Kansas Court Enforces Statutory Indemnification and Awards Attorneys' Fees in Fiduciary Duty Lawsuit
The Kansas LLC Act requires an LLC to indemnify its members or managers, in some cases, for their attorneys’ fees to the extent they are successful in litigation. The statute was recently interpreted to require an LLC to indemnify a member for his attorneys’ fees in a lawsuit where the member successfully sued to establish his membership in the LLC and to recover on fiduciary duty claims against two other members. Davis v. Winning Streak Sports, LLC, No. 107,613, 2013 WL 1010622 (Kan. Ct. App. Mar. 15, 2013).
Background. Christopher Davis sued Winning Streak Sports, LLC (WSS), U.S. Hardwood Distributors, Inc. (Hardwood), and Lauren Larson. (Hardwood and Larson were members of WSS.) Davis sought a declaratory judgment that he owned a 49% membership interest in WSS, and claimed damages from Hardwood and Larson for breaches of their fiduciary duties as members of WSS.
Davis was partially successful. The trial court ruled that he was a member of WSS, but only a 0.96% member, and awarded him damages of $600,000 for breaches of fiduciary duties by Hardwood and Larson. The court also awarded WSS $74,788 on its counterclaim against Davis for breach of contract. Both sides appealed, and in 2010 the Court of Appeals affirmed the trial court’s rulings. Winning Streak, Inc. v. Winning Streak Sports, LLC, No. 100,725, 2010 WL 348272 (Kan. Ct. App. 2010) (unpublished opinion), rev. denied, 222 P.3d 564 (Kan. 2010).
Claim for Attorneys’ Fees. Davis then brought suit to recover his attorneys’ fees incurred in the original action against WSS. Davis contended that he was entitled to indemnification for his attorneys’ fees under Section 17-7670(b) of the Kansas LLC Act. The trial court ruled on summary judgment that Davis was not a prevailing party and therefore was not entitled to recover his attorneys’ fees, and Davis appealed.
The Court of Appeals saw the interpretation of Section 17-7670(b) as central to its resolution of the appeal. This section has two components: paragraph (a) authorizes an LLC to indemnify any member, manager, or other person from any and all claims, and paragraph (b) mandates indemnification in limited circumstances:
(a) Subject to such standards and restrictions, if any, as are set forth in its operating agreement, a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.
(b) To the extent that a member, manager, officer, employee or agent has been successful on the merits or otherwise or the defenses of any action, suits or proceeding, or in defense of any issue or matter therein, such director, officer, employee or agent shall be indemnified against expenses actually and reasonably incurred by such person in connection therewith, including attorney fees.
Kan. Stat. Ann. § 17-7670.
The parties focused their arguments on whether Davis or WSS was the prevailing party, but the Court of Appeals saw those arguments as misplaced. “The statute in plain and simple language requires indemnity to the extent that a litigant prevails. There is no doubt that Davis prevailed, at least in part, in this litigation.” Davis, 2013 WL 1010622, at *5 (emphasis in original).
Because Davis prevailed in part, and because the statute is mandatory (“such director, officer, employee or agent shall be indemnified”), the court concluded that Davis was entitled to indemnification to the extent he was successful in the original litigation, and that the amount of the fees would have to be decided by the trial court. Id.
The court went on to consider additional arguments made by WSS that were not reached at trial.
No Operating Agreement. WSS had no operating agreement, and WSS claimed that therefore Davis could not seek relief under Section 17-7670(b). Paragraph (a) authorizes LLCs to indemnify managers and members, “[s]ubject to such standards and restrictions, if any, as are set forth in its operating agreement,” and WSS argued that an operating agreement is therefore required for both paragraphs. The court, however, ruled that the plain language of paragraph (b) controlled and that the lack of an operating agreement did not render Section 17-7670(b) inoperative. Id. at *8.
Unconstitutionally Vague. WSS argued that paragraph (b) is unconstitutionally vague, because it begins by referring to “a member, manager, officer, employee or agent,” and then refers to “such director, officer, employee or agent.” The first phrase refers to a member or manager, while the second phrase refers to “such director.” The court said this was an obvious clerical error in the drafting of the statute, and read the paragraph to include LLC members in the class of persons entitled to indemnity to the extent they are successful. Id. at *9.
Claims Personal to Davis. Lastly, WSS argued that Davis’s claims, whether or not successful, did not qualify for indemnification because they advanced only his personal, private interest. Note that paragraph (b) of Section 17-7670 is silent about the nature of the “action, suits or proceeding,” and in fact refers to “any action, suits or proceeding” (emphasis added).
The court apparently assumed that paragraph (b) requires a nexus between the lawsuit and the interests of the LLC, i.e., that there be some benefit to the LLC. But the court did not require that the lawsuit benefit only the LLC. “WSS does not provide any support for the notion that indemnity is not required when the underlying action benefits both the LLC and the individual plaintiff.” Id.
The court took note that (a) Davis contended he was a member of the LLC at the time of his suit, (b) some of Davis’s claims not only affected him personally but also dealt with the integrity of the LLC’s books and records, and (c) the issues Davis brought forth also benefited the LLC’s interest in properly identifying its members and their interest in the LLC, and in the accuracy of its books and records. “We cannot conclude, as WSS argues, that Davis’s suit advanced only his private interest.” Id. at *10.
The court therefore ruled that Davis was entitled to summary judgment on his indemnification claim for attorneys’ fees, and remanded the case to the trial court to determine the amount of attorneys’ fees that Davis should recover.
Comment. This case revolves around a poorly drafted paragraph of the Kansas LLC Act: Section 17-7670(b), quoted above. The Court of Appeals discussed the statute’s inconsistent reference to “such directors.” But beyond that, the scope of the statute’s indemnification requirement is breathtakingly wide. The statute requires an LLC to indemnify a member or manager to the extent it is successful in maintaining or defending “any action, suits or proceeding.” There is no explicit requirement that the member’s or manager’s suit or defense be in its capacity as a member or manager, or even that the suit have any connection to the LLC.
