Idaho’s Contractor Registration Act requires that construction contractors register with the state, and bars unregistered contractors from placing a mechanic’s lien on the property they worked on or suing to collect compensation for their work. Registration after the contractor’s work is done does not cure the defect. Many other states have similar laws.
Earlier this year the Idaho Supreme Court had to decide whether an LLC member’s contractor registration satisfied the registration requirement for the LLC, a general contractor. Stonebrook Constr., LLC v. Chase Home Fin., LLC, 277 P.3d 374 (Idaho 2012). The court held that the member’s registration was not sufficient to satisfy the LLC’s registration requirement. Id. at 380.
Background. In 2006 Tyler Schwendiman and Brandon Burton began operating a construction company under the name “Stonebrook Construction,” and Schwendiman registered as a contractor in his own name. Then in 2007 Schwendiman and Burton formed Stonebrook Construction, LLC as an Idaho LLC. They did not register it as an Idaho contractor because they believed Schwendiman’s registration satisfied Idaho’s Contractor Registration Act, Idaho Code ch. 54-52 (ICRA). Stonebrook,277 P.3d at 376.
In 2007 and 2008, Stonebrook Construction, LLC entered into a contract to build a home and provided labor and materials for the residence, but it was not paid the agreed-upon amount. Stonebrook recorded a claim of lien against the property and then brought an action to foreclose its lien. Chase Home Finance held a deed of trust against the property, however, and intervened in the LLC’s foreclosure action. Id.
Chase moved for summary judgment on the ground that Stonebrook was barred from claiming a lien on the property because it had not registered as required by the ICRA. The trial court granted Chase’s motion and dismissed Stonebrook’s lien claim. Stonebrook appealed.
The Appeal. Stonebrook’s major argument was that it was not out of compliance with the ICRA because the ICRA applies to any “person,” and “person” is defined as “any individual, firm, partnership, limited liability company, … or any combination thereof acting as a unit.” Idaho Code § 54-5203(6) (emphasis added). Stonebrook contended that Schwendiman (who had registered under the ICRA) and Stonebrook were a combination acting as a unit, and therefore formed a unit that had registered.
This was a clever argument, and it resonates with the partnership-like characteristics of LLCs. But it didn’t work. The court conceded that “it may be possible to construct an interpretation that supports this contention,” but concluded that “a plain reading of the statute leads us to conclude that the Act requires the listed entities, including combinations of those entities, to register.” The court said it could not accept the proposition that Schwendiman and Burton formed an LLC and then worked as individuals in combination with their own LLC to perform the very services the LLC was created to do. Stonebrook, 277 P.3d at 378-79.
The court pointed out that Stonebrook’s arguments were inconsistent with the separate entity nature of the LLC and the members’ insulation from the LLC’s debts and obligations. Id. at 379. Idaho’s LLC Act provides that a limited liability company is an entity distinct from its members, and that the debts and liabilities of an LLC are solely its own and do not become the members’ liabilities merely because of their status as members. Idaho Code § 30-6-104(1), § 30-6-304(1).
The court also dismissed Stonebrook’s argument that it had substantially complied with the ICRA, because Stonebrook made no effort at all to comply. Stonebrook also argued that Schwendiman’s personal contractor registration should be recognized to avoid an unreasonably harsh result. The court found the ICRA’s plain language to be unambiguous, and concluded that “[a]lthough the result for Stonebrook is harsh, it is the result the Legislature intended.” Stonebrook, 277 P.3dat 379-80. The court accordingly affirmed the trial court’s grant of summary judgment in favor of Chase.
Perhaps the only ray of light for Stonebrook was that the court denied Chase’s request for attorneys’ fees, finding that Stonebrook had made a good-faith argument for substantial compliance with the ICRA, which was a legitimate issue of first impression for the court.
Limited liability company agreements often include procedures for member voting on significant company actions. But sometimes it is convenient to instead ask the members to sign a written consent document and thus avoid the need for an in-person meeting. The Delaware Court of Chancery last month had to decide whether an LLC agreement that allowed member voting, but said almost nothing about members taking action by written consent, precluded the use of member written consents. Paul v. Delaware Coastal Anesthesia, LLC, No. 7084-VCG, 2012 WL 1934469 (Del. Ch. May 29, 2012).
