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.
Last fall the Delaware Supreme Court surprised many corporate lawyers when it declared that whether the Delaware LLC Act imposes fiduciary duties on LLC managers is an open question. Gatz Props., LLC v. Auriga Capital Corp., 59 A.3d 1206, 1218 n.62 (Del. 2012).
Prior to Gatz, most Delaware lawyers believed that Delaware LLC managers were subject to fiduciary duties, absent contrary provisions in the LLC agreement. The Delaware LLC Act does not explicitly say that, but it’s implied in Section 18-1101(c):
To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement ….
(Emphasis added.) There was also case law from the Court of Chancery, most notably the Chancery opinion in the Gatz case: Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 839 (Del. Ch. 2012). The Chancery opinion comprehensively explained how and why the Delaware LLC Act applies fiduciary duties to LLC managers. I discussed that decision here.
The Supreme Court affirmed the judgment of the Court of Chancery, but it did so by relying only on the LLC agreement’s contractual provisions for fiduciary duties. The court rebuked the Court of Chancery for unnecessarily expounding on the statute’s interpretation, since deciding whether the LLC Act imposed fiduciary duties was not necessary to resolve the dispute. The Supreme Court declared that Chancery’s “statutory pronouncements must be regarded as dictum without any precedential value.” Gatz, 59 A.3d at 1218.
The Supreme Court’s opinion in Gatz was startling and generated a lot of commentary. I discussed it here. Not only did it reveal a gaping hole in Delaware’s LLC law, it also reflected some tension in the relationship between the Supreme Court and the Court of Chancery.
The Fix. Recognizing that the LLC Act may be ambiguous on whether fiduciary duties apply to LLC managers, the Supreme Court suggested that the Delaware State Bar Association “may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.” Id. at 1219.
And lo, it is happening. The Corporation Law Section of the Delaware State Bar Association has approved proposed legislation which is now awaiting the Bar Association’s final approval. Approval is expected by the end of this month, after which the proposal presumably will be introduced as a bill in the Delaware General Assembly. It would then proceed through the legislative process, and if all goes well will be passed by the legislature and signed into law by Governor Markell. Given the importance of predictable rules to Delaware’s prominence in the world of corporate law, I think it likely that this proposal will be adopted relatively soon.
The proposed amendment would add 11 words to the LLC Act. Section 18-1104 would be modified to read as follows (the new language is underscored):
In any case not provided for in the chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.
The Synopsis to the proposed bill elaborates on the amendment:
Section 8. The amendment to Section 18-1104 confirms that in some circumstances fiduciary duties not explicitly provided for in the limited liability company agreement apply. For example, a manager of a manager-managed limited liability company would ordinarily have fiduciary duties even in the absence of a provision in the limited liability company agreement establishing such duties. Section 18-1101(c) continues to provide that such duties may be expanded, restricted or eliminated by the limited liability company agreement.
Comment. This is an intriguingly short insert to the statute. In one sense it says nothing, because the current language – “the rules of law and equity” – would normally be read to mean all the rules of law and equity. If the rules of law and equity include the rules relating to fiduciary duties, then why the insertion?
Sometimes lawyers will use a phrase in contracts – “including, for the avoidance of doubt” – as a way of clarifying the purpose of an “including” clause. That thinking may be behind the proposed revision, i.e., it may be intended to eliminate any doubt whether fiduciary duties are included in the statute’s reference to “the rules of law and equity.”
Chancery’s opinion in Auriga Capital characterized fiduciary duties as originating in equity, and the proposed amendment’s emphasis on equitable rules can be viewed as a nod to the Chancery Court analysis.
A contract that limits a corporate director’s vote is generally invalid, but not so for LLC managers. The guiding principle for LLCs is freedom of contract, unlike corporations, but that principle can clash with the principles undergirding an LLC manager’s fiduciary duties. For example, what’s the result if an LLC’s operating agreement requires that one of the LLC’s managers vote as directed by a designated member? Does that manager have any fiduciary duties? The Delaware Court of Chancery recently held that such a manager was not without fiduciary duties, even though he had no power to vote. Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. C.A. 4113-VCN, 2013 WL 764688 (Del. Ch. Feb. 28, 2013).
The plaintiffs owned units in Advance Realty Group, LLC, a Delaware LLC. Several of the plaintiffs were individuals who were executives of the LLC until their termination in 2007, and the other plaintiffs were entities owned by the individual plaintiffs. The plaintiffs raised a number of claims after their termination, but the most noteworthy was their contention that defendant Ronald Rayevich, a manager of the LLC, had breached his fiduciary duties to the LLC.
Rayevich was a member of the LLC’s managing board, which had the duty to manage the business and affairs of the LLC. He had no discretion in how to vote as a member, however, because he was required by the LLC’s Operating Agreement to follow the voting instructions of one of the LLC’s members.
The defendants moved for partial summary judgment on several of the plaintiffs’ claims, including the claim against Rayevich.
The Claim. The plaintiffs’ claim against Rayevich centered on his involvement in the managing board’s approval in 2008 of the LLC’s Conversion and Exchange Agreement (Agreement), which the plaintiffs contended negatively affected their LLC interests. The plaintiffs argued that although Rayevich had no choice in voting for the Agreement, he nonetheless violated his fiduciary duties because he failed (1) to evaluate whether the terms of the Agreement were in the best interests of the members, (2) to voice his opposition in light of the conflicts of interests involving his fellow board members, or (3) to take any steps to prevent the self-dealing of the insider defendants. Id. at *3.
Rayevich contended that he was entitled to summary judgment because (a) the plaintiffs had not overcome the presumption that he acted in good faith, and (b) even if he did breach his fiduciary duties, he was not acting willfully or in bad faith and therefore was exculpated from liability under the provisions of the LLC agreement.
The court pointed out that Rayevich is presumed to have acted on an informed basis in good faith, but said that he could not avoid liability simply by pointing out that he had no discretion to vote as a board member. Even though he could not vote, he had an obligation to consider the interests of the members and to take action to protect their interests. “[F]iduciary duties extend beyond voting. They may involve, for example, studying the proposed action, determining the appropriateness of the proposed action, setting forth a dissenting view to fellow board members, and, in the proper circumstances, informing unit holders about the potential adverse affects of a proposed action.” Id.
Procedural Posture. The court’s opinion is a ruling on the defendants’ motion for summary judgment. To prevail on a summary judgment motion the moving party must demonstrate that there is no material question of fact, and that on the undisputed facts it is entitled to judgment as a matter of law. Id. at *1. The party resisting a summary judgment motion does so either by showing that the moving party is not entitled to judgment under the law, or that the relevant facts are disputed. The parties establish the facts through affidavits submitted to the court, and there is no live testimony. A summary judgment motion can be an efficient way to resolve issues before trial.
The plaintiffs’ claim against Rayevich failed because they did not establish the facts necessary to resist his summary judgment motion. “Specific facts, as contrasted with mere allegations, are needed to resist a motion for summary judgment.” Id. at *3. The plaintiffs did not put forth facts to show Rayevich’s lack of good faith, that he was not independent and disinterested, that he was not informed about or had not considered the Agreement, or that his conduct was willful or in bad faith. Rayevich was therefore presumed to have acted in good faith and was entitled to exculpation under the LLC’s Operating Agreement, and the court ordered summary judgment in his favor on the plaintiffs’ claims.
