruiter stated that his firm would be unwilling to even attempt to market McConnon because marketing an individual associated with fraudulent activity would hurt the recruiter’s business. The recruiter’s expert opinion was that McConnon would be unemployable in his field for the foreseeable future, other than for much lower-paying work only tangentially related to the capital markets.
Based on the recruiter’s expert opinions and on McConnon’s prior average annual earnings of more than $3.4 million, the CPA calculated McConnon’s lost future earnings over a 10-year period using two different methods, averaged the results, and estimated the lost earnings at $39.8 million. The court found the recruiter’s estimate of McConnon’s earnings if he had stayed at his prior firm to be overly optimistic, adjusted the amount downward, and awarded McConnon $32.2 million for lost future earnings.
Lyons’ compensation before leaving his prior employer was much lower, at about $200,000 per year. The executive recruiter and the CPA went through an analysis similar to their McConnon analysis, and after adjusting the CPA’s estimate, the court awarded Lyons $1.9 million for lost future earnings.
Comment. This case does not make new law, but it is a fascinating and odd case to consider. For one thing, the bad acts by the defendant were so egregious that the court’s legal conclusions of fraud and breach of fiduciary duty seem clear cut. Also, the fact that the defendant did not appear at trial would presumably undercut, at least to some degree, the precedential value of the court’s rulings.
The awards for the plaintiffs’ lost future earnings are unusual because they are based on injury to McConnon’s and Lyons’ reputations. Crombie’s fraudulent futures-trading scheme, and the involvement of McConnon and Lyons in Paron Capital Management, LLC, so tarred their reputations that they could no longer work in their former, highly paid capacities. And the facts showed that the effects on their careers would be long-lasting – up to ten years. (If Crombie had participated in the trial and presented experts with different opinions, the court might have reached different factual conclusions.) The long duration of the impact on the plaintiffs’ reputations, and in McConnon’s case the high level of his compensation prior to joining Crombie, led to a breathtakingly large ($32.2 million) award for McConnon.
The case is also a cautionary tale about due diligence. It’s hard to fault McConnon’s and Lyons’ investigation, as reported by the court, yet their due diligence completely failed. The court’s finding was that the plaintiffs acted reasonably in investigating Crombie. Id. at 15. Yet in hindsight, perhaps Crombie’s claim of consistent, high annual returns from his futures-trading program should have called for more probing of Crombie’s prior clients, and more double-checking of the authenticity of documents provided by Crombie.
Texas Court Follows Form Over Substance In Sorting Out Different Fiduciary Duties in Multi-Level LLC and Partnership
The Texas Court of Appeals struggled to reconcile conflicting fiduciary duty rules between two related entities, an LLC and a limited partnership, in Strebel v. Wimberly, No. 01-10-00227-CV, 2012 WL 112253 (Tex. App. Jan. 12, 2012).
Douglas Strebel and John Wimberly started a tax advisory business and formed Black River Capital, LLC, a Delaware limited liability company, in 2003. The business prospered, and on December 8, 2005 they restructured the business and amended and restated the LLC agreement. Strebel and Wimberly were the LLC members, with profit sharing ratios of 60% and 40% respectively. They and their wives were the managers, and Strebel was the Managing Manager and CEO with broad decision-making and management powers. Strebel was required to consult with the other managers before making certain major decisions, and to obtain Wimberly’s consent before taking certain other specific actions, including changes to Wimberly’s profit sharing ratio.
At the same time, they formed a new Texas limited partnership, Black River Capital Partners, LP, and transferred all of the LLC’s business assets to the limited partnership (LP). The LLC was the LP’s general partner, with broad power and authority to control the LP, and had a 1% profit share. The limited partners were Strebel, Wimberly, Strebel’s wife, and Eric Manley. Later Steve Houle also became a limited partner.
The LLC and the LP had completely different fiduciary duty rules. The LLC’s operating agreement stated that “the Managers shall have fiduciary duties to the Company and the Members equivalent to the fiduciary duties of directors of Delaware corporations.” Id. at *3 (emphasis added) . In stark contrast, the LP’s partnership agreement stated that “the General Partner shall have no duties (including fiduciary duties) except as set forth in th[e] Agreement,” and there were no other relevant provisions. Id. (emphasis added).
Problems between Strebel and Wimberly began to develop later. Strebel was in the driver’s seat as Managing Manager of the LLC, which in turn was the general partner of the LP. He also held a majority of the limited partners’ voting rights in the LP. Using his authority, Strebel retroactively reduced Wimberly’s profit share in the LP, and caused the LP in 2007 to award a $3 million bonus to himself and another $1 million in bonuses to limited partners Houle and Manley. Wimberly received no bonus. Id. at *5. Unhappy with these developments, Wimberly sued Strebel in 2007, alleging breach of fiduciary duty, unjust enrichment, oppression of a minority member, defamation, and breach of contract.