Background. Dr. Leena Paul was one of four 25% members of the LLC. The LLC’s operating agreement allowed a member of the LLC to be terminated without cause on 90 days’ notice by “the Company acting by vote” of members holding 75% of the interests in the LLC. The three members other than Dr. Paul agreed by written consent to terminate Dr. Paul’s membership in the LLC and gave her written notice of her termination.
Dr. Paul sued the LLC and the three members to set aside her termination, contending that the LLC’s operating agreement did not allow the LLC members to take action by written consent. Paul, at *1. The three members then filed a motion to dismiss the complaint.
Analysis. Dr. Paul’s complaint pointed to Section 7.8 of the operating agreement, which required that notice of any member meeting must state the place, date, and time of the meeting. It also stated: “At a meeting of Members at which a quorum is present, the affirmative vote of Members holding a majority of the Membership Shares and entitled to vote on the matter shall be the act of the Members, unless a greater number is required by the Act.” Id. at *2. Dr. Paul contended that the members’ consent was void because no membership meeting was held and proper notice of the action was not given to members.
Dr. Paul also contended that as an LLC member she had a fundamental right to vote her interests in the LLC. But the court disposed of that argument in a footnote by pointing out that Section 18-302 of the Delaware LLC Act allows LLC members to take action by written consent rather than voting at a meeting, unless otherwise provided by the LLC agreement. Id. at *2 n.10.
The other members asserted that their member action by written consent was valid under Section 18-302 of the Delaware LLC Act:
Unless otherwise provided in a limited liability company agreement, on any matter that is to be voted on, consented to or approved by members, the members may take such action without a meeting, without prior notice and without a vote if consented to, in writing or by electronic transmission, by members having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all members entitled to vote thereon were present and voted.
This section allows LLC members to take action by written consent, without a meeting, “unless otherwise provided in a limited liability company agreement.” The question for the court, therefore, was whether the operating agreement “otherwise provided,” i.e., preempted the statute’s authorization of written consents.
The court first noted that LLCs are contractual in nature, that the members have wide latitude to craft their rights and obligations, and that the LLC Act exists as a “gap filler” to supply terms not covered in the agreement. The court then turned to the language of the operating agreement.
The LLC agreement provided procedures for meetings of the members and defined the requisite vote to take action, but did not expressly bar the use of member consents. Further, the agreement’s sections on record dates and proxies allowed members to “express consent to Company action in writing without a meeting.” Id. at *2. The court concluded that, reading the operating agreement as a whole, it did not “‘otherwise provide,’ so as to preempt, actions by written consent to terminate a member,” and dismissed the complaint. Id. at *3.
Comment. This is a short and straightforward opinion, but I think it noteworthy for two reasons. One is that this issue, i.e., using written consents in lieu of member voting in person at a meeting, comes up frequently. On multiple occasions clients involved in an LLC have asked me, “Do we need to have a meeting or can we just sign a written consent?” The question is asked because scheduling or other issues may make a written consent convenient, or the written consent may be important to avoid delays.
The other point is for lawyers who draft LLC agreements. If an LLC agreement is intended to allow members the option either to vote or to take action by written consent, both should be explicitly authorized. If only one of these two approval methods is authorized, it leaves an inference that the lack of explicit authorization is intended to bar use of the other method.
Oregon Workers' Compensation Law Does Not Shield Employer LLC's Managing Member from Negligence Claim by Injured Worker
The Oregon Court of Appeals recently held that the exclusive remedy provision of Oregon’s workers’ compensation law does not shield an employer LLC’s managing member from a negligence claim by the LLC’s injured worker. Cortez v. NACCO Materials Handling Grp., Inc., No. A144045; 050302632, 2012 WL 758895 (Or. App. Feb. 29, 2012).