The court did not directly address the scope of paragraph (b), but it appeared to implicitly accept WSS’s premise that Davis would not have been entitled to indemnification for his attorneys’ fees if his suit had only addressed his personal interests.
So when does Section 17-7670(b) apply? Presumably a member that is successful in a suit for dissolution of the LLC, or in a suit for breach of fiduciary duty by a manager or other member, would be entitled to its attorneys’ fees under paragraph (b). Either of those claims arguably would, at least in many cases, benefit the LLC as well as the individual plaintiff.
This statute is an outlier in another respect. Many state LLC statutes authorize an LLC to provide in the LLC’s operating agreement for indemnification of managers and members, but few if any other LLC statutes require indemnification of members’ or managers’ attorneys’ fees. Both Washington and Delaware, for example, authorize but don’t require indemnification. RCW 25.15.040; Del. Code Ann. tit. 6, § 18-108.
Delaware Supreme Court Affirms Reformation of LLC Agreements But Reverses Award of Attorneys' Fees - Law Firm Was Working for Free
Last year the Delaware Court of Chancery reformed the cash distribution waterfall provisions of three real estate joint venture LLC agreements. Chancery also awarded attorneys’ fees to the successful plaintiff, even though the plaintiff’s law firm was not charging to represent it. The law firm was not charging because of its errors in drafting the three LLC agreements. ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Last week the Delaware Supreme Court affirmed Chancery’s reformation decision but reversed the award of attorneys’ fees. Scion Breckenridge Managing Member, LLC v. ASB Allegiance Real Estate Fund, No. 437, 2012, 2013 WL 1914714 (Del. May 9, 2013).
Background. The case involved errors in three Delaware LLC agreements that were entered into in 2007 and 2008. Each agreement was for a real estate development project, each agreement contained a distribution waterfall that allocated cash distributions in a specified order to the members, and each agreement contained the same error in the scheme of distributions. The errors originated in draft agreements prepared by the investors’ law firm.
The errors would have benefited the real estate developer at the expense of the investors, if enforced. The developer knew of the mistake but kept silent, and the investors did not notice the errors and signed the agreements. Eventually the mistakes came to light, but the developer contended there was no mistake. The investors put their law firm on notice of a malpractice claim and sued the developer to reform the LLC agreements to correct the mistake. The investors’ law firm agreed not to charge for representing them in the lawsuit. Scion Breckenridge, 2013 WL 1914714 at *5.
For a more detailed summary of the facts and a review of the Court of Chancery’s analysis, see my 2012 post here and Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog here.
Reformation. In the course of affirming the Chancery Court’s grant of reformation, the Supreme Court clarified prior Delaware case law on two points.
Failure to Read the Contract. The developer argued that failure to read a contract bars a claim for reformation. ASB, the advisor to the investors, had approved the first of the three incorrect LLC agreements based on an internal review and memorandum which summarized the deal terms as agreed upon in the parties’ preliminary emails, not as they were memorialized in the detailed LLC agreement. ASB’s president had relied on the internal review and had reviewed parts but not all of the final agreement. He acknowledged in his testimony that the error was obvious once it was pointed out. The two subsequent agreements were based on the first incorrect agreement and contained the same mistake, which the investors failed to recognize.
The Supreme Court recognized that prior Delaware cases were unclear on whether a negligent mistake, such as failure to carefully read a contract, should bar reformation. To resolve the confusion, the court adopted the standard in the Restatement (Second) of Contracts: “[a] mistaken party’s fault in failing to know or discover the facts before making the contract” will not bar a reformation claim “unless his fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.” Restatement (Second) of Contracts§ 157 (1981). The court expressly overruled prior Delaware cases to the extent inconsistent with this standard.
The court also noted that the rule is different when a party seeks to avoid or rescind a contract. A party cannot seek avoidance of a contract he or she had not read before signing.
Because ASB’s president had acted in good faith and in accordance with reasonable standards of fair dealing, the court held that his failure to read the contracts did not bar the company from seeking reformation of the agreements.
Unilateral Mistake. The developer argued that a unilateral mistake by one party, coupled with knowing silence by the other party, is not enough to support reformation. The Supreme Court recognized that prior Delaware case law was contradictory on whether reformation based on unilateral mistake requires something exceptional beyond the other party’s knowing silence, such as fraud or trickery. The court relied on Cerberus Int’l Ltd. v. Apollo Mgmt., L.P., 794 A.2d 1141 (Del. 2002) and held that unilateral mistake and knowing silence by the other party are sufficient to support a reformation claim. The court ruled that other cases are overruled to the extent they impose additional requirements such as exceptional circumstances.
Ratification. The developer also argued that the investors had ratified the three mistaken agreements by various acts, including an amendment of one of the agreements. All of the alleged acts of ratification occurred before the investors learned of the error. The court affirmed the Chancery Court’s conclusion: “[R]atification does not preclude reformation unless the ratifying party actually knew of the error.” Scion Breckenridge, 2013 WL 1914714 at *9.
Attorneys’ Fees. The agreements contained an attorneys’ fee clause:
In the event that any of the parties to this Agreement undertakes any action to enforce the provisions of this Agreement against any other party, the non-prevailing party shall reimburse the prevailing party for all reasonable costs and expenses incurred in connection with such enforcement, including reasonable attorneys’ fees.
ASB Allegiance Real Estate Fund, 2012 WL 1869416 at *20.
The Court of Chancery had ruled that the investors were entitled to an award of their reasonable attorneys’ fees: “Here, the non-breaching side of the case caption litigated the dispute at significant cost, albeit a cost that DLA Piper and ASB have allocated between themselves. The contractual fee-shifting provision obligates the breaching side of the caption to bear that cost, regardless of the allocation between DLA Piper and ASB.” Id.