A jury trial returned a verdict in Wimberly’s favor. The jury found that Strebel had breached his fiduciary duties and awarded Wimberly damages of $2.9 million. Id. at *6. The trial court had instructed the jury that Strebel owed Wimberly fiduciary duties in his management of the business of the “Black River Entities,” because of their relationship at the LLC level (Strebel as Managing Manager and Wimberly as member) and at the LP level (both were limited partners). Id.
The Court of Appeals analyzed the fiduciary duties separately at the LLC level and at the LP level. Id. at *8. The court began with the LLC. Strebel had contended that the words in the LLC agreement “the Managers shall have fiduciary duties to the Company and the Members” meant that fiduciary duties were owed to the Members collectively, and that therefore no fiduciary duties were owed to any Member individually. Id. After a surprisingly lengthy discussion, the court disposed of that argument and pointed out that such an interpretation would in effect delete the words “and the Members” from the LLC agreement. The court agreed with the trial court that the LLC agreement imposed on Strebel, as the Managing Manager, fiduciary duties of due care, good faith, and loyalty to Wimberly as an individual member of the LLC. Id. at *9.
The limited partnership agreement, on the other hand, was clear that the LP’s general partner (the LLC) owed no fiduciary duties to the LP or its limited partners. The trial court had found, however, that Strebel owed Wimberly a fiduciary duty because they were both limited partners. The LP agreement was silent on whether there were any fiduciary duties between the limited partners. After a lengthy discussion of prior cases and a Baylor Law Review article, the court concluded: “We reconcile these cases by holding that status as a limited partner alone does not give rise to a fiduciary duty to other limited partners.” Id. at *13.
The court’s determination that there were no fiduciary duties owed by the LP’s general partner or any limited partner effectively destroyed Wimberly’s cause of action, because the court focused only on the harm to Wimberly directly resulting from the actions of the LLC as it controlled the LP, and ignored the obligations of the LLC’s manager to its members as he directed the LP’s activities:
[W]e conclude Wimberly’s claims relate to actions taken by Strebel as the controlling manager of the general partner (i.e., Black River, LLC) against Wimberly as a limited partner in Black River LP while operating under the LP agreement. The contractual disclaimer of fiduciary duties in the Black River LP Agreement thus forecloses Wimberly’s recovery on his breach of fiduciary duty claim.
Id. at *15. The court reversed the trial court’s finding on the breach of fiduciary duty claim, and remanded for further proceedings on Wimberly’s oppression of a minority member claim. Id. at *18.
Unfortunately, the court’s analysis exalted form over substance. The LLC’s only business was to control the LP – all of the LLC’s assets had been assigned to the LP. The LLC’s Managing Manager Strebel owed the LLC’s members the duties of good faith and loyalty. How could the LLC’s manager satisfy the duty of loyalty he owed to the members other than ensuring, as the LLC directed the LP, that the LP’s limited partners who were also LLC members were treated fairly and in good faith?
The court in its analysis relied on the chestnut that applying the LLC’s fiduciary duties to the actions taken by its manager in directing the LP “would render meaningless the express disclaimer of fiduciary duties in the limited partnership agreement under which that the parties were operating.” Id. at *17. But that’s not correct, because three of the limited partners (Manley, Houle, and Strebel’s wife) were not members of the LLC, and for them the disclaimer was highly meaningful.
This case shows the analytical difficulties that can arise in sorting out the obligations of managers in multi-entity, multi-level structures. It’s also a lesson for the lawyer advising clients about such structures to be wary of inconsistent standards and obligations.
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.
The Delaware Court of Chancery last month issued a lengthy and thorough analysis in a dispute over an LLC manager’s claimed breaches of fiduciary duties. Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012).
The dispute arose because the LLC’s manager and majority owner (along with his family) took steps to squeeze out the minority investors in order to obtain ownership of the LLC’s valuable golf course. The court’s lengthy catalog of the manager’s activities shows a manager bent on ridding the LLC of the disfavored minority. Professor Ann Conaway in her blog described the manager as “a devilish manager of an LLC who acted every bit the part of Lord Voldemort determined to ‘do in’ his members,” here. The court’s unremarkable holding, given the facts, was that the manager breached his fiduciary duties of loyalty and care. Auriga, 2012 WL 294892 at *25.