Background. Workers’ compensation insurance provides reasonably quick and sure payments to workers injured on the job, regardless of whether or not the employer is negligent. Payments cover medical expenses and disability, but the tradeoff for not requiring the employee to prove negligence is that the amounts are fixed and limited. Workers’ compensation statutes normally provide that the worker’s claim under the statute is the worker’s exclusive remedy against the employer, other employees, and the officers and directors of the employer.
The Case. In Cortez the plaintiff was injured while employed by Sun Studs, LLC, an Oregon limited liability company. Later he filed for and obtained workers’ compensation benefits from Sun Studs’ insurer. He then sued Sun Studs’ sole member, Swanson Group, Inc., for (a) negligence, (b) violations of Oregon’s Employer Liability Law (ELL), Or. Rev. Stat. § 654.305 to 654.336, and (c) noncompliance with the workers’ compensation statute, Or. Rev. Stat. § 656.017. Sun Studs was member-managed and Swanson Group was therefore its sole managing member.
The plaintiff conceded at trial that he could not prove noncompliance with the workers’ compensation statute, and the trial court dismissed his negligence and ELL claims based on the exclusive remedy provision of Oregon’s workers’ compensation statute.
The question before the Court of Appeals was therefore whether the exclusive remedy language in Oregon’s workers’ compensation statute protected the LLC’s managing member from the plaintiff’s negligence and ELL claims. The statute says:
The exemption from liability given an employer under this section is also extended to the employer’s insurer, the self-insured employer’s claims administrator, the Department of Consumer and Business Services, and the contracted agents, employees, officers and directors of the employer, the employer’s insurer, the self-insured employer’s claims administrator and the department ….
Or. Rev. Stat. § 656.018(3) (emphasis added). The court phrased the issue as “whether the legislature intended to include ‘members’ of limited liability companies among those exempt from liability under the exclusive remedy provisions of ORS 656.018.” Cortez, 2012 WL 758895, at *2.
The Court’s Analysis. The court first noted that an LLC is a legal entity distinct from its members, so that even if the exclusive remedy provision applies to an LLC as an employer, it does not necessarily apply to the LLC’s members. Id. at *3. The court then pointed out that when the legislature enacted Oregon’s LLC Act, it included a provision that extended the coverage of certain other statutes to LLC members and managers: “Whenever a section of Oregon Revised Statutes applies to both ‘partners’ and ‘directors’, the section shall also apply: … [i]n a limited liability company without managers, to the members of the limited liability company.” Id. at *4 (quoting Or. Rev. Stat. § 63.002). The list of entities and persons in the exclusive remedy statute includes directors but not partners, so § 63.002 was nonapplicable. The court saw that omission as further evidence that the legislature had not intended to exempt LLC members from liability under § 656.018(3).
The court also reasoned by analogy to corporate shareholders, citing Fields v. Jantec, Inc., 317 Or. 432, 857 P.2d 95 (1993). “Thus, a shareholder, as an owner of a corporation, does not fall under the protection of the exclusive remedy provision in ORS 656.018(3). By analogy, a member, as an owner of an LLC, also does not fall under the protection of the exclusive remedy provision in ORS 656.018(3).” Cortez, at *4.The court did not discuss the fact that Swanson Group, the LLC’s managing member, was both a member and a manager, much like the sole shareholder in Fields who was also an officer and director.
The defendant also claimed that it was not liable because of § 63.165 of the LLC Act, which states that “[a] member or manager is not personally liable for a debt, obligation or liability of the limited liability company solely by reason of being or acting as a member or manager.” The court pointed out that § 63.165 does not shield an LLC member from its own tortious conduct. Cortez, at *5.
The court’s final conclusion was that neither the exclusive remedy provision of the workers’ compensation statute, § 656.018(3), nor the liability limitation of the LLC Act, § 63.165, shielded Swanson Group from the plaintiff’s negligence claim. The court dismissed the plaintiff’s ELL claim on other grounds, and remanded the case to the trial court to resolve the plaintiff’s negligence claim.