Comment. Ross Holding points out the need for LLC managers to be proactive, and that fiduciary duties extend beyond mere voting. In the context of a multi-manager board, a manager who either has no vote or who is outvoted must be informed and give independent consideration to the proposal, and must consider expressing a dissenting view when appropriate and possibly informing the members about the potential adverse impact of a proposed action.
North Carolina Court Resolves Conflict Between LLC Act Rules on Member Withdrawals and Assignments to Non-Members
A North Carolina court last month was faced with troubling issues involving assignments of LLC member interests and changes of control. There was no dispute that the assignments conveyed the assigning members’ economic rights. The question was whether the associated control rights (management and voting) were retained by the assignor, conveyed to the assignee, or left inchoate and unusable by either the assignor or assignee until and unless the assignee was admitted as a member. The court in Blythe v. Bell, No. 11 CVS 933, 2012 WL 6163118 (N.C. Super. Dec. 10, 2012), had to resolve conflicting provisions of North Carolina’s LLC Act applicable to assignments and member withdrawals.
Drymax Sports, LLC was formed as a North Carolina limited liability company in 2003 by Hickory Brands, Inc. (HBI) and four individuals. The members and their initial percentage holdings were:
William Blythe 40%
Nissan Joseph 20%
Rob Bell 5%
Virginia Bell 5%
In 2007 HBI assigned all of its interest in equal parts to Rob Bell and Virginia Bell. In 2008 Joseph assigned his interest to HBI.
By 2011 a number of disputes between the members had arisen, and Blythe filed a lawsuit against the other members. After completion of pre-trial discovery, the parties filed cross-motions for summary judgment on the effects of the two assignments. The Blythe opinion is the trial court’s ruling. (The Blythe court is a specialized North Carolina Business Court, which handles cases involving complex and significant corporate and commercial law issues.)
Control Dispute. The motions were essentially a fight for control of Drymax. Blythe contended that the assignments by HBI and Joseph divested them of control but did not convey control rights to the assignees because the assignments were not approved by unanimous member consent. Id. at *5. That would leave only Blythe, Rob Bell, and Virginia Bell with control rights, resulting in Blythe’s effective voting control being increased from 40% to 80%, even though his economic interest would remain at 40%.
The defendants contended that HBI’s assignments to Rob Bell and Virginia Bell did not require unanimous member approval because they already were members, and that the assignments therefore conveyed control rights. The defendants also argued that Joseph’s assignment to HBI (which was at that time a non-member) did not convey control rights, and that Joseph retained his control interests because HBI was not admitted as a member. Id. at *6.
The court found that there was no operating agreement and that therefore the effects of the assignments were determined by the default provisions of the North Carolina Limited Liability Company Act. Section 57C-5-02 provides that an LLC interest is assignable but that an assignee receives only the economic rights, i.e., the right to receive the distributions and allocations to which the assignor would have been entitled. Section 57C-5-04(a) provides that an assignee may become a member by complying with the operating agreement (if there is one) or by the unanimous consent of the members, and that an assignee who becomes a member has the rights of a member, including voting control, with respect to the interest assigned.
Section 57C-5-02 disenfranchises members who assign all of their member interests: “Except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of his membership interest.” This rule is phrased as an absolute – it does not depend on whether the assignee is admitted as a member.
These two sections, when read together, appear to require that if a member assigns all of its interest to an assignee that is not admitted as a member, neither the assignor nor the assignee will be able to vote or use any control rights associated with the transferred interest.
The court also referred to Section 57C-5-06, which states: “A member may withdraw only at the time or upon the happening of the events specified in the articles of organization or a written operating agreement.” Withdrawal is not defined in the LLC Act, but the court characterized this section as a limit on a member’s right to terminate its membership. Id. at *5.
Conflicts in the LLC Act. The court was faced with the following rules: (i) a non-member assignee of an LLC interest who is not admitted as a member cannot vote the interest; (ii) an assignor of 100% of its LLC interest is no longer a member, and therefore has no right to vote that interest; and (iii) a member cannot withdraw from the LLC unless allowed by the articles of organization or a written operating agreement. But if the assignor is not able to vote the assigned interest, hasn’t it effectively withdrawn in violation of rule (iii)? And if neither the assignor nor the assignee can vote the assigned interest, then is it correct that no one can vote it and therefore there could be control shifts among the remaining members?
The court concluded that the rule against withdrawal trumps the rule that the assignor of 100% of its interest is no longer a member. It held that (a) HBI’s assignments to Rob Bell and Virginia Bell transferred HBI’s economic and control rights to them because the Bells were already members at the time of the assignment, and (b) Joseph’s assignment to HBI did not cause Joseph to lose his member control rights with regard to the assigned interest because HBI was at that time not a member. Id. at *8. Therefore no voting control was suspended – HBI’s assignments to the Bells transferred control because they already were members, and Joseph retained control regarding his assignment because HBI was not a member. Blythe’s 40% interest continued to represent 40% of the voting.
The court based both prongs of its ruling on the LLC Act’s prohibition on unilateral member withdrawal: “Plaintiffs’ construction providing otherwise would conflict with Section 57C-5-06 … because under Plaintiffs’ construction, a member could voluntarily assign all his interest and immediately cease being a member without the need for any other member’s consent…. The court cannot find a fair reading of the Act, reconciling all its provisions, that reflects a legislative purpose that allow[s] a member to cease being a member leaving his prior control interest inchoate.” Id.
The Court’s Ruling. The Blythe court was on the horns of a dilemma. It was faced with a square conflict between Section 57C-5-06 (a member may withdraw only if allowed by the articles of organization or a written operating agreement) and Section 57C-5-02 (except as provided in the articles of organization or a written operating agreement, a member ceases to be a member upon assignment of all of its membership interest).
Joseph assigned all of his interest. Under the statute he therefore ceased to be a member, but he was also barred from withdrawing as a member. The court sliced the Gordian knot by holding that Joseph did continue as a member and retained the control rights associated with the interest assigned, until his assignee is admitted as a member.
The court’s decision resolved the conflict for Joseph’s assignment, but the court ignored the same conflict inherent in HBI’s assignment of all of its interest to Rob Bell and Virginia Bell. Because the Bells were already members they received control rights as well as economic rights for the interests they received from HBI. The court made no mention of the fact that HBI’s assignment and the associated transfer of the control rights to the Bells amounted to a withdrawal by HBI, in conflict with the LLC Act’s bar on withdrawal.
An alternative approach would have been for the court to simply enforce Section 57C-5-02’s requirement that a member ceases to be a member upon assignment of all of its membership interest. If such an assignment amounts to a prohibited withdrawal, then the other members could assert a cause of action for that violation of the statute and sue for damages.
Other Statutes. The statutory provisions that the Blythe court wrestled with are not an anomaly. Delaware and Washington both have essentially the same rules as North Carolina regarding assignments and withdrawal, including the same conflict between the assignment rules and the “no withdrawal” rule. And it appears that neither has a reported opinion dealing with a similar fact pattern where there is no LLC agreement.
Solution. These statutes should be amended to eliminate this conflict. One approach that would do minimal violence to the existing rules would be to recognize that the prohibition on withdrawal is not as important for most LLCs as it is to partnerships. By simply changing the default rule so that withdrawal is allowed unless prohibited by the LLC agreement or certificate of formation, the statutory conflict that Blythe dealt with would be eliminated. LLCs would still be able to limit withdrawal in their LLC agreements if desired.
