Idaho LLC Member Owes No Fiduciary Duty to LLC's Manager
The Idaho Supreme Court has again examined the fiduciary duties of LLC members, in High Valley Concrete, L.L.C. v. Sargent, 2010 WL 2681188 (Idaho July 8, 2010). Last year the Idaho Supreme Court analyzed fiduciary duties between LLC members in Bushi v. Sage Health Care, PLLC, which I discussed here. In Bushi the court concluded that managing members of an LLC owe each other fiduciary duties.
In High Valley the LLC’s manager claimed that the sole member owed a fiduciary duty to the manager. High Valley was organized by Cary Sargent and Doyle Beck as an Idaho LLC. They initially planned for Beck to have a 51% interest and Sargent to have a 49% interest in the company. Ownership certificates for both were drawn up and signed, and each made his initial contribution to the LLC. Beck then requested that all of the LLC units be issued to him so that he could have the tax losses until the company became profitable – “then we’ll clear up - we’ll change the paperwork back.” High Valley, 2010 WL 2681188 at *1. Sargent agreed to the change, so Beck became the sole member and Sargent the manager.
Sargent was later fired, and the LLC sued Sargent for conversion, fraud, and breach of fiduciary duty. Sargent, the manager, in turn sued Beck, the sole member, for breach of fiduciary duty. Sargent claimed that he was damaged by the loss of his contributions to High Valley. At trial the LLC was awarded judgment on its claims against Sargent, and Sargent was awarded judgment on his fiduciary duty claim against Beck. Beck appealed.
The court began by noting that fiduciary relationships usually involve one party placing property or authority in the hands of another, or being authorized to act on behalf of the other. Id. at *4. The court described a fiduciary as one who is in a superior position to the other, where the other reposes special trust and confidence in the fiduciary. Examples include partners, principal and agent, attorney and client, and the executor and beneficiary of an estate. Id. at *5. Arm’s-length business transactions, standing alone, do not give rise to a fiduciary relationship.
The court had previously held in Bushi that LLC managing members owe each other fiduciary duties. But the High Valley court found that Sargent was not a member. Sargent had the opportunity to obtain a membership interest at the time of the LLC’s formation, but instead he allowed Beck to become the LLC’s only member. Bushi was therefore not applicable.
None of the other indicia of a fiduciary relationship were present. There was no indication that Sargent had any reason to believe that Beck was acting in Sargent’s interest. And although Beck had discussed reinstating Sargent’s 49%, Sargent testified that Beck was not holding Sargent’s 49% for him. Finding none of the control, property transfer, or “superior position” attributes of a fiduciary relationship to be present, the court held that no fiduciary relationship existed.
What is novel about this case is the role reversal. Usually members raise fiduciary duty claims against managers, not the other way round, as in High Valley. The managers, after all, are the ones in control of the LLC. It’s that control of the other party’s assets or business that lies at the heart of most fiduciary relationships.
It’s unclear from the court’s opinion what was the basis of the jury’s finding of a breach of fiduciary duty by Beck. The jury may have believed that Beck’s initial statements about later re-establishing Sargent’s 49% amounted to a sort of trust arrangement, a promise to hold the 49% for Sargent and to later restore the 49% to him. But the Idaho Supreme Court relied on the following bit of Sargent’s testimony:
Q. Did you understand that Beck was going to hold your 49 percent for you?
A. No. I understood that I – that the ownership would remain the same, that he was just doing it for his personal tax purposes or his business’ tax purposes.
Id. at *1. That “no” answer appears to have torpedoed Sargent’s case. I suspect that with further questioning by his counsel, Sargent could have made clear that there was more to the arrangement than his brief answer indicated. But that’s the thing about trial testimony – you don’t get a second crack at it after the trial is over.