The Supreme Court disagreed, instead focusing on the language of the attorneys’ fee clause: “The plain meaning of ‘incurred,’ combined with ‘reimburse,’ does not extend to this situation where ASB did not incur any payment obligation because DLA Piper agreed to represent it without charge.” Scion Breckenridge, 2013 WL 1914714 at *10. Under its arrangement with the law firm, ASB was not liable for payment at any point. The court noted that an award of attorneys’ fees to ASB would either (a) result in a windfall to ASB (if ASB retained the award), or (b) if ASB passed on the fees to its law firm, “effectively reward DLA Piper for successfully litigating this reformation action to correct its own mistakes.” Id. at *11. The court therefore reversed Chancery’s award of attorneys’ fees to ASB.
ASB, however, had also sought attorneys’ fees under the trial court’s inherent equitable powers. Chancery had not ruled on that claim because it relied on the contractual fee-shifting provision.
The Supreme Court noted that trial courts have inherent equitable power to shift attorneys’ fees under recognized exceptions to the American rule that litigants generally bear their own legal fees, except under contractual or statutory rights to receive fees. The court therefore remanded the case to Chancery to consider whether ASB is entitled to attorneys’ fees under the trial court’s equitable powers.
Comment. The Supreme Court’s clarifications on reformation were useful. Its reversal of the award of attorneys’ fees, on the other hand, seems a hyper-technical and strict interpretation of the language of the attorneys’ fee clause in the parties’ agreements.
The denial of an award of attorneys’ fees seems somewhat unfair, given the gist of the parties’ fee-shifting agreement and the facts of the case – the developer’s in-house attorney knowingly let the mistake be written into the contracts and then tried to enforce the mistake. It will be interesting on the remand to see if Chancery sees fit to apply any of the equitable grounds for shifting the investors’ attorneys’ fees to the developer.
The Supreme Court’s analysis also suggests that the investors and their attorneys might have been able to structure a fee agreement that would have satisfied the investors and yet accommodated an award of attorneys’ fees. For example, they could have agreed that the law firm would be paid its customary fees, except that it would be obligated to write off its fees if the lawsuit was not successfully resolved and to the extent the award of attorneys’ fees did not cover its bill. This approach would yield the same result to the investors, who would not end up paying any net attorneys’ fees under any circumstances. And the law firm would not receive a windfall, since it would be owed fees to the extent the court made an award.
Oregon Court Upholds LLC Capital Calls That Benefit Individual Members
The link between capital contributions to an LLC and the LLC’s purpose is usually clear. The contributions from the members support the LLC’s purpose and are in proportion to the members’ interests in the LLC. Similarly, the increase in value of the LLC’s assets is shared among the members in proportion to their interests. But in a recent case before the Oregon Court of Appeals, one member objected when the required capital contributions were used to directly benefit individual members, as well as benefiting the LLC. Awbrey Towers, LLC v. Western Radio Servs., Inc.,278 P.3d 44 (Or. Ct. App. 2012).
Background. Awbrey Towers, LLC was formed in 2000 to purchase a 19-acre antenna site located on Awbrey Butte in Bend, Oregon. The LLC’s operating agreement stated that its purpose was to “[a]cquire, own and operate an antenna site on Awbrey Butte in Bend, Oregon” and to “[e]ngage in such other activities as are related or incidental to the foregoing purpose and such additional purposes as may be determined from time to time by the Members.” Id. at 46 (brackets in original). Each of the seven LLC members owned a communication tower on the site and leased the land for its tower from the LLC. Each apparently held a one-seventh interest in the LLC.
The LLC’s operating agreement allowed the LLC to require additional capital contributions from the members “as may be necessary to service any debt incurred in connection with the acquisition of the Tower Site and such additional capital needs of the Company as determined by a vote of the Members.” Id.
By late 2001 two members were preparing conditional use permit applications for the City of Bend in order to make changes to their towers, and another member, Western Radio Services, Inc., applied for a building permit from the City to build a new tower. It soon became clear to the members that all seven contemplated building new towers or expanding their towers at some point, so five of the members met with the City to discuss its permitting process. The City indicated that it did not want to deal with the conditional use permit applications separately. It informed the members that it would not accept permit applications from any member until a ten-year master plan for development of the entire site was submitted, and it denied Western Radio’s building permit application. Id.
The members concluded that the master plan required by the City would affect all the members’ interests and decided that the LLC should develop and submit the plan. Western Radio objected on the grounds that the master plan was necessary only for the conditional use permits required of the other six members, not for the type of tower that Western Radio desired to build. The other members nonetheless approved the LLC’s development of the master plan and its payment of the necessary legal and engineering expenses.
The LLC made a series of capital calls over the next several years, mainly in connection with the master plan. The members, other than Western Radio, voted in favor of resolutions approving the capital calls. Western Radio paid some of the requested amounts but withheld expenses for the master plan. Id. at 46-47.
Eventually the LLC sued Western Radio for its unpaid capital contributions. Western Radio argued at trial that the capital calls were invalid because they were intended to cover engineering and legal costs incurred by individual members for their own benefit, not for the benefit of the LLC, and therefore constituted illegal distributions in kind for the benefit of individual members.
The trial court found for the LLC and entered judgment in the amount of $51,310 against Western Radio, and also awarded the LLC its attorneys’ fees. Id. at 47.
Court’s Analysis. The heart of Western Radio’s argument was that the majority members improperly benefited themselves by making capital calls for expenditures that benefited those members but did not benefit the LLC or Western Radio. The Court of Appeals, however, pointed to trial testimony showing that expenditures supporting the master plan allowed the members to further develop the property, thereby increasing its value. Because the LLC owned the property, this testimony supported the trial court’s finding that the expenditures benefited the LLC. Id. at 48.