The Oregon LLC Act is a good example of that approach. Oregon’s rules on LLC assignments are essentially the same as those of Washington, Delaware, and North Carolina, except that a member may voluntarily withdraw from an LLC on six months’ notice unless prohibited by the LLC’s articles of organization or operating agreement. Or. Rev. Stat. § 63.205.
Two weeks ago the Delaware Supreme Court confounded the conventional wisdom and rebuked the Court of Chancery, by ruling that whether fiduciary duties apply to LLC managers is an open question in Delaware law. Gatz Properties, LLC v. Auriga Capital Corp., No. 148, 2012, 2012 WL 5425227 (Del. Nov. 7, 2012). Most Delaware corporate lawyers have assumed that LLC managers are subject to fiduciary duties unless limited by the LLC agreement, and the lower court in Gatz had interpreted Delaware’s LLC Act to impose fiduciary duties on LLC managers.
The Trial Court. The Court of Chancery ruled earlier this year on Gatz in Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012). The court found that an LLC’s manager and majority owner breached his fiduciary duties by taking steps to squeeze out the minority investors at an unfair price in order to obtain ownership of the LLC’s valuable golf course.
Chancellor Strine, the author of the trial court opinion, held that the terms of the parties’ LLC agreement, and the Delaware LLC Act, imposed fiduciary duties on the LLC’s manager. The court analyzed the Delaware LLC Act and its history, reviewed precedential cases, analogized the LLC Act to Delaware’s General Corporation Law in its treatment of fiduciary duties, and concluded that the LLC Act applies fiduciary duties to LLC managers and controllers unless the parties’ LLC agreement limits those duties. Commentators hailed the Chancellor’s opinion as a comprehensive and detailed explanation of how and why the Delaware Act applies fiduciary duties to LLC managers. I discussed that decision, here.
Supreme Court’s Ruling. The Supreme Court affirmed the judgment of the Court of Chancery and its award of damages and attorneys’ fees, but it did so by relying only on the LLC agreement’s contractual imposition of fiduciary duties. That was sufficient to decide the case, said the court, and therefore the Court of Chancery should not have expounded on whether the LLC Act imposed fiduciary duties on the manager.
Where, as here, the dispute over whether fiduciary standards apply could be decided solely by reference to the LLC Agreement, it was improvident and unnecessary for the trial court to reach out and decide, sua sponte, the default fiduciary duty issue as a matter of statutory construction. The trial court did so despite expressly acknowledging that the existence of fiduciary duties under the LLC Agreement was “no longer contested by the parties.” For the reasons next discussed, that court’s statutory pronouncements must be regarded as dictum without any precedential value.
Gatz, 2012 WL 5425227, at *9 (footnote omitted). In its footnote the court said it felt compelled to “address this dictum” so in future cases it would not be misinterpreted as a correct rule of law when “in fact the question remains open.” Id., at *9 n.62.
The court elaborated on why the lower court’s discussion should be regarded as dictum. First, the LLC Agreement in Gatz addressed the issue that controlled the dispute. Second, the parties had not asked the court to decide whether the LLC Act imposed fiduciary duties. Third, it was wrong for the trial court to imply that once practitioners have relied on repeated decisions of the Court of Chancery on an issue, the Supreme Court should not change the rule relied on by those decisions. Fourth, reasonable minds can differ on whether DLLCA Section 18-1102’s provision that to the extent a manager has fiduciary duties, they can be limited by the LLC agreement, is “consciously ambiguous.” Fifth, “the court’s excursus on this issue strayed beyond the proper purview and function of a judicial opinion,” which is to “resolve the issues that the parties present in a clear and concise manner.” Id. at *10.
The court also discussed the proper role of the trial court: “We remind Delaware judges that the obligation to write judicial opinions on the issues presented is not a license to use those opinions as a platform from which to propagate their individual world views on issues not presented. A judge's duty is to resolve the issues that the parties present in a clear and concise manner.” Id.
After admonishing the trial court not to go beyond the issues presented, the Supreme Court then pontificated that the appropriate committee of the Delaware State Bar Association “may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.” Id.
Comment. This case has generated a tremendous amount of commentary by bloggers and the press, including an article in The New York Times, here, and an alert from the American Bar Association’s Committee on LLCs and Partnerships, here. Besides undoing what many corporate lawyers thought was a settled legal principle, the opinion also admonished the highly respected chief judge of the Delaware Court of Chancery, Chancellor Leo Strine, that it was “improvident and unnecessary” to reach out and decide the fiduciary duty issue.
What can lawyers take away from this case? The moral for lawyers forming Delaware LLCs is clear: use language in the LLC agreement that clearly defines the fiduciary duties applicable to the managers and the limits of those duties.
But in other contexts the court’s ruling raises questions. For example, members of existing Delaware LLCs may be relying on LLC agreements that were written under the assumption that fiduciary duties implicitly apply to the managers. Such an agreement may yield unexpected results in the event of a dispute, if the Delaware Supreme Court ultimately holds that fiduciary duties do not apply to LLCs. Perhaps those members’ lawyers should be thinking about amendments to clarify explicitly what the parties intended.
In the case of existing disputes involving allegations of breach of fiduciary duties, Gatz has suddenly shifted the landscape. Now the parties don’t know what the Delaware law on LLC fiduciary duties is. Presumably the Court of Chancery will continue to rule as it has in the past, i.e., that LLC managers are subject to fiduciary duties unless those duties are explicitly limited in the LLC agreement. But we won’t know definitively what the law is until either a case comes up to the Supreme Court that squarely presents the issue, or the Delaware legislature clarifies the issue by amending the LLC Act.
The Montana Supreme Court recently interpreted for the first time the grounds for judicial dissolution of an LLC under Montana’s Limited Liability Company Act. Gordon v. Kuzara, No. DA 12-0116, 2012 WL 4086512 (Mont. Sept. 18, 2012). The Supreme Court upheld the trial court’s dissolution order.
Background. James and Christina Gordon entered into Half Breed Land and Livestock LLC with several members of the Kuzara family in 2006. The purpose of the LLC was to raise and sell cattle, and the members contributed cash and cattle to the company and commenced operations. By 2008 the Gordons became aware of various irregularities, held a meeting of the members, audited the LLC’s records, and eventually filed suit seeking a judicial order dissolving the LLC.
Round 1. The court’s recent decision was not the first time this dispute has been in front of the Montana Supreme Court. After the Gordons filed their suit seeking dissolution, Joseph Kim Kuzara, one of the defendants, filed a motion to compel arbitration based on an arbitration clause in the LLC’s Operating Agreement. That motion, if successful, would have resulted in the case being decided by an arbitrator instead of by the trial court. The trial court denied the motion, and on the appeal the Supreme Court ruled in December, 2010 that the arbitration clause in the Operating Agreement did not apply to a member’s request for judicial dissolution. I commented on that decision, here.
Round 2. The Gordons based their petition for dissolution on Mont. Code Ann. § 35-8-902(1), which provides several alternative grounds for judicial dissolution:
(a) the economic purpose of the company is likely to be unreasonably frustrated;
(b) another member has engaged in conduct relating to the company’s business that makes it not reasonably practicable to carry on the company’s business with that member remaining as a member;
(c) it is not otherwise reasonably practicable to carry on the company’s business in conformity with the articles of organization and the operating agreement;
(d) the company failed to purchase the petitioner’s distributional interest as required by 35-8-805; or
(e) the members or managers in control of the company have acted, are acting, or will act in a manner that is illegal, oppressive, fraudulent, or unfairly prejudicial to the petitioner.