Comment. The court began its analysis by mistakenly framing the issue as “whether the legislature intended to include ‘members’ of limited liability companies among those exempt from liability under the exclusive remedy provisions” of the statute. Cortez, at *2. This characterization oversimplifies by ignoring the distinction between members of a member-managed LLC and members of a manager-managed LLC. The former are both owners and active managers of the LLC. The latter are only owners.
Oregon’s LLC Act defines a manager-managed LLC as an LLC that is designated as a manager-managed LLC in its articles of organization or whose articles of organization otherwise expressly provide that the LLC will be managed by a manager or managers. Or. Rev. Stat. § 63.001.
A member-managed LLC, on the other hand, is defined simply as an LLC other than a manager-managed LLC. Id. Swanson Group was the sole member of a member-managed LLC. Cortez, 2012 WL 758895 at *1.
Members of a member-managed Oregon LLC are “managers” under the LLC Act and have full rights to control the management and conduct of the LLC. Or. Rev. Stat. § 63.130(1)(a), 63.130(7). More significantly, a member of a member-managed LLC is an agent of the LLC and the act of such a member on behalf of the LLC binds the LLC.
Conversely, members of a manager-managed LLC have no right to participate in the management and control of the LLC and are not agents of the LLC. (The rights of members in the two types of LLCs are subject to modification in the articles of organization or operating agreement, but the court in Cortez did not refer to any such provisions of either.)
Thus, members of a member-managed LLC act as agents and representatives of the LLC when they manage it and conduct its business and affairs. And it is representatives of the employer that the key language in the exclusive remedy focuses on: “the contracted agents, employees, officers and directors of the employer.” Or. Rev. Stat. § 656.018(3).
It seems clear that an LLC’s manager is the type of representative that § 656.018(3) is intended to cover. But as the Cortez court pointed out, courts must neither insert in the statute what has been omitted nor omit what has been inserted. Cortez, at *2. The court seems to have ignored, however, the reference in the statute to agents. The LLC Act defines each member of a member-managed LLC as an agent of the LLC, so under a proper understanding of Swanson Group’s status as the sole managing member of the LLC, it should have been shielded from the plaintiff’s negligence claim.
Business people use LLCs when starting a new business venture so they can be shielded from personal liability for the venture’s obligations. Limited liability for members is a fundamental part of the states’ LLC laws. The Pennsylvania LLC Act, for example, states:
Except as provided in subsection (e), the members of a limited liability company shall not be liable, solely by reason of being a member, under an order of a court or in any other manner for a debt, obligation or liability of the company of any kind or for the acts of any member, manager, agent or employee of the company.
15 Pa. Cons. Stat. § 8922(a). (Subsection (e) is only applicable if the LLC’s certificate of organization provides that some or all of the members are personally liable for the debts or liabilities of the LLCs. That is almost never done.)
The members can of course give up their liability shield, either intentionally in a contract or sometimes by mistake. One part of a contract that can be a pitfall for LLC members is the signature block, the place at the end of the contract where the parties sign it. (I assume the contract is in writing.)
The standard way to indicate that an LLC (and none of its members) is a party to a contract is to use the LLC’s name and the title of the signing member (or manager if it is manager-managed). Unfortunately this detail is sometimes overlooked or mishandled.
In Hazer v. Zabala, 26 A.3d 1166, 2011 Pa. Super. LEXIS 2227 (Pa. Super. Ct. Aug. 11, 2011), Juan Zabala signed his name to a lease, and underneath printed “DBA/ZABALA BROKER, LLC.” Hazer, 26 A.3d at 1170. (The lease did not otherwise recite the name of the tenant.) The landlord sued Zabala when the rent was not paid, and Zabala defended on the ground that the LLC, not Zabala, was the party to the lease.
The court disagreed. It recognized “DBA” as an abbreviation for “doing business as,” and saw the acronym as an indication that Zabala Broker, LLC was simply another name for Juan Zabala. “‘DBA’ identifies an equivalency or single identity between the appellations.” Id. at 1170.