Western Radio argued that the LLC’s expenditures on the plan benefited the other members but not Western Radio and therefore were improper. The court rejected that argument because Western Radio’s President testified at trial that the City would not consider Western Radio’s building permit applications without a master plan for the site, which meant that the LLC’s expenditures on the master plan benefited Western Radio as well as the other members.
The Court of Appeals also affirmed the trial court’s other theory – “that defendant had ratified the expenditures in question by acquiescing in the informal procedures by which the members had reimbursed plaintiff for all sorts of expenses, including those that defendant acknowledged it should pay.” Id. The trial testimony showed that when the LLC’s income was inadequate to pay its bills, the LLC’s manager would often simply ask each member to deposit one-seventh of the amount of the bills into the LLC’s bank account, without a member authorization for a formal capital call.
Attorneys’ Fees. Western Radio objected to the trial court’s award of attorneys’ fees, which was based on the operating agreement and on the relevant Oregon statute. The operating agreement provided:
Attorneys’ Fees. In the event any Member brings an action to enforce any provisions of this Operating Agreement against the Company or any other Member, whether such action is at law, in equity or otherwise, the prevailing party shall be entitled, in addition to any other rights or remedies available to it, to collect from the non-prevailing party or parties the reasonable costs and expenses incurred in the investigation preceding such action and the prosecution of such action, including but not limited to reasonable attorney’s fees and court costs.
Id. at 49. The LLC acknowledged that this paragraph, by its terms, applies only if the lawsuit in question is initiated by a Member. The LLC based its claim, however, on Or. Rev. Stat. § 20.096(1) (2007), which at that time stated:
In any action or suit in which a claim is made based on a contract, where such contract specifically provides that attorney fees and costs incurred to enforce the provisions of the contract shall be awarded to one of the parties, the party that prevails on the claim, whether that party is the party specified in the contract or not, shall be entitled to reasonable attorney fees in addition to costs and disbursements.
Western Radio contended that the issue was not mutuality of remedy and that the statute was not relevant – the paragraph in the operating agreement was mutual and provided for the prevailing party to recover its attorneys’ fees. It argued, rather, that the language “[i]n the event any Member brings an action to enforce [the agreement]…” was a pre-condition to any party having a right to recover fees, and that because the LLC had brought the suit it could not recover attorneys’ fees. 278 P.3d at 49.
Relying on Jewell v. Triple B. Enterprises, Inc., 626 P.2d 1383 (Or. 1981), and subsequent cases, the court held that under the statute, whenever a party to a contract with an attorneys’ fees clause brings the kind of action contemplated by the clause, regardless of who brought the suit, the prevailing party can recover its attorneys’ fees. The court accordingly upheld the award of attorneys’ fees to the LLC. 278 P.3d at 51.
Comment. The court upheld the LLC’s expenditures on the master plan on the grounds that (a) the LLC itself benefited because the master plan made the LLC’s antenna site more valuable, and (b) each of the members enjoyed some benefit. This may be a sort of “rough justice,” but it ignores the potential disparity of benefit from one member to another. The City required the master plan as a precondition to accepting applications for the members’ conditional use permits and for Western Radio’s building permit. Presumably the permits would have different utility to the various members, but the opinion implicitly treats the benefit to each member as equal.
The drafting lesson from the dispute over the attorneys’ fee clause is straightforward. If the attorneys’ fee clause in an LLC agreement is intended to include any potential suit brought by the LLC, it could read, for example: “In the event that any dispute between the Company and any Member or between any Members should result in litigation or arbitration, the prevailing party in such dispute shall be entitled to recover its reasonable fees, costs and expenses, including without limitation its reasonable attorneys’ fees and expenses.”
Idaho Contractor Registration by LLC's Member Is Not Attributed to the LLC
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.
Delaware Court Corrects Error in LLC Agreements' Waterfall Provisions
Reformation is an equitable remedy that courts use to “reform” or correct a mistake in a written agreement, to conform it to what the parties actually intended their agreement to say. The Delaware Court of Chancery recently reformed the cash distribution waterfall provisions of the limited liability company agreements for three real estate joint ventures in ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, No. C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Background. Investors and Developer entered into five real estate deals in 2007 and 2008, each structured as an LLC. In each deal the Investors put up 99% of the cash and Developer put up 1%. Each agreement provided that when the LLC’s property was sold, the sale proceeds would be distributed to the members according to a hierarchy that established the order in which funds would be distributed, often called a “waterfall.” The waterfall from the first two deals, using simplified language, was:
(a) First, 99% to Investors and 1% to Developer until each has received an 8% preferred return (similar to an annual interest rate) on its invested capital;
(b) Then 99% to Investors and 1% to Developer until each has received the return of its invested capital; and
(c) Then 20% to Developer, and 80% to be divided 1% to Developer and 99% to Investors.
In other words, both parties receive interest on their investment, then they get their investment back, and then they share, not based on the 99%-1% ratio of invested capital, but based on a ratio that gives the Developer a higher percentage return. The higher level of return to the Developer, after the threshold amounts are paid out, is intended as an incentive for the Developer. It is often referred to as a “promote” by real estate professionals. The above waterfall has a 20% promote.
When the parties negotiated the third of the five deals, they agreed on a two-tiered promote. This was similar to the waterfall above, except that the final level, which defines the promote, shifts to a higher promote percentage for the Developer after a specified amount has been distributed. In the example above, the third level would have a limiting cap added, and a fourth level would be added with the higher promote.
The Mistake. Unfortunately, in the process of preparing the written LLC agreement for the third deal, the return of capital paragraph was mistakenly placed after the first promote paragraph. That’s a much better deal for the Developer, which would receive the first portion of its promote before the parties get their capital returned. Thus the Developer could get its promote even if the overall deal were a loss and did not return any of the parties’ invested capital. This written agreement was approved and signed by the parties, even though it was not what they had negotiated.