It was undisputed by Kuzara that on multiple occasions the proceeds of calf sales by the LLC had been deposited into the LLC’s account and then immediately remitted to Kuzara’s family corporation, and that on one occasion a withdrawal of $2,000 from the LLC’s account, which was remitted to Kuzara’s family corporation, caused an overdraft of the LLC’s bank account. Kuzara was also charging the LLC for his time at $20 an hour, despite the fact that § 35-8-504(4) of the Montana LLC Act provides that an LLC member is not entitled to remuneration for services performed for the LLC, except when winding up the business. Gordon, 2012 WL 4086512, at *4.
The court affirmed the trial court’s summary judgment ruling and the dissolution order, holding that the defendants’ undisputed actions were adequate to support the trial court’s ruling under either clause (a), clause (b), or clause (e) of § 35-8-902(1). Id. The court noted that the listed grounds for dissolution are stated in the disjunctive, and “a finding that any one of the grounds for dissolution has been met is sufficient to uphold a judicial order of dissolution.” Id. at *4. The court did not describe how each of the listed grounds applied to the specific facts, but apparently saw an ongoing pattern of bad behavior that could fit under any of the three specified grounds. “The reasonable conclusion was that R Three, as a member of the LLC, was being disproportionately enriched and was girding itself to make future claims against the LLC through the acts and omissions of Kim Kuzara.” Id. at *4.
While the Gordons’ dissolution action was pending, Kuzara moved to amend the defendants’ answer in order to add counterclaims against the Gordons for breach of the duty of loyalty and for negligent interference with a business relationship. The trial court refused to allow the amendment and the Supreme Court affirmed. The court pointed out that the arbitration clause in the Operating Agreement, which it had determined in Round 1 was not applicable to a dissolution petition, would apply to the tort counterclaims. To add the counterclaims would have been legally insufficient and futile, said the court, because the parties’ Operating Agreement required those claims to be arbitrated. The trial court’s refusal to allow the amendment to Kuzara’s answer was therefore affirmed. Id. at *5.
Comment. The court in Gordon found that the facts showed a pattern of misappropriation of funds and unauthorized charges to the LLC which implicated several of the statutory grounds for judicial dissolution. That appears to be a fair reading of the statute, and it points out that there is some redundancy in the alternative grounds in Montana’s statute.
Some states take a more narrow approach to judicial dissolution. Delaware, for example, only allows one ground for judicial dissolution: “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” Del. Code Ann. tit. 6, § 18-802. This is similar to the approach taken for limited partnerships in the Revised Uniform Limited Partnership Act, § 802. Washington also follows the RULPA approach, but adds “or … other circumstances render dissolution equitable.” RCW 25.15.275.
The grounds for judicial dissolution listed in state LLC statutes vary widely. Given the courts’ willingness to assert their equitable powers broadly, however, I think the outcomes from the cases are more consistent than the statutes would lead one to think. For an example, see my discussion of Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012), here.
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.
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 Awards Lost Future Earnings to LLC Investors Because of Promoter's Fraud and Breaches of Fiduciary Duty
Many new businesses fail, for a variety of reasons, and that usually means the investors lose their investment. But it’s a bitter pill for the investors when the venture fails because of the promoter’s fraud and breaches of fiduciary duties. In a Delaware Court of Chancery case decided this week, the plaintiffs alleged fraud and breaches of fiduciary duty, and claimed that they had not only lost their investment, but also that their reputations were so besmirched by their involvement in the company’s fraudulent futures-trading scheme that they were effectively unemployable and were therefore entitled to damages for their lost future earnings. Paron Capital Mgmt., LLC v. Crombie, C.A. No. 6380-VCP (Del. Ch. May 22, 2012)(slip op.). The court agreed.
Background. Peter McConnon and Timothy Lyons met James Crombie in 2010. McConnon was a principal of a multi-billion dollar hedge fund based in London, and Lyons had worked as a senior investment professional for a number of financial institutions. Crombie had developed a software-based trading program in futures contracts, and explained that his trading program had annual returns of 25% in 2007 and 38% in 2008. He asserted that he had $30 million in assets under management, and invited McConnon and Lyons to join him in a new company to manage a hedge fund product and to trade futures on behalf of client accounts.
Due Diligence. Before deciding to join Crombie and form the new company, McConnon and Lyons conducted extensive due diligence on Crombie, his history, and his software product. They reviewed marketing materials from Crombie, including an independent verification from accounting firm Yulish & Associates, which certified that the returns claimed by Crombie were actual returns, verified through a third-party clearing broker. They checked references from 10 of Crombie’s former clients and colleagues, including mutual acquaintances. They interviewed Crombie in person and observed the software operate. They searched industry databases, interviewed Crombie’s lawyer about a lawsuit Crombie was involved in, and hired Kroll, Inc., an international risk consulting firm, to conduct a comprehensive background search on Crombie. None of those efforts turned up any red flags.
The New Company. Satisfied with their investigation, McConnon and Lyons entered into business with Crombie. They formed Paron Capital Management, LLC, a Delaware limited liability company, on June 2, 2010. Crombie had a 75% interest and was the initial manager, McConnon had a 20% interest, and Lyons a 5% interest. They commissioned an updated, independent verification of Crombie’s track record from Rothstein, Kass & Company, a national accounting firm, and used its report to begin marketing Paron to potential clients. Paron’s marketing materials were sent to over a hundred of McConnon’s and Lyons’ client contacts.
Fraud Revealed. On March 10, 2011, Paron received an audit request from its regulator, the National Futures Association (NFA). Numerous documents about Paron’s operations and Crombie’s predecessor company, JDC Ventures, LLC, were provided to the NFA. The NFA detected discrepancies and requested additional information. McConnon and Lyons began to investigate and learned that documents provided by Crombie to the NFA and to the accounting firm that had verified Crombie’s track record were false and had been forged by Crombie. After further investigation, McConnon and Lyons removed Crombie as a manager and member of the LLC, and the NFA issued a notice prohibiting Crombie and Paron from accessing, disbursing, or transferring any funds in Crombie’s name or a client’s name without prior NFA approval.
Lawsuits. On April 13 and 14, 2011, McConnon and Lyons filed two lawsuits against Crombie. Crombie entered into a stipulated judgment in the first lawsuit, in which he admitted that he was properly removed as a manager and member of the LLC, and agreed to a permanent injunction against using Paron assets or holding himself out as being affiliated with Paron.
In the second lawsuit, the plaintiffs sought damages for Crombie’s fraud and breach of fiduciary duty. A three-day trial was held in October 2011. Crombie failed to appear and presented no evidence, claiming financial hardship. Crombie filed for bankruptcy in February 2012, and the lawsuit was stayed. Later in February the stay was lifted.
Fraud. The court’s findings of Crombie’s fraud are damning. “[M]any of the representations Crombie made about his track record, employment history, and personal financial situation were outright lies.” Paron Capital Mgmt., slip op. at 10. Crombie forged account statements from multiple sources. Id. at 11. Crombie misrepresented his relationship with a prior employer and his personal financial situation. He failed to disclose another lawsuit against him and numerous personal debts he owed. The court found the plaintiffs’ reliance on Crombie’s representations to be justifiable, which isn’t surprising given their extensive due diligence.
