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.
Who Are the Owners of an LLC?
A lender took an assignment of a 25% interest in an LLC in exchange for the lender’s cancellation of the LLC’s debt, but the lender was never admitted as a member. Later the lender agreed to sell his “25 percent ownership interest,” but his buyer defaulted and claimed that the lender did not have an ownership interest in the LLC.
Ownership of property is covered in a first-year law school class because it is a fundamental legal concept, but sometimes the application of even fundamental concepts can be troublesome. In this case the Kentucky Supreme Court overruled the Court of Appeals and held that in the context of an LLC, “ownership” and membership in the LLC are synonymous – that the owner of an economic interest in the LLC does not have an “ownership interest” if he is not admitted as a member. Spurlock v. Begley, No. 2009-SC-000050-DG, 2010 Ky. LEXIS 80 (Ky. Apr. 22, 2010).
Tate Begley loaned $75,000 to Caribou Coal Mining Processing, LLC (Caribou), in exchange for Caribou’s promissory note. The note was unpaid and went into default. Robert Griffin, the founder of Caribou, orally promised to give Begley a 25% interest in Caribou in exchange for the $75,000 debt. Begley and Ben Spurlock then entered into a one-paragraph written agreement (Sale Agreement) in which Spurlock agreed to pay Begley $70,000 in exchange for Begley’s “25 percent ownership of Caribou Coal Processing LLC.” Spurlock, 2010 Ky. LEXIS 80, at *8.
A year later Caribou was insolvent and had ceased operations, and Begley sued Spurlock for non-payment on the Sale Agreement. Spurlock defended on the grounds of failure of consideration, contending that Begley did not hold an ownership interest in Caribou. At trial the jury found that Griffin had indeed transferred a 25% ownership interest to Begley and ruled for Begley on his Sale Agreement with Spurlock. The Court of Appeals affirmed.
The Kentucky LLC Act uses the term “members” rather than “owners,” as do most other state statutes. Ky. Rev. Stat. § 275.015(16). If there is no written operating agreement, a person acquiring an interest directly from the LLC becomes a member only if all members consent in writing, and a person acquiring an interest by assignment from a member becomes a member only if a majority in interest of the members consent in writing. Ky. Rev. Stat. §§ 275.275(1), 275.265(1).
If the assignee is not admitted as a member, the membership interest becomes divided. The economic rights are held by the assignee and the governance rights are retained by the assignor, who continues to be a member. Ky. Rev. Stat. § 275.255(1)(d). If the members consent and the assignee is admitted, the transfer of the membership interest conveys both the economic and the governance rights. Spurlock, 2010 Ky. LEXIS 80, at *7.
After reviewing the Act’s provisions, the court concluded:
This, then, leads to the conclusion that simply acquiring economic rights does not, in and of itself, equate to “ownership” or “membership” in the limited liability company.
. . .
… In the context of limited liability companies, “ownership” and “membership” are synonymous.
Id. At *7-8. The court then reasoned that because Begley acquired only an economic interest and was not admitted as a member, he did not acquire an ownership interest in the LLC. Spurlock therefore had a valid defense of failure of consideration under the Sale Agreement.
The court’s analysis makes sense if one understands “ownership” in the sense of “[t]he complete dominion, title, or proprietary right in a thing or claim.” Black’s Law Dictionary 1260 (4th ed. 1968). After all, Begley did not have all of the rights of a member – he had the economic rights but not the governance rights. And if the word “membership” is used only for a person who is both admitted as an LLC member and who holds all of the associated economic rights, then the court’s conflating of ownership and membership is correct.
But as the Spurlock court itself pointed out, a member who transfers its economic interest to a non-admitted assignee continues to be a member even though it has no remaining economic rights. Presumably the court would not have found Begley to have “ownership” if he had been admitted as a member but had assigned his interest to a non-admitted assignee, leaving Begley a member holding governance rights and no economic interest. In that scenario, LLC membership would not equate to ownership.
More careful drafting of the Sale Agreement could have changed the result in this case. If the Sale Agreement had referred to an “economic interest” or simply an “interest,” rather than an “ownership interest,” or if it had included language otherwise clarifying that Begley had not been admitted as a member, then Spurlock would have had no defense. The court did not examine the intent of the parties; it simply construed any ambiguity in the phrase “ownership interest” against Begley because he drafted and prepared the Sale Agreement. Spurlock, 2010 Ky. LEXIS 80, at *8-9..
The court also could have been more careful with its language. Its generalized equating of “ownership” and “membership” reaches too far by ignoring the fact that an LLC can have a member with no economic interest. Words are slippery and should be used carefully. The question, as Humpty Dumpty said to Alice, is which is to be master, the words or their speaker.