This mistake happened because the responsible partner at the Investors’ law firm, who was heavily involved in the first transaction, turned the second deal over to an inexperienced associate lawyer. The terms of the second transaction mirrored the terms of the first, but when the terms of the waterfall changed in the third transaction the associate accidentally placed the key paragraph in the wrong position. The partner either did not read the final agreement or did not notice the mistake, and the error remained in the final agreement.
The court found that the in-house lawyer at the Developer knew of the mistake and knew that it was favorable to Developer, but said nothing about it to the Investors’ counsel. The executive in charge of the deal for the Investors reviewed the agreement, but did not notice the mistake and signed the agreement.
To compound the error, in short order the parties entered into two more real estate ventures, using the same structure and copying the same erroneous waterfall language. In both cases the waterfall as written by the Investors’ lawyer was not what the parties negotiated, the Developer knew of the mistake and knew that it was favorable to Developer, the Developer said nothing, and the Investors did not catch the mistake.
This situation inevitably led to conflict, which was precipitated by the Developer’s exercise of a put right in one of the three LLC agreements with the mistaken waterfall. The Developer’s buyout price under its put right was based on the agreement’s distribution provisions and the venture’s fair value.
The venture was underwater, since it had a fair market value of $35.5 million and the Investors had invested $47.3 million. As written, the waterfall entitled the Developer to $1.83 million, but as negotiated, the waterfall would have entitled the Developer to only $348,000. The result would be that instead of the Investors and the Developer sharing the loss 99%-1%, the Developer would make a 282% profit and the Investors would lose roughly 30% of their investment. Id. at *10.
The Developer demanded the higher amount based on the language of the waterfall. The Investors examined the agreement and determined that it was in error and was not in accordance with what they had negotiated. The Investors had what their executive called “a very, very tough conversation” with their law firm, and put the law firm on notice of a malpractice claim. Id. The executive said at trial that he was “incredibly upset that this had happened because it was clear what the document said, and that it was just wrong.” Id.
The Lawsuit. The Investors filed suit and sought an order reforming the waterfall provisions in the three disputed LLC agreements to match what had been negotiated. The Developer counterclaimed, seeking to enforce the agreements as written. The trial lasted four days and included nine fact witnesses, two expert witnesses, 300 documentary exhibits, and 25 deposition transcripts.
The court applied the doctrine of unilateral mistake, which allows reformation of a contract if the party seeking reformation can show by clear and convincing evidence that it was mistaken and that the other party knew of the mistake but remained silent. The plaintiff must show that there was a specific prior contractual understanding that conflicts with the terms of the written agreement. Id. at *13.
After a detailed review of the evidence, the court found that the Investors had demonstrated by clear and convincing evidence that they were entitled to reformation of the three LLC agreements. The court also dismissed the Developer’s defenses that (a) the Investors’ representative had not read the agreements, (b) the Investors had ratified the agreements, and (c) the Investors had unclean hands. The court accordingly rewrote the waterfall provision, placed the corrected language in its opinion, and ordered the two other disputed LLC agreements to be corrected in the same way. Id. at *21.
The court also awarded the Investors their attorneys’ fees, under the contractual fee-shifting provisions of the disputed agreements. The Developer argued that the Investors had not incurred any attorneys’ fees because the Investors’ law firm was not billing for its fees. (The same law firm that had made the mistakes in the three agreements represented the Investors in the lawsuit. Presumably it was not charging for the litigation because without its mistakes on the three agreements there would have been no litigation.) The court found that the arrangements between the Investors and their law firm to allocate the litigation costs did not affect the Developer’s obligations under the fee-shifting provision in the agreements. Id. at *20.
For a more detailed review of the court’s analysis, see Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here.
Comment. This strikes me as a surprising case. Not because of the legal doctrine of reformation or the court’s legal analysis, but because of how the business transactions played out and the roles of the lawyers involved.
For one thing, lawyers and business people who work on large real estate ventures such as these know that the waterfall provisions are not boilerplate – they are at the heart of the deal. Who puts how much money into the deal and who gets how much out are major components of what real estate partnerships and LLCs are all about.
For another thing, waterfall provisions, and especially the ones in this case, are not all that hard to read. They are a series of fairly short clauses in reasonably simple language that specify an algorithm to pay out the cash from the venture to the members. The sequential order of those clauses is key to how the waterfall works. Getting the paragraphs out of order is roughly comparable to getting a divide and an addition out of order in an algebraic expression. The result will usually be wrong.
These truisms make the mistakes that took place here, on both sides, rather startling. I say on both sides because the Investors’ law firm made the drafting mistakes, but the Developer’s lawyer made a mistake in judgment by not revealing the drafting mistake.
The drafting mistakes appear to reflect a classic organizational blunder by the Investors’ law firm. A senior partner turns over responsibility for a series of transactions to an associate lawyer who lacks the experience to understand the terms of the waterfall. The associate makes the mistake, and then the partner either doesn’t read the agreement or if she did, doesn’t focus on the key terms of the waterfall. The Investors’ representative relies on the partner at the law firm, and the partner relies overmuch on the inexperienced associate.
The Developer’s attorney, on the other hand, showed bad judgment in not revealing the error. The court found that he was a sophisticated and experienced real estate venture attorney who recognized the error but intentionally remained silent in order to capture an undeserved benefit for the Developer. Id. at *15.
As Francis Pileggi pointed out in his blog post, here, the court did not address the legal ethics issues in its opinion. But even setting that aside, in deals of this magnitude it’s foolish to think that a fundamental drafting error, inconsistent with what the parties clearly had agreed on, will not be discovered when it comes to light and would cost the other party a lot of money unless corrected. And as the court’s opinion shows, basic contract law can provide relief in this type of situation.
This is not a case where the lawyers appear at their best.
Delaware Court of Chancery Pores Over Fiduciary Duty Claims Against LLC Manager
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.
LLC Managers on Both Sides of Transaction Breach Delaware's Entire Fairness Standard
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.