Zabala’s signature did not identify himself as an officer, member or agent of the LLC, and the court found that the corporate rule applied to LLCs: “Corporations necessarily act through agents and if one so acting is to escape personal liability for what he intends to be a corporate obligation, the limitation of his responsibility should be made to appear on the face of the instrument.” Id. (internal quotation marks and citations omitted). Zabala’s failure to use any title such as “member” or “managing member” doomed his appeal.
The court was also unswayed by the fact that rent checks from an account in the name of Zabala Broker, LLC were accepted by the landlord. The court affirmed the trial court’s finding that the landlord was justified in accepting the checks in the belief that they were simply paid on behalf of Mr. Zabala.
The court’s analysis focused on the notion that “DBA” is used to indicate an alternative name for an individual or entity. It usually is, and the court’s analysis would have made perfect sense if Juan Zabala had used “Zabala Broker” as a DBA. What is odd is that he included “LLC” in the DBA, i.e., “Zabala Broker, LLC.” That indicates that he was holding himself out as a limited liability company, which doesn’t make sense. An individual is not an entity. It would seem more logical to view the use of “DBA Zabala Broker, LLC” as an awkward attempt to indicate that he was signing on behalf of the LLC, in a representative capacity.
However, the court also pointed out in a footnote that Zabala Broker, LLC was not formed until December 15, 2008, two and a half months after the lease was signed. Id. Although the court didn’t discuss the fact that the LLC did not exist at the time of signing the lease, that nonexistence supports the court’s conclusion that Zabala had not clearly indicated that he was signing in a representative capacity.
Lawyers routinely and reflexively write contractual signature blocks using the entity’s name and the title of the signing individual. In most cases where an incorrect signature block is used the signer is inexperienced or rushed, without an attorney to review and catch the mistake. In the song The End of the Innocence, Don Henley sings “The lawyers dwell on small details.” But sometimes those small details can cause large problems, and that’s what happened in Hazer v. Zabala.
Caution: LLC Members and Managers Should Be Careful When Executing Documents In A Representative Capacity
Note: The following is posted by guest blogger Janet Jacobs.
Like most other entities, LLCs can act only through their representatives, and LLC members are often called on to act and execute documents on behalf of the LLC. Generally, LLC members and managers are not held personally liable for the debts and liabilities of the LLC, provided the acting member or manager indicates that he or she is signing on behalf of the LLC. Usually, the simplest way to demonstrate that the signatory is not accountable personally is to add his or her title to the signature line on the document. Example: Mary Smith, Managing Member of XYC, LLC. However, as pointed out in a recent Maryland case, adding a title to a signature block will not remove personal liability if the text of the document clearly indicates an intention to hold the signatory personally liable.
In Ubom v. Suntrust Bank, No. 2862 (Md. Ct. Spec. App. Apr. 4, 2011), Mr. Ubom applied for a line of credit in the name of his law firm, Ubom Law Group (“ULG”). Mr. Ubom was the sole member and the managing attorney of ULG. The credit agreement form requested information about the applicant (ULG) and the guarantor. Mr. Udom duly completed the applicant LLC’s information. On the page of guarantor information, he provided his driver’s license and social security numbers, date of birth, address, personal financial information and employment information. The only detail that Mr. Udom did NOT provide on the guarantor information page was his legal name. On the signature page of the credit agreement, Mr. Ubom signed twice: once on the applicant line and once on the guarantor line. Both signature lines allowed the signatory to add a title – Mr. Udom added the words “Managing Partner” after each of his signatures.
The credit agreement contained the following language: “To induce Bank to open the Account and extend credit to the applicant, or to renew or extend such other credit, each of the individuals signing this Application as a ‘Guarantor’ … hereby jointly and severally guarantee payment to the Bank of all obligations and liabilities of the applicant of any nature whatsoever….” Mr. Udom asserted that he had questioned the bank’s representative specifically about his personal liability based on this language, and that person had assured him that so long as Mr. Udom (a) left the “Legal Name of Guarantor” blank and (b) inserted his title on the signature lines, he would not be personally obligated to repay UGL’s debt to the bank.