Fiduciary Duties. The LLC’s operating agreement did not limit or exclude Crombie’s fiduciary duties as the manager, so Crombie owed the plaintiffs the traditional fiduciary duties of loyalty and care. Id. Those duties were breached both by Crombie’s preparation of fraudulent marketing materials for the LLC and by his continued concealment of material information about his track record, employment history, and personal finances. The court noted that under Delaware law, a fiduciary who remains silent about false, earlier communications that are relied upon by the beneficiary breaches his duty of loyalty. Id. at 16.
Damages. The court awarded McConnon reliance damages and mitigation costs totaling about $1.5 million. Those consisted of his loans and costs advanced to Crombie and to Paron in reliance on Crombie’s misrepresentations, and legal fees incurred in regulatory proceedings against Crombie and Paron and in foreclosing on collateral pledged by Crombie for the loan.
The vast majority of the damages claimed by McConnon and Lyons were for lost future earnings. “Specifically, Plaintiffs claim that their association with Crombie and Paron damaged their relationships with clients and effectively made them unemployable because they would be required to disclose their association with Paron to future employers, who, in turn, would have to disclose it to investors.” Id. at 20.
McConnon and Lyons provided trial testimony from two expert witnesses, an executive search professional with the financial services industry and a CPA certified in fraud examination and financial forensics. The executive recruiter testified that in his opinion, the clients he represents would not hire McConnon because of his association with Paron. The recruiter stated that his firm would be unwilling to even attempt to market McConnon because marketing an individual associated with fraudulent activity would hurt the recruiter’s business. The recruiter’s expert opinion was that McConnon would be unemployable in his field for the foreseeable future, other than for much lower-paying work only tangentially related to the capital markets.
Based on the recruiter’s expert opinions and on McConnon’s prior average annual earnings of more than $3.4 million, the CPA calculated McConnon’s lost future earnings over a 10-year period using two different methods, averaged the results, and estimated the lost earnings at $39.8 million. The court found the recruiter’s estimate of McConnon’s earnings if he had stayed at his prior firm to be overly optimistic, adjusted the amount downward, and awarded McConnon $32.2 million for lost future earnings.
Lyons’ compensation before leaving his prior employer was much lower, at about $200,000 per year. The executive recruiter and the CPA went through an analysis similar to their McConnon analysis, and after adjusting the CPA’s estimate, the court awarded Lyons $1.9 million for lost future earnings.
Comment. This case does not make new law, but it is a fascinating and odd case to consider. For one thing, the bad acts by the defendant were so egregious that the court’s legal conclusions of fraud and breach of fiduciary duty seem clear cut. Also, the fact that the defendant did not appear at trial would presumably undercut, at least to some degree, the precedential value of the court’s rulings.
The awards for the plaintiffs’ lost future earnings are unusual because they are based on injury to McConnon’s and Lyons’ reputations. Crombie’s fraudulent futures-trading scheme, and the involvement of McConnon and Lyons in Paron Capital Management, LLC, so tarred their reputations that they could no longer work in their former, highly paid capacities. And the facts showed that the effects on their careers would be long-lasting – up to ten years. (If Crombie had participated in the trial and presented experts with different opinions, the court might have reached different factual conclusions.) The long duration of the impact on the plaintiffs’ reputations, and in McConnon’s case the high level of his compensation prior to joining Crombie, led to a breathtakingly large ($32.2 million) award for McConnon.
The case is also a cautionary tale about due diligence. It’s hard to fault McConnon’s and Lyons’ investigation, as reported by the court, yet their due diligence completely failed. The court’s finding was that the plaintiffs acted reasonably in investigating Crombie. Id. at 15. Yet in hindsight, perhaps Crombie’s claim of consistent, high annual returns from his futures-trading program should have called for more probing of Crombie’s prior clients, and more double-checking of the authenticity of documents provided by Crombie.
I will be speaking at a continuing legal education seminar for the Delaware State Bar Association later this month, on May 22, 2012, in Wilmington, Delaware. The DSBA’s Corporation Law Section will be presenting its annual seminar, Recent Developments in Delaware Corporate and Alternative Entity Law, and I’ll be one of four speakers on a panel discussion about Corporate Law Updates via Blogs.
Francis Pileggi, of the Delaware Corporate & Commercial Litigation Blog, will be our panel moderator. The other panel members are Kevin LaCroix of The D&O Diary; Professor Christine Hurt, The Conglomerate; and Professor Brian Quinn, The M&A Law Prof. For the logistics of the Seminar, see Francis Pileggi’s summary, here.
Francis has given our panel latitude to discuss the process of blogging about corporate law developments, as well as what we have gleaned about corporate and LLC law from our blogging. From my perspective this seminar is a timely opportunity to look back and review the lessons from blogging about LLC law, since this month marks the third anniversary of LLCLawMonitor.com. I’m looking forward to a lively face-to-face discussion with bloggers that I regularly read but have never met in person.
Kansas recently became the latest state to authorize series limited liability companies. Governor Sam Brownback signed Substitute House Bill 2207 on March 29, 2012, amending the Kansas Limited Liability Company Act to authorize series LLCs. Sub. H.R. 2207. The bill will become law on July 1, 2012, and Kansas will then join the eight other states that have authorized series LLCs.
Series LLCs. A series LLC can partition its assets and members into one or more separate series, each of which can have designated members and managers, and can own its own assets separately from the assets of the LLC or any other series. The liabilities of each series will be enforceable only against the assets of that series, and each series can enter into contracts, sue, and be sued in its own name.
Multiple series within one LLC can be used to avoid some of the inefficiencies and costs involved with using multiple LLCs. For example, separate parcels of real estate could each be owned by a separate series, but all within one LLC. Or, the divisions of a business could be held within one LLC, but with each division in a separate series.
Other States. Delaware was the first state to authorize series LLCs, in 1996. Del. Code Ann. tit. 6, § 18-215. Since then Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah have enacted statutes similar to Delaware’s, although there are some differences. I previously wrote about series LLCs when Texas passed its series LLC law in 2009, here, and when the Internal Revenue Service proposed regulations for series LLCs, here.
Kansas Requirements. The Kansas statute is similar in many respects to the Delaware Act. Both authorize an LLC’s operating agreement to establish one or more designated series, and both provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
- the records of the series account for its assets separately from the assets of any other series or the LLC generally,
- the operating agreement states the liability limitations, and
- the certificate of formation, and in the case of a Kansas LLC, the articles of organization, give notice of the limitations on liability.
Series LLCs are relatively new. There are few reported opinions dealing with series LLCs, and the IRS’s proposed regulations have not yet been finalized. There are therefore many unresolved legal questions about series LLC issues such as taxation, bankruptcy, liability limitations, and piercing the veil, particularly when doing business in states outside the state of formation. Caution is advised when implementing a series LLC, given the uncertainty and lack of predictability inherent in their use.
The Federal District Court in New York granted summary judgment to pierce the veil of a Delaware limited liability company in Soroof Trading Development Co. Ltd. v. GE Fuel Cell Systems LLC, No. 10 Civ. 1391(LTS)(JCF), 2012 WL 209110 (S.D.N.Y. Jan. 24, 2012). The court found the LLC to be the alter ego of its members, but did not explain how Delaware’s requirement of unfairness or injustice was met.