Washington Dismisses Lawsuit by Cancelled LLC and Denies Award of Attorneys' Fees to Defendant
Washington’s Court of Appeals has issued another opinion dealing with the impact on litigation of the cancellation of an LLC’s certificate of formation. Metco Homes, LLC v. N.P.R. Constr., Inc., No. 64535-8-I, 2010 Wash. App. LEXIS 2428 (Wash. Ct. App. Nov. 1, 2010) (unpublished).
Metco was a construction contractor and developed a condominium project in Everett. N.P.R. was Metco’s subcontractor and installed the project’s siding. The siding leaked, Metco sued N.P.R., and before trial Metco’s certificate of formation was administratively cancelled by the Washington Secretary of State. On N.P.R.’s motion the trial court dismissed Metco’s suit and awarded attorneys’ fees to N.P.R. based on the attorneys’ fees clause in their contract.
The Metco case is part of the progeny of Chadwick Farms Owners Association v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), which I previously reviewed, here. Chadwick Farms held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate.
An unusual aspect of Metco is the timing of Metco’s cancellation and the maneuvering of the trial date by N.P.R.’s counsel. Metco was administratively dissolved by the Washington Secretary of State on June 1, 2006, apparently for failing to file its annual report and pay its annual fee. Under the LLC Act then in effect, its certificate of formation was due to be cancelled two years later, on June 1, 2008. Metco’s trial date was originally set for trial on May 5, 2008, at which time its certificate of formation would not yet have been cancelled.
Metco was apparently unaware of its dissolution and impending cancellation. That’s odd, because the Secretary of State sends several notices to the registered agent of an LLC that fails to renew its annual report. But N.P.R.’s counsel was well aware of the impending cancellation.
As alleged by Metco, N.P.R.’s counsel misrepresented a scheduling conflict and successfully importuned Metco to reschedule the trial to a later date, after June 1, 2008. Simultaneously she was drafting motion papers to dismiss Metco’s suit on grounds of cancellation of its certificate of formation (which would not happen until June 1). After Metco was cancelled on June 1, she filed N.P.R.’s motion for dismissal of Metco’s lawsuit.
The Court of Appeals found the allegations regarding N.P.R.’s counsel to be disturbing, if true. Metco, 2010 Wash. App. LEXIS 2428, at *8. But even if true, said the court, reinstatement of Metco’s lawsuit would not be required.
[I]t is simply inaccurate to say the alleged deception “caused” the cancelation. Regardless of the alleged actions of NPR’s counsel, Metco could have renewed the LLC at any time in the two years after it was administratively dissolved. Under these circumstances, the trial court’s decision was neither untenable nor was it based on an incorrect standard of law. The trial court did not abuse its discretion in denying the motion to vacate.
Id. Because N.P.R. prevailed at trial, the trial court awarded N.P.R. its attorneys’ fees against Metco, pursuant to the attorneys’ fees clause in their contract. The Court of Appeals reversed and rather straightforwardly applied Chadwick Farms. “[A] lawsuit to enforce contractual duties owed by a LLC, including a duty to pay attorney fees and costs, cannot be maintained after the LLC has been cancelled.” Id. at *8-9.
The court’s emphasis on Metco’s ability to avoid cancellation by simply filing its annual report and paying the fees, and the court’s unwillingness to reinstate the lawsuit even if misrepresentation by the defendant’s counsel were to be established, show the draconian results of the Chadwick Farms ruling. Fortunately, the relevant provisions of Washington’s LLC Act have since been amended to eliminate the possibility of cancelling an LLC’s certificate of formation. I previously described those changes, here.
Washington LLCs: Dissenters' Rights and Attorneys' Fees
The Washington Supreme Court recently reversed a trial court and Court of Appeals decision on an award of attorneys’ fees to an LLC dissenter. Humphrey Indus., Ltd. v. Clay St. Assocs., LLC, No. 82687-1, 2010 Wash. LEXIS 1004 (Wash. Nov. 10, 2010). The Humphrey case stands out because there are so few reported cases on LLC dissenters’ rights, and because the five-to-four decision required the LLC to comply strictly with the statute’s 30-day period for paying the dissenter the value of its LLC interest. Clay Street Associates, LLC was formed in 1997 to hold a single real estate property. In 2004 most of the members decided to approve a sale of the property. The LLC agreement required unanimous member approval, and member Humphrey Industries, Ltd. refused to approve the sale. Circumvention of Unanimity. The other members then eliminated the unanimity requirement by approving a merger of the LLC into a new LLC that did not require unanimity for a sale of the property. (Unless the LLC agreement provides otherwise, a merger requires the approval of only a majority of the member interests, measured by their capital contributions to the LLC. RCW 25.15.400.) Members have the right to dissent from a merger of a Washington LLC and obtain the fair value of their member interest in cash. RCW 25.15.430. Humphrey exercised its dissenter’s right and demanded the fair value of its LLC interest. Dissenters’ Rights. Dissenters’ rights, sometimes called appraisal rights, originated with corporations: Essentially, an appraisal is the method of paying shareholders for taking their property; it is the statutory means whereby shareholders can avoid the conversion of their property into other property not of their choosing and is given to shareholders as compensation for the abrogation of the common-law rule that a single shareholder could block a merger. The purpose of these statutes is to protect the property rights of dissenting shareholders from actions by majority shareholders that alter the character of their investment. 