The court’s discussion and analysis, on the other hand, were remarkable. Not for the court’s legal conclusion, but for its comprehensive and detailed review of the Delaware LLC Act and the Delaware case law on LLC fiduciary duties. The court’s conclusion was consistent with prior Delaware case law: “[O]ur Supreme Court, and this court, have consistently held that default fiduciary duties apply to those managers of alternative entities who would qualify as fiduciaries under traditional equitable principles, including managers of LLCs,” unless those duties are clearly waived or modified in the LLC’s operating agreement. Id. at *2.
In explaining its decision, the court reviewed (i) the Delaware LLC Act; (ii) the lack of any language in the Act establishing fiduciary duties for LLC managers; (iii) the Act’s authorization in Section 18-1101 that, to the extent a member or manager has duties including fiduciary duties, those duties may be expanded, restricted, or eliminated by the LLC agreement; and (iv) the history of revisions to Section 18-1101. The court analogized the LLC Act to Delaware’s General Corporation Law and noted the Delaware Supreme Court’s application of fiduciary duties to Delaware corporations notwithstanding the absence of any definition or creation of fiduciary duties in the DGCL.
The court also examined Section 1104 of the LLC Act, which provides that “[i]n any case not provided for in this chapter, the rules of law and equity … shall govern.” Del. Code Ann. tit. 6, § 18-1104 (emphasis added). The court found fiduciary duties to be grounded in equity and therefore to be mandated by Section 1104. Auriga, 2012 WL 294892 at *8.
The facts are complex, and the court’s lengthy analysis is multi-part, thorough, and detailed. The brief description above is only a high-level overview. For a more detailed review of the Auriga opinion, I recommend Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here, and Peter Mahler’s post on his New York Business Divorce blog, here.
A part of the opinion that I found particularly interesting is the court’s discussion of the difference between the implied covenant of good faith and fair dealing, and the fiduciary duties of loyalty and care. Both are equitable gap-fillers, but they operate in different ways. The implied covenant of good faith and fair dealing applies only “when the express terms of the contract indicate that the parties would have agreed to the obligation had they negotiated the issue.” Auriga, 2012 WL 294892 at *10. In other words, the implied covenant operates only in cases where the language of the contract as a whole suggests an obligation and points to a result, but does not provide an explicit answer. Id. at *10 n.57. Fiduciary duties, in contrast, provide a framework to govern the discretionary actions of business managers acting under the enabling framework of the LLC agreement. Id. *10.
One part of the opinion will likely be of more interest to litigators than to business lawyers – the court’s award of attorneys’ fees to the plaintiffs. In civil litigation such as the Auriga case, each party normally bears its own legal fees. (This is sometimes referred to as the American Rule, and is in contrast to the English Rule, under which the loser pays the winner’s attorneys’ fees.)
Delaware recognizes an exception to the American Rule when a litigant has acted in bad faith. Id. at *29. The Auriga court awarded the plaintiffs one half of their reasonable attorneys’ fees and costs – the award because of the defendants’ bad faith, and the one-half limit because the plaintiffs’ efforts in the litigation were “less than ideal in terms of timeliness or prudent focus.” Id.
The court said the bad-faith exception should not be lightly invoked and requires clear evidence of the wrongdoer’s subjective bad faith. The court found plenty of evidence, though: “The record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue. Rather than focus on only bona fide arguments, Gatz and his counsel simply splattered the record with a series of legally and factually implausible assertions.” Id. The court also considered the defendants’ pre-litigation conduct, as well as violations of the discovery rules.
The procedure mandated by the court for determining the attorneys’ fees appears designed to streamline the process. The plaintiffs must simply submit an affidavit with the amount of their “reasonable attorneys’ fees and costs.” Id. The court will then consider that amount to be reasonable unless the defendants’ legal counsel produces their own billing records in support of an argument that the plaintiffs’ attorneys’ fees are too high. And in case there was any doubt about the court’s attitude, the court remarked that “[i]n objecting to the amount of the fee, Gatz and his counsel should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it.” Id. at *29 n.184.
The Auriga case is fascinating for a host of reasons: (a) the court’s detailed and lengthy review of Delaware’s LLC fiduciary duty law, (b) the emphasis on the origins of fiduciary duty principles in equity (the Delaware Court of Chancery, like the original English version, is a court of equity), (c) the discussion of the implied covenant of good faith and fair dealing, (d) invocation of the principle that uncertainties in damages are resolved against the breaching fiduciary, (e) the award of attorneys’ fees, and (f) the court’s colorful language. The opinion has already generated significant commentary in the blogosphere, and in the future it will undoubtedly be the subject of law review articles and continuing legal education seminars.
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.
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.
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.
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 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.
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.
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.
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.
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.
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.