Background. This case was a dispute over a distribution agreement made in 2000. The agreement gave Soroof Trading Development Co. Ltd. the exclusive right to distribute fuel cells in Saudi Arabia that were to be manufactured by GE Fuel Cell Systems LLC. Soroof paid the LLC a $1 million, non-refundable distributor fee, and the LLC was obligated to use its reasonable efforts to supply the fuel cells to Soroof. The LLC was unable to complete development of the fuel cells, though, and never delivered any. In 2005 the LLC informed Soroof that it was unable to manufacture the fuel cells, and in 2006 the LLC was dissolved and a certificate of cancellation was filed with the Delaware Secretary of State.
Soroof eventually sued the LLC and its two members for breach of the distribution agreement, misrepresentation, conversion, imposition of a constructive trust, unjust enrichment, and an accounting. The LLC moved for judgment on the pleadings, with the result that the court dismissed all of Soroof’s causes of action but allowed Soroof to replead its claims for breach of contract and misrepresentation.
Soroof desired to pierce the LLC’s veil in order to assert its claims against the LLC’s members, which were not parties to the distribution agreement. (The LLC had been formed as a Delaware LLC with two members, GE Microgen, Inc. and Plug Power, Inc.) Soroof therefore made a two-part motion for partial summary judgment, (a) to nullify the LLC’s certificate of cancellation, and (b) to pierce the LLC’s veil. The defendants made a motion for dismissal of all claims against the LLC.
Dismissal of Claims Against the LLC. When the LLC was dissolved in 2006, a certificate of cancellation was filed, cancelling the LLC’s certificate of formation. See DLLCA § 18-203. Once a certificate of cancellation is filed, a Delaware LLC cannot be sued, unless the certificate is nullified on the ground that the LLC was not properly wound up in compliance with Delaware law. Soroof, 2012 WL 209110, at *13. Soroof alleged that the LLC had not been properly wound up because no provision had been made for Soroof’s claims, but the court pointed out that a dissolved LLC is only required to pay or make provision for claims to the extent of its assets, which in this case were nominal. Id. at *14. Soroof argued that the certificate of cancellation should be nullified because the LLC was the alter ego of the members, but it cited no legal authority to support that argument. The court dismissed all of Soroof’s claims against the LLC.
Piercing the Veil. The court then turned to Soroof’s claim that the LLC’s veil should be pierced, which would enable Soroof to pursue its claims against the LLC’s two members. The court stated the rule as follows:
Delaware law permits a court to pierce the corporate veil where there is fraud or where [the corporation] is in fact a mere instrumentality or alter ego of its owner…. To prevail under the alter-ego theory of piercing the veil, a plaintiff need not prove that there was actual fraud but must show a mingling of the operations of the entity and its owner plus an overall element of injustice or unfairness.
Id. (brackets in original)(quoting NetJets Aviation, Inc. v. LHC Commc’ns LLC, 537 F.3d 168, 177 (2d Cir. 2008)). Interestingly, the court cited no Delaware cases, instead referring only to the NetJets case from the Second Circuit.
The court recited the alter ego factors to be considered (capitalization, solvency, payment of dividends, adequate records, functioning officers and directors, other corporate formalities, siphoning funds off, and the entity functioning as a “façade” for the owner), and pointed out that less emphasis should be placed on LLC formalities than on corporate formalities.
The court then described the undisputed facts relevant to piercing GE Fuel Cell Systems LLC’s veil:
- The LLC had no cash assets at the time of dissolution.
- The LLC had no employees, and the individuals working at the LLC were actually employees of the members.
- The LLC did not lease its office space but used the premises of its members.
- There was no sign on the LLC’s premises indicating its presence.
After describing these factors, the court simply stated that “Plaintiff's uncontroverted proffers demonstrate an extensive ‘mingling of the operations’ of [the LLC] and its owners, such that [the LLC] was a mere instrumentality or alter ego of GE Microgen and Plug Power, as well as an overall element of unfairness to Soroof,” and granted Soroof’s motion for summary judgment piercing the LLC’s veil. Id. at *15. The court was silent as to how the facts showed “unfairness to Soroof,” other than implicitly recognizing that without piercing the veil Soroof’s claim would be unsatisfied. Of course, that is usually why plaintiffs seek to pierce a corporate defendant’s veil.
Comment. The court’s refusal to nullify the LLC’s certificate of cancellation seems unexceptional under the circumstances, even though the result is that all of Soroof’s claims against the LLC were dismissed. That dismissal, though, arguably should have led to dismissal of the veil piercing claims against the LLC’s members as well. That is because piercing the veil is not an independent cause of action, but merely a method of imposing liability on an underlying claim. Cambridge Elecs. Corp. v. MGA Elecs., Inc., No. CV02-8636MMM(PJWX), 2005 WL 927179, at *1 (C.D. Cal. 2005). Piercing the veil is an equitable remedy, not a cause of action unto itself. MidAmerican Distribution, Inc. v. Clarification Tech., Inc., 807 F. Supp. 2d 646, 683 (E.D. Ky. 2011).
In short, the claims against the LLC were dismissed, and therefore there was no underlying LLC liability for which the members should be made liable by piercing the LLC’s veil.
Even ignoring that issue, it appears unlikely that a Delaware court would have pierced the veil of the LLC on the facts recited by the Soroof court. The threshold in Delaware to pierce the veil of a corporation or LLC is high. Generally fraud, illegality, or other egregious facts must be present, and the Delaware courts “have only been persuaded to ‘pierce the corporate veil’ after substantial consideration of the shareholder-owner’s disregard of the separate corporate fiction and the degree of injustice impressed on the litigants by recognition of the corporate entity.” Midland Interiors, Inc. v. Burleigh, No. CIV.A. 18544, 2006 WL 3783476, at *3 (Del. Ch. 2006). See Francis Pileggi’s discussion of Midland Interiors, here.
The Soroof opinion is not an isolated instance of a court straining to pierce the veil of an LLC. Last month I posted here about Colorado’s Martin v. Freeman case, where the veil of a single member LLC was pierced without any showing of wrongdoing. Both cases support Professor Stephen Bainbridge’s thesis that “veil piercing achieves neither fairness nor efficiency, but rather only uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 78.
The Colorado Court of Appeals last month liberalized the standard for piercing an LLC’s veil by holding that neither fraud, wrongful intent, nor bad faith need be shown by an LLC’s creditor to reach the assets of the LLC’s single member. Martin v. Freeman, No. 11CA0145, 2012 WL 311660 (Colo. App. Feb. 2, 2012).
Background. Dean Freeman was the single member of Tradewinds Group, LLC, a Delaware limited liability company. Tradewinds contracted to have Robert Martin construct an airplane hangar, but in 2006 Tradewinds sued Martin for breach of the construction agreement. While the litigation was pending, Tradewinds sold its only meaningful asset (other than its claim in the litigation) for $300,000 in 2007. Tradewinds distributed the proceeds to Freeman, and Freeman continued to pay the litigation expenses.
The trial court found for Tradewinds on its breach of contract claim and entered judgment in its favor, and Martin appealed. The Court of Appeals reversed the trial court and remanded with directions to enter judgment in Martin’s favor. On remand, the trial court in 2009 awarded Martin costs of $36,600. Tradewinds was unable to pay, and Martin sued Freeman to pierce the LLC veil and recover the $36,600 from Freeman. The trial court pierced the LLC’s veil and found Freeman personally liable for the cost award. Id. at *1.