12B William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 5906.10, at 386-87 (rev. vol. 2009) (footnotes omitted). Some but not all of the states have provisions for dissenters’ rights in their LLC Acts. For example, besides Washington, California, Florida, Minnesota, and New York have statutory provisions for LLC dissenters’ rights. Delaware’s LLC Act has no provision for dissenters’ rights, but it authorizes an LLC’s operating agreement or a merger agreement to provide contractual appraisal rights. DLLCA § 18-210. The Merger. The LLC’s merger became effective December 7, 2004. The LLC was required by the statute to pay Humphrey the fair value of its member interest within 30 days, RCW 25.15.460(1), but the LLC lacked funds. It proceeded to sell the real estate, and on May 27, 2005 paid Humphrey its estimate of the fair value of Humphrey’s member interest as of the merger date, plus interest. Humphrey disputed the LLC’s valuation and demanded a larger amount. Litigation ensued, the LLC made a settlement offer, settlement talks broke off, and the litigation went to trial. The trial court found that the LLC had undervalued Humphrey’s interest and ordered the LLC to pay Humphrey an additional $60,588. Attorneys’ Fees. Then the parties argued over attorneys’ fees. The statute says that in a proceeding over the valuation of a dissenter’s member interest, the court may assess attorneys’ fees and expert fees: (a) Against the limited liability company and in favor of any or all dissenters if the court finds the limited liability company did not substantially comply with the requirements of this article; or RCW 25.15.480(2). These provisions are similar to those in the Model Business Corporation Act and in many state corporate statutes. E.g., RCW 23B.13.310. Trial Court Ruling. The trial court found that the LLC had violated the Act by not paying Humphrey for its interest within 30 days of the merger as required by RCW 25.15.460(1). But, said the court, the LLC had “substantially complied” because it lacked the funds to pay, moved expeditiously to sell the real estate to generate funds to pay Humphrey, and paid interest on the delay period. Further, the trial court found that Humphrey acted arbitrarily, vexatiously, and not in good faith in pursuing its dissenters’ rights claim. It therefore awarded attorneys’ fees and expenses to the LLC. Humphrey appealed and the Court of Appeals affirmed. Supreme Court Weighs In. The Washington Supreme Court in Humphrey saw the 30-day payment requirement differently. The court characterized the purpose of the 30-day requirement as ensuring that dissenters have immediate use of the money which the LLC estimates to be the value of their member interests. Humphrey, 2010 Wash. LEXIS 1004, at *13-14. Humphrey should have received payment within 30 days of the merger date; instead the LLC sent the funds almost six months later. “A six-month deferral of payment is not ‘substantial compliance’ with a statute that unambiguously requires payment ‘within thirty days.’” Id. at *17. The court therefore reversed the Court of Appeals’ determination that the LLC had substantially complied with the LLC Act, and remanded to the trial court to determine whether Humphrey should be awarded attorneys’ fees based on the LLC’s noncompliance with the Act’s 30-day payment requirement. Id. at *20. The court also reversed the award of attorneys’ fees to the LLC. The trial court had concluded that Humphrey had acted arbitrarily, vexatiously, and not in good faith, based on its refusal to accept a settlement offer that would have provided more to Humphrey than it received from the trial court’s valuation award, and based on Humphrey’s conduct in other lawsuits against the LLC. The Supreme Court pointed out that evidence of conduct or statements in settlement negotiations is not admissible to prove the validity or invalidity of a claim or its amount. The court opined that even if the evidence was admitted for a permissible purpose, the record did not establish that Humphrey’s actions were arbitrary, vexatious, or in bad faith. Id. at *21. Ill-Motivated Merger. In a strange aside, the court stated: “If any acts were in bad faith, they were committed by the other members of Clay Street, who sought to bypass the dissenters’ rights statute and section 8.1 of their own LLC Agreement, which specifies that the property ‘shall not be sold, conveyed, and/or assigned without the mutual consent of each of the members.’” Id. at * 21-22 (ellipsis omitted). But after all, the members’ agreement did not require unanimous approval of a merger, and the LLC Act allows the surviving LLC to have different terms in its operating agreement. Where’s the bad faith in taking action allowed by the statute and the LLC agreement, in order to sell an asset and distribute the net proceeds to the members as their interests lie? Delaware’s doctrine of independent legal significance, DLLCA § 18-1101(h), would support the validity of using a merger to eliminate a unanimous voting requirement, but Washington’s LLC Act has no such provision. Holding. The court therefore reversed the trial court’s award of attorneys’ fees against Humphrey, and remanded for consideration of whether, in light of the LLC’s failure to substantially comply with the Act, Humphrey is entitled to attorneys’ fees. Dissent. The dissent contended that the legislature would have been well aware that in some cases 30 days is a short time to accomplish the accounting, appraisal, and other steps required to accomplish a merger and transfer property and assets, and that therefore the legislature must have intended the “substantial compliance” requirement to apply to the 30-day payment period as well as to the other provisions of the dissenters’ rights section. Humphrey, 2010 Wash. LEXIS 1004, at *26-27 (Chambers, dissenting). The majority riposted in a footnote that prudent planning is the answer: “It is likely that the legislature chose 30 days assuming that merging business entities would have the prudence and good faith to lay the groundwork for selling property well before a merger became effective, or seek other financing, so as to meet the statutory requirement.” Id. at * 18 n.11 (majority opinion). Lessons. The obvious lesson for any Washington LLC planning a merger is that if any members dissent, the LLC must be prepared to pay the dissenting members the fair value of their interests within 30 days of the later of the date the merger becomes effective or the date the member’s payment demand is received. The other lesson is a cautionary note for drafters of LLC agreements. A requirement that all members consent before specified actions are taken is not adequate unless mergers also require unanimous consent. The LLC agreement in Humphrey did not require unanimity for a merger, and the LLC was therefore able to merge and eliminate the unanimous voting requirement. A member resisting a unanimous vote will have dissenters’ rights if the LLC uses a merger to get around the voting requirement, but that may be small consolation to the dissenting member.
(b) Against either the limited liability company or a dissenter, in favor of any other party, if the court finds that the party against whom the fees and expenses are assessed acted arbitrarily, vexatiously, or not in good faith with respect to the rights provided by this article.
