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.
A low-profit limited liability company, or L3C, is an LLC whose primary purpose is not to earn a profit but instead to significantly further the accomplishment of one or more charitable or educational purposes. It may still make a profit, though, and is not a non-profit as that term is used in corporate non-profit statutes or in federal income tax regulations.
L3Cs are well-intentioned as a way to increase the flow of capital to socially beneficial enterprises, but they don’t provide the principal benefits their promoters tout and can easily mislead investors and foundations. Nonetheless, nine states so far have passed legislation authorizing L3Cs, although the momentum for state passage seems to be weakening. No states have passed L3C legislation this year, and only one in 2011 (Rhode Island), one in 2010 (Louisiana), and two in 2009 (Maine and Illinois).
I wrote last September about some of the problems with L3Cs, when Rhode Island passed its L3C statute, here. In that post I discussed an article by Bill Callison, a partner at Faegre and Benson, and Allan Vestal, Dean and Professor of Law at Drake University: J. William Callison & Allan Vestal, The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 273 (2010). I also discussed an article by Daniel Kleinberger, Professor of Law at William Mitchell College of Law, that analyzes a number of L3C issues: Daniel S. Kleinberger, A Myth Deconstructed: The “Emperor’s New Clothes” on the Low-Profit Limited Liability Company, 35 Del. J. Corp. L. 879 (2010). These articles pointed out some of the significant problems with L3Cs.
In my last L3C post I lamented the communication gap between (a) the lawyers and law professors who analyze and criticize the L3C form, and (b) the state legislators who hear only the alleged benefits from L3C promoters. I suggested then that one of the national bodies with expertise and a broad constituency, such as the National Conference of Commissioners on Uniform State Laws, the American Law Institute, or the Business Law Section or Tax Law Section of the American Bar Association, should play a more active role in making recommendations to the states.
Lo and behold, the Business Law Section of the American Bar Association, on behalf of its committees on LLCs and nonprofit organizations, has taken action to oppose L3Cs. The Section submitted a letter dated April 19, 2012, including a detailed, 17-page Appendix, to Steve Simon, the Assistant Minority Leader of the Minnesota House of Representatives. The letter detailed the problems with the proposed L3C structure and urged Representative Simon to oppose a bill before the Minnesota legislature, House File No. 2702, which was intended to authorize L3Cs. And although I don’t know how the politics played out, after its introduction and first reading, House File No. 2702 received no hearings or other action during the legislative session that ended in May.
The major points of the letter are that L3Cs will not stimulate private foundation investment in socially beneficial enterprises, and that the type of tranched L3C investment by private foundations, as urged by L3C advocates, is highly risky for private foundations and will not be accepted by them. Other criticisms are that (1) L3C promoters erroneously imply that state law can streamline and simplify federal tax law compliance; (2) the model form of L3C statute proposed by advocates has a serious technical flaw; and (3) most state LLC statutes already permit the type of ventures contemplated by the L3C legislation. The letter and its appendix are a thorough and well-written communication.
This action by the ABA’s Business Law Section is a big and positive step in the right direction, and I commend the Section. Although the letter makes clear that it is not the official position of the entire ABA, it does represent the views of the ABA’s Business Law Section, which has about 54,000 members. Furthermore, it represents the considered opinions of both the Committee on Limited Liability Companies, Partnerships and Unincorporated Entities and the Committee on Nonprofit Organizations. The lawyers and academics who sit on these committees represent the perspectives of both the business lawyers who help clients form, operate, and invest in LLCs and other business entities and the lawyers who represent a variety of non-profit organizations, both public charities and private foundations.
Rhode Island passed legislation in June to authorize low-profit limited liability companies (L3Cs). The bill was signed by the Governor on June 20, 2011, and will take effect on July 1, 2012. With the passage of this legislation, Rhode Island becomes the ninth state to authorize L3Cs, joining Illinois, Louisiana, Maine, Michigan, North Carolina, Utah, Vermont, and Wyoming.
An L3C is a specific type of limited liability company, one whose primary purpose is not to earn a profit but rather to “significantly further the accomplishment of one or more charitable or educational purposes.” 2011 R.I. Pub. Laws ch. 79 (H. B. 5279A). I have previously written about L3Cs, here and here.
The promoters and advocates of L3Cs say that private foundations, as well as commercial investors, will be encouraged to invest in L3C enterprises. The state legislatures seem to be jumping on the bandwagon: L3C bills were introduced in at least nine states this year in addition to Rhode Island, which I wrote about in March, here.
These L3C bills are being pushed because the non-profit community is strongly interested in collaboration between the not-for-profit world and the for-profit-world, and wants to leverage the financial strength of the for-profit, investment-oriented community into charitable and educational activities. Arthur Wood, Transcript: New Legal Structure to Address the Social Capital Famine, 35 Vt. L. Rev. 45 (2010).
The fly in the ointment is that commentators – business lawyers and professors – have written at length about perceived defects in the L3C structure. For example, Bill Callison, a partner at Faegre and Benson, and Allan Vestal, Dean and Professor of Law at Drake University, have written about what they call the L3C illusion. J. William Callison & Allan Vestal, The L3C Illusion: Why Low-Profit Limited Liability Companies Will Not Stimulate Socially Optimal Private Foundation Investment in Entrepreneurial Ventures, 35 Vt. L. Rev. 273 (2010).
Another: Daniel Kleinberger, Professor of Law at William Mitchell College of Law, published an article last year that analyzes a number of L3C issues. Daniel S. Kleinberger, A Myth Deconstructed: The “Emperor’s New Clothes” on the Low-Profit Limited Liability Company, 35 Del. J. Corp. L. 879 (2010). If the title of his piece doesn’t give you its thesis, let me list the titles of the sections covered in Part Vof his article, The L3C Concept Debunked: (A) The L3C is Unnecessary, (B) The L3C “Brand” is Unwise, (C) The L3C Construct is Inherently Misleading, and (D) Current L3C Legislation is Nonsensical and Useless. I refer you to his article for Professor Kleinberger’s lengthy and detailed analysis.
With serious questions being raised by academics and business lawyers, one has to wonder why the states are rushing to adopt L3C legislation.
To quote Paul Newman in Cool Hand Luke: “What we’ve got here is a failure to communicate.” The business lawyers and professors are analyzing and criticizing the L3C structure, the non-profit community and other promoters are pushing the L3C law hard at a local level, and state legislatures are passing the laws. But the issues raised by the commentators are apparently being ignored. This is not a good way to make public policy.
What should happen here? There are clearly substantial problems and issues with the current form of L3C law that the states are adopting. The existing L3C laws should either be taken off the books or changed to address the problems, and new laws in the current L3C form should not be passed. Conceivably a form of L3C that addresses the problematic issues could be promulgated for consideration by the states.
I think one of the national bodies with expertise and a broad constituency, such as the National Conference of Commissioners on Uniform State Laws, the American Law Institute, or the Business Law Section or Tax Law Section of the American Bar Association, should take this issue in hand, study it, and make recommendations after thoroughly analyzing the issue and considering input from the various groups and experts. Such a process would result in recommendations and possibly a model statute that would be persuasive to state legislatures.
If you are an NCCUSL commissioner, an ALI member, or a member of the ABA’s Business Law Section or Tax Law Section, think about getting your organization involved in taking a hard look at L3Cs.