The Court of Appeals began by reciting the Colorado requirements to pierce the LLC veil: “the court must conclude (1) the corporate entity is an alter ego or mere instrumentality; (2) the corporate form was used to perpetrate a fraud or defeat a rightful claim; and (3) an equitable result would be achieved by disregarding the corporate form.” Id.
Alter Ego. The court described several factors to be considered in determining alter ego status, including commingling of funds and assets, inadequacy of corporate records, thin capitalization, disregard of legal formalities, and using entity funds for non-entity purposes. The court then listed the trial court’s findings in support of the conclusion that Tradewinds was Freeman’s alter ego:
• Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;
• Tradewinds maintained negligible corporate records;
• the records concerning Tradewinds’ substantive transactions were inadequate;
• the fact that a single individual served as the entity’s sole member and manager facilitated misuse;
• the entity was thinly capitalized;
• undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;
• Tradewinds was never operated as an active business;
• Legal formalities were disregarded;
• Freeman paid Tradds’ debts without characterizing the transactions;
• Tradewinds’ assets, including the airplane, were used for nonentity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation;
• Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.
Id. at *2. The list is long, but many of the items amount to disregard of various formalities.
The court quoted part of the section of the relevant Colorado LLC statute that addresses LLC veil piercing, Colo. Rev. Stat. § 7-80-107(2), but did not discuss it. The court also referred to other secondary authorities such as 1 Fletcher’s Cyclopedia of the Law of Corporations § 41.35 (“a sole shareholder will not likely be suspect merely because he or she conducts business in an informal manner”) and 2 Ribstein and Keatinge on Limited Liability Companies § 12.3 (“veil piercing on the ground of inadequate capitalization is even less likely for LLCs than corporations”). The Court of Appeals nonetheless concluded, with no further analysis, that the trial court’s findings supported the conclusion that Tradewinds was Freeman’s alter ego. Martin, 2012 WS 311660 at *2.
The court’s perfunctory treatment of Colorado’s LLC Act is puzzling. The Act provides:
7-80-107. Application of corporation case law to set aside limited liability.
1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.
(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.
The statute appears to require that most of the Martin court’s alter ego factors be disregarded, which probably would have resulted in failure of the veil-piercing claim.
The court also did not consider what law should apply. Tradewinds was a Delaware corporation, but the court did not discuss whether Delaware law should apply. Although the authorities are split, many jurisdictions apply the law of the state of incorporation to resolve veil piercing questions. 1 Fletcher’s Cyclopedia of the Law of Corporations § 43.72. Application of Delaware law on piercing the veil almost certainly would have resulted in dismissal of Martin’s claim. See Francis Pileggi’s discussion at Delaware Corporate & Commercial Litigation Blog, here.
Perpetrate a Fraud or Defeat a Rightful Claim. The second factor necessary to pierce the veil is that the LLC form was used to perpetrate a fraud or defeat a rightful claim. Martin, 2012 WL 311660 at *3. The trial court’s findings of fact were clear that there was no fraud, wrongful intent or bad faith in Freeman’s actions, so for the Court of Appeals the question came down to whether the LLC form was used to “defeat a rightful claim.” Bearing in mind that the LLC’s sale of the airplane and the distribution of the sale proceeds to Freeman took place in 2007, while the award of costs against the LLC did not occur until two years later in 2009, the Court of Appeals concluded that “defeating a potential creditor’s claim is sufficient to support the second prong…. Any party engaged in litigation is exposed to potential liability.” Id.
The trial court had found as a factual matter, however, that Freeman had fully provided for all known or reasonably possible debts of the LLC at the time of the distribution of the airplane sale proceeds. Id. The Court of Appeals dismissed that finding as irrelevant because it was made in analyzing whether Freeman violated the LLC Act’s restrictions on distributions by insolvent LLCs. One would have thought that facts are facts, though, especially when the Court of Appeals had said at the beginning of its opinion: “We therefore accept the [trial] court’s factual findings and review de novo its application of the law to those facts.” Id. at *1.
As part of its analysis of whether Freeman used the LLC to defeat a rightful claim, the court said it was not aware of any Colorado case establishing that a party must show wrongful intent to pierce the corporate veil. The dissent by Judge Jones, however, cited and quoted numerous prior Colorado cases that appear to require fraud, crime, an illegal act, or conduct that was at the least intended to defeat the creditor’s claim. Id. at *6-7. In any event, the court concluded, “as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.” Id at *3.
Equitable Result. Having navigated between the Scylla and Charybdis of “alter ego” and “perpetuate a fraud or defeat a rightful claim,” the court sailed to its conclusion that Tradewinds’ veil should be pierced and Martin’s claim against Freeman sustained. Id. at *4. The court never discussed the third prong (that an equitable result would be achieved), because the defendants only challenged the trial court’s conclusions on the first and second prongs.
Comment. Piercing the veil is a “seriously flawed doctrine,” “one of the most befuddled [areas of the law],” and is beset by “uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 77 (2005); Franklin A. Gevurtz, Piercing Piercing: An Attempt to Lift the Veil of Confusion Surrounding the Doctrine of Piercing the Corporate Veil, 76 Or. L. Rev. 853, 853 (1997).
The Martin case illustrates some of the problems that appear in many veil-piercing cases. For example, the court lists 11 alter ego factors but discusses only one, the commingling (which consisted mainly of Freeman using personal assets to satisfy the LLC’s obligations, and receiving a distribution of the airplane sale proceeds after he had provided for all known or reasonably foreseeable debts). Then, after summarizing the defendants’ arguments, the opinion simply cuts to the conclusion that “the court considered the appropriate factors and its findings support a conclusion that Tradewinds was Freeman’s alter ego.” It would be useful to know the extent to which the LLC Act’s maxim, that non-observance of formalities is not grounds for imposing personal liability, applies in a veil-piercing case.
It also would have been helpful if the court had provided guidance on the extent to which the single-member nature of the LLC was considered in the alter ego determination. Because the court found that an LLC’s veil could be pierced even without any wrongful intent or bad faith, it’s hard to escape the conclusion that the court was heavily influenced by the single-member character of the LLC.
The Martin case can be viewed as an example of the uphill battle that single-member LLCs must wage in having their existence and separate nature respected. But the court’s holding that no wrongdoing, wrongful intent, or bad faith of any kind need be shown to pierce the LLC veil and impose personal liability is a hollowing out of the liability protection for LLC members and corporate shareholders, and goes far beyond existing law.
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.
New York Court Orders Dissolution of LLC - Recharacterizes Capital Contributions as Loans to Reach Equitable Result
An involuntary dissolution case was decided by the New York Supreme Court (the trial court) two weeks ago, on a petition for dissolution by one of the two members of a limited liability company. Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012).
Background. Mizrahi and Cohen’s LLC owned a four-story commercial office building, with the ground floor rented by Cohen’s optometry business and the second floor rented by Mizrahi’s dental practice. The LLC consistently operated at a loss from 2006, the first year the building was occupied. The losses were covered by the members’ periodic capital contributions, although the LLC’s operating agreement didn’t require any additional capital contributions after the initial contributions. The two members each had a 50% ownership interest in the LLC, and initially they contributed additional capital in equal amounts. After a few years, however, Cohen’s capital contributions became sporadic and Mizrahi contributed most of the capital necessary to keep the LLC from defaulting on its mortgage. Over a span of several years Mizrahi contributed approximately $900,000 more than Cohen.