How Not to Draft an Attorneys' Fees Clause
Many LLC operating agreements include a fee-shifting provision, a clause that requires the losing party in litigation between members to pay the prevailing party’s reasonable attorneys’ fees. These fee provisions are usually relegated to the boilerplate sections near the end of the operating agreement, and often don’t get much attention when the agreement is being prepared. A ruling last month from the Idaho Supreme Court shows that if the attorneys’ fees clause is not carefully crafted, it may not work the way the parties intended.
In Henderson v. Henderson Investment Properties, L.L.C., No. 35138, 2010 WL 569890 (Idaho Feb. 19, 2010), the Supreme Court reversed the trial court’s award of $21,552 in attorneys’ fees. The LLC in the case was formed by a husband and wife and their son and daughter-in-law to operate a sandwich shop. Acrimony later developed between the generations, and the father brought suit to dissolve the LLC. The Idaho LLC Act allows a court to order dissolution if actual or threatened irreparable harm results either from member deadlock or from illegal, oppressive or fraudulent acts of the controlling members. Idaho Code Ann. § 53-643.
Mr. Henderson alleged both deadlock and illegal, oppressive or fraudulent acts, with resulting irreparable harm. The trial court dismissed the complaint, holding that although there had been a deadlock it had not resulted in actual or threatened irreparable injury, and that there had been no illegal, oppressive or fraudulent acts. The trial court also awarded attorneys’ fees to the son and daughter-in-law, based on this provision in the LLC’s operating agreement:
In any action or proceeding brought to enforce any provision of this Agreement, or where any provision is validly asserted as a defense, the successful party is entitled to recover reasonable attorneys’ fees in addition to any other available remedy.
The Supreme Court analyzed that language and reversed the award of attorneys’ fees because it found that the plaintiff did not seek “to enforce any provision of the Agreement,” as required by the clause. The plaintiff instead sought dissolution, which is a statutory remedy.
If the parties had been asked about this clause when they signed their operating agreement, they probably would have interpreted it to mean that in any litigation about their rights and duties as members, the winner would have been entitled to recover its reasonable attorneys’ fees.
This clause did not work that way because it applied only to contractual disputes, i.e., disputes over the terms of the operating agreement. The clause did not apply to any of the rights of members that are defined by the statutory provisions of Idaho’s LLC Act. In this case the dispute was over dissolution, a purely statutory remedy. The irony is that if the operating agreement had simply parroted the language of the statute’s dissolution remedy, Idaho Code Ann. § 53-643, then under the court’s reasoning the defendants would have been entitled to attorneys’ fees.
Many important rights of LLC members, such as sharing of profits, rights to distributions, and rights to certain records of the LLC, are controlled by provisions in Idaho’s LLC Act. The Act allows some of those provisions to be waived or modified in the operating agreement, while others are non-waivable. That approach is typical of other states’ LLC statutes.
Under an attorneys’ fees clause like that in Henderson, and under that court’s reasoning, the right of the winning party to get a judgment for attorneys’ fees will depend on whether the dispute was governed by the LLC statute or by specific terms in the operating agreement. That does not seem like the result most business people would intend when they put an attorneys’ fees clause in their operating agreement.
A better solution, of course, is to use a broader attorneys’ fees clause. One example I’ve seen is:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement or to interpret or enforce any rights under this Agreement, [the prevailing party may recover.]
The language “any controversy arising out of this Agreement” may be broad enough to cover both contractual and statutory claims, although it is perhaps susceptible to the argument that statutory rights not referred to in the operating agreement do not “arise out of” the agreement.
I've also seen another approach that would have changed the result in Henderson, but it may be too broad for some situations:
In the event that any dispute between the Company and the Members or among the Members should result in litigation, [the prevailing party may recover.]
This language literally applies to “any dispute” between members, which could cover a dispute between members that has nothing to do with the LLC. A more natural interpretation would limit the scope of the clause to member disputes that have something to do with the LLC, i.e., with their status as members of the LLC. But to be safe, something like the following might be best:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement, or to interpret or enforce any rights under this Agreement or the [name of State] Limited Liability Company Act, [the prevailing party may recover.]
Some LLC operating agreements require that disputes be settled by binding arbitration instead of litigation. A recently-published treatise on drafting operating agreements for Delaware LLCs has a nice treatment of arbitration and attorneys’ fees, among other things. John M. Cunningham & Vernon R. Proctor, Drafting Delaware Limited Liability Company Agreements: Forms and Practice Manual (2009).
In the model operating agreements provided by Cunningham and Proctor, arbitrable matters include “material matters: (1) That arise under or relate to this Agreement or that relate to the LLC…” Cunningham & Proctor, supra, at Form 6.1, § 30.3. Their model agreement then goes on to assign attorneys’ fees to the nonprevailing party:
To the extent that an arbitrator determines that a party to an arbitration has failed to prevail in that arbitration, the arbitrator shall allocate to that party the costs of the arbitration, including reasonable attorneys’ fees and fees payable to the arbitrator.
Cunningham & Proctor, supra, at Form 6.1, § 30.11(c). This approach allows the arbitration to cover any dispute related to the operating agreement or the LLC, and applies the “loser pays” rule to the entire arbitration. This approach would avoid the type of problem dealt with in the Henderson case.
The clause at issue in Henderson, and the court’s ruling, show in microcosm why contract drafting is difficult. The unexpected scenario can rise up to swat the drafter. I’ll wager that when the parties put together their operating agreement in the Henderson case, they paid little or no attention to the exact words of the clause. Before any disputes arose I’m sure they would have said that any dispute directly related to the LLC was intended to be covered by the “loser pays” rule of the clause. But yet it wasn’t.
It was not a case of the language being unclear (although some might argue that); it was primarily a case of the language not reaching far enough in its scope. The Henderson case is an object lesson in vignette form for lawyers who draft contracts. The lesson? Know the underlying law and the context in which you’re drafting, and don’t rely too quickly on language taken from other contracts.