Three years later, the loan was in default and Suntrust filed a complaint against ULG as the primary obligor and Mr. Udom as guarantor. Mr. Udom did not deny that ULG was liable, but he did contest the allegation that he was personally liable as guarantor, on the grounds that he signed only in a representative capacity, as should have been evident from the addition of the words “Managing Partner.”
Not so, said the lower court. Citing the fact that Mr. Udom was “a sophisticated gentlemen … an attorney,” it granted summary judgment in favor of the bank. While it is beyond the scope of this blog to delve into whether attorneys are automatically mavens in all aspects of business dealings, the lyrics of a song written by the immortal George Gershwin come to mind: “It ain’t necessarily so.”
The court of appeals agreed with the lower court. It turned down Mr. Udom’s request to introduce testimony concerning the bank’s assurances regarding his personal liability, on the grounds that Maryland followed the principle of “objective interpretation” of a contract. In other words, a court should look only at the contract, except in cases of ambiguity, fraud, duress or mistake. In the court’s eyes, the language of the contract was unambiguous. (The court did not discuss whether there was any fraud, duress or mistake involved in the execution of the contract.)
The Udom court explained away Mr. Ubom’s careful addition of the words “Managing Partner” as being only a "descriptive phrase". It pointed out quite correctly that there would be no value in having the primary obligor (the LLC) also act as guarantor of the same obligation, a common sense approach that would be quite persuasive were it not for a conflicting ruling made by the same court in an earlier but strikingly similar case.
In L & H Enterprises Inc. v. Allied Building Products Corp., 88 MdApp. 644 (1991), the credit agreement signed by two officers of the debtor entity provided as follows: “In consideration of [the creditor’s] extending credit I/we jointly and severally do guarantee unconditionally at all times … the payment of indebtedness … of the [debtor]….” The signing officers had provided some personal information but wrote “N/A” in the section calling for information about their respective spouses. The court found the insertion of “N/A” to be compelling evidence of the officers' intention not to be held personally liable, because the spouse’s signature would be a prerequisite for the creditor to reach marital assets. (It would have been helpful if the opinion had confirmed that the officers were, in fact, married, and that the inclusion of “N/A” didn’t simply mean that the officers were single.) The court also found it very significant that there was only one signature line for the applicant; there was no place where a guarantor could sign. As the officers clearly signed the agreement on behalf of the applicant entity, despite the clarity of the italicized language, sufficient ambiguity was created by these other factors to relieve the officers of personal liability.
The opinion issued by the Udom court contains one snippet of information that lends some credence to Mr. Udom’s allegation that he had been told he would nto be held personally liable for ULG's debt: Suntrust Bank held the mortgage on Mr. Udom’s house. Even if one discounts Mr. Udom’s assertion that the bank manager talked him into taking out a business loan, there was a pre-existing relationship between the parties that could have led Mr. Udom to rely on the word of a trusted bank manager rather than the language of the contract.
The Udom case provides some useful takeaways:
- First, for LLC members and managers who execute documents in the name of the LLC and who wish to avoid being held personally liable for the LLC's debts:
- Trust but verify: if the language of the agreement does not align with oral statements made by the other contracting party, consult an attorney before you sign.
- Remember, there is a reason documents require more than one signature. Each signature line generally supports different promises, obligations, covenants, representations or acknowledgments. Be sure you understand what each signature line is supporting. If one signature line is for the entity, the presence of a second signature line should be a red flag.
- Don’t rely on the insertion of a title to protect you from personal liability. If the text of the document indicates an intent to bind anyone other than the LLC, you can expect that if your LLC defaults, the other party to the agreement may try and enforce personal liability. Signing while crossing your fingers and hoping for the best will not change the objective interpretation of the promises, obligations, covenants, representations or acknoweldgements in the text of the document.
- Second, for attorneys reading this blog: irrespective of your practice area, you are assumed to be a sophisticated business person. At a minimum, you will be expected to have read and understood any document you signed. You will not get the benefit of the customary judicial flexibility extended to ordinary consumers in their dealings with banks and other institutions.
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.
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.