New York Addresses Fiduciary Duties of LLC Organizers
The New York Appellate Division recently applied the fiduciary rules for corporate organizers to the organizers of LLCs, and found the LLC organizers to be fiduciaries of the investors they solicited to become members. Roni LLC v. Arfa, No. 1758, 601224/07, 2010 N.Y. App. Div. LEXIS 4613 (June 3, 2010).
The defendants were the promoters and organizers of several New York LLCs. The organizers entered into real estate purchase agreements, and then assigned the agreements to the LLCs after their formation. The organizers, who were the initial members of the LLCs, solicited outside investors to purchase member interests in the LLCs. The investors’ funds were then used by the LLCs to purchase the real properties.
Subsequently the investors sued the organizers, claiming that the organizers concealed brokerage commissions they received from property sellers and mortgage brokers. The investors alleged that the undisclosed commissions inflated the purchase prices of the real estate by at least $6.5 million.
The investors asserted claims for waste, breach of fiduciary duty, actual fraud, constructive fraud and an accounting. The organizers moved to dismiss for failure to state a cause of action and for failure to plead actual fraud and breach of fiduciary duty with specificity. The trial court denied the motion and upheld all claims, other than the claim for waste. The organizers appealed the dismissal of the motion, contending that the investors had not alleged adequate facts to establish that the organizers were their fiduciaries.
The key to the court’s decision was its extension of the corporate rule to LLCs. The court noted that “[i]t is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders.” Id. at **5. From there it was a short jump to LLCs: “By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Id. at **5-6. As fiduciaries, the organizers were obligated to fully disclose the organizers’ interests that might affect the LLC and its members, including the organizers’ profits from organizing the LLC. Id. at **6. The court held that the investors had therefore stated a cause of action by alleging that the defendant organizers had failed to disclose the commissions they received from sellers and mortgage brokers, which inflated the purchase prices of the LLCs’ real estate. Id.
The organizers also defended on grounds that the investors had failed to allege that the undisclosed commissions were material, that the investors justifiably relied on the organizers’ silence, and that the investors were damaged. The court made short work of those defenses. Damages had been alleged, said the court. And because the case was an appeal of the trial court’s denial of the plaintiffs’ motion to dismiss, the issues of materiality and reliance could not be resolved as a matter of law, but would have to be resolved at trial. Id. at **7-8.
The Roni court’s resolution of the fiduciary duties of LLC organizers is an example of legal reasoning by analogy. The court looked at the rule that applied to organizers of corporations, and apparently deciding that LLCs are similar enough to corporations, applied the corporate rule to LLCs.
As the law of LLCs develops, state courts are frequently called upon to decide novel LLC issues. In doing so the courts often look to the law applicable in the analogous corporate context. Examples that I have written on previously include New York (de facto corporations, here), Colorado (creditors’ claims against directors, here), Oregon (requirements for derivative suits, here), and Michigan (officer liability for corporate torts, here).
The Roni court did not explain the principles underlying the corporate rule that it relied upon, but simply applied it “[b]y extension.” Id. at **5-6. The court’s implicit recognition of a close analogy between corporations and LLCs was presumably based on the entity nature of each and the similar roles played by the organizers of each type of entity.
LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Idaho's First Case on LLC Fiduciary Duties
The law of fiduciary duties in LLCs is not well settled. For example, less than half of the states have reported opinions on fiduciary duties in LLCs. Cases of first impression on basic fiduciary duty issues in LLCs will be arising for a long time to come.
State courts, when first faced with a claim of breach of fiduciary duty by an LLC manager or member, normally look initially to the state’s LLC Act. Many state LLC Acts have provisions setting fiduciary standards. For example, Ohio’s LLC Act requires managers to act in good faith, in (or not opposed to) the best interests of the company, and with the care of an ordinarily prudent person.
Sometimes there is no help in the Act – some states have no provisions addressing whether members or managers of an LLC owe fiduciary duties to the company or the members. For example, the LLC Acts of Delaware, Washington and Indiana are silent on the issue.
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.