Mizrahi sued for dissolution of the LLC and an accounting of the proceeds of the company. The New York LLC Act uses the familiar standard for judicial dissolution: “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” N.Y. Ltd. Liab. Co. Law § 702. (Washington and Delaware, for example, have similar provisions in their LLC statutes. RCW 25.15.275; Del. Code Ann. tit. 6, § 18-802.)
The Appellate Division held in 2010 that Section 702 requires that for dissolution to be ordered, the petitioner must show, “in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.” In re 1545 Ocean Ave., LLC, 72 A.D.3d 121, 131, 893 N.Y.S.2d 590 (N.Y. 2010).
Dissolution. The gist of the court’s analysis was that continuing the LLC was financially unfeasible because of (a) the significant losses incurred over the years, (b) Cohen’s failure to contribute equally in meeting the losses and his undermining the financial integrity of the LLC by unilaterally withdrawing $230,000 of his capital, and (c) the likelihood that it was only a matter of time, should Mizrahi exercise his right to refrain from making further capital contributions, until the LLC would default on its mortgage and the mortgage be foreclosed upon. Mizrahi, 2012 WL 104775, at *8.
The facts of the case and the court’s analysis are ably described in more detail by Peter Mahler in his New York Business Divorce law blog, here.
Accounting and Winding Up. Having determined that the LLC would be dissolved, the court discussed the accounting procedures to be followed and the winding up and distribution requirements of the LLC’s operating agreement. The operating agreement required that after payment to the LLC’s creditors and satisfaction of its liabilities, any remaining assets would be distributed to the members “according to their ownership interests,” i.e., 50% to each. There was no provision for returning a member’s capital, apparently on the assumption that the members would contribute capital in equal amounts, thus maintaining the 50/50 ratio for contributions as well as for their ownership interests.
But as it turned out, Mizrahi had contributed $900,000 more than Cohen. Ignoring that fact in the final 50/50 distribution would be consistent with the operating agreement but manifestly unfair. “[C]rediting the sums advanced by plaintiff to his capital account would work an inequitable result in that the Operating Agreement prevents the return of a Capital Contribution.” Id. at *11.
The court therefore ordered that Mizrahi’s capital contributions in excess of the amount of Cohen’s capital contributions would be treated as a loan to the LLC, to be repaid to Mizrahi as a debt of the LLC prior to the distributions to the members based on their 50/50 percentage of ownership. Id.
The court also ordered that Cohen’s $230,000 withdrawal from the LLC, whether treated as a loan or a capital withdrawal, would be applied to reduce the amount of any distribution to Cohen. Id. at *9.
The court’s resolutions of these two issues are clearly equitable and fair, but it is striking that the court gives no explanation or authority for either, other than its passing reference to avoiding an “inequitable” result. Trial courts have broad equitable powers, but one would have expected at least some citations to authority for the court’s application of those powers.
Last week the Delaware Supreme Court ruled on the appeal of CML V, LLC v. Bax, in which the Court of Chancery held last year that a creditor of an insolvent LLC does not have standing to maintain a derivative suit in the name of the LLC against its managers. I wrote about that surprising result here – surprising because it is inconsistent with the corporate rule.
Delaware’s Supreme Court affirmed the Court of Chancery decision, holding that “Section 18-1002 of the LLC Act, by its plain language, limits LLC derivative standing to ‘member[s]’ or ‘assignee[s],’ and thereby denies derivative standing to LLC creditors.” CML V, LLC v. Bax, No. 735,2010, 2011 Del. LEXIS 480, at *24 (Del. Sept. 2, 2011) (brackets in the original).
The Court’s conclusion turned on its analysis of Sections 18-1001 and 18-1002 of the Delaware LLC Act:
§ 18-1001. Right to bring action. A member or an assignee of a limited liability company interest may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if managers or members with authority to do so have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed.
§ 18-1002. Proper plaintiff. In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:
(1) At the time of the transaction of which the plaintiff complains; or
(2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction.
The Court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as requiring that the plaintiff be an LLC member or an assignee of a member. The Court emphasized the mandatory language in Section 18-1002: “must be a member or assignee,” and found Sections 18-1002 and 18-1002 to be unambiguous. CML, 2011 Del. LEXIS 480, at *11.
CML argued that (i) Section 18-1001 authorizes derivative standing to members or assignees but is not by its language exclusive, (ii) Section 18-1002 addresses only the chronology of such a member’s or assignee’s status, and (iii) when the two sections are read together they are similar in their effect to the comparable provisions of the Delaware General Corporation Law, Del. Code Ann. tit. 8, § 327, which has long been interpreted as allowing derivative standing for creditors of insolvent corporations.
CML’s position is buttressed by what the Court of Chancery characterized as an awkward fact:
[V]irtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit. Particularly in light of Production Resources and Gheewalla, an exclusive reading of Section 18-1002 would cause LLC derivative actions to differ markedly from their corporate cousins. If practitioners widely understood the derivative standing provisions to have this effect, one would expect treatises, articles, and commentaries to call attention to that fact. … [O]ne also would expect courts to have encountered parties raising the statutory provisions as a defense. Yet the universe of authorities favoring the no-standing position consists of (i) a single sentence at the end of a footnote in one Delaware treatise, see Symonds & O’Toole, supra, § 9.09, at 9-61 n.270, and (ii) abbreviated treatment in an unreported district court decision, see Magten, 2007 WL 129003, at *3.
Many commentators, by contrast, have assumed that creditors of an insolvent LLC can sue derivatively. In light of this assumption, they have debated vigorously whether an LLC agreement can limit the fiduciary duties that the creditors would invoke. That question never arises if creditors lack standing to sue under Section 18-1002.
CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220, at *12-13 (Del. Ch. Nov. 3, 2010) (footnote omitted).
This widespread reading of Sections 18-1001 and 18-1002 significantly undercuts the Court’s assertion that these two sections are unambiguous.
Nonetheless, the Court has spoken and the rule is now clear, at least until changed by legislative action. Given the gulf between the Court’s reading of the statute and the widespread past interpretations by commentators and practicing lawyers, it would not be surprising to see legislative action on this point. As the Court said, “The General Assembly is well suited to make that policy choice and we must honor that choice.” CML, 2011 Del. LEXIS 480, at *13.
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.
A Bankruptcy Appellate Panel (BAP) of the Tenth Circuit recently upheld a bankruptcy court’s dismissal of an LLC’s Chapter 11 bankruptcy petition on the ground that the LLC’s operating agreement barred the LLC from filing for bankruptcy. DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), No. CO-10-046, 2010 Bankr. LEXIS 4176 (B.A.P. 10th Cir., Dec. 6, 2010). Bankruptcy law has long refused to enforce contractual prohibitions on voluntary bankruptcy filings, so this case appears to be a chink in that rule.
DB Capital Holdings, LLC was a Colorado condominium developer whose project was 14 months late and $4 million over its $82 million budget. It had no funds to continue the project and was both insolvent and in breach of its loan agreements with its principal lender. At the lender’s request, a receiver was appointed by a Colorado state court to take charge of and protect the LLC’s project.
The LLC’s two members were in disagreement over the receivership, and the LLC’s sole manager then filed a Chapter 11 bankruptcy petition on behalf of the LLC. At that point one of the members filed a motion to dismiss the Chapter 11 case, claiming that the manager lacked authority because the LLC’s operating agreement barred its bankruptcy filing. The operating agreement stated:
The Company (v) to extent permitted under applicable Law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy ….
Id. at *9 (ellipsis in original). The bankruptcy court held that the LLC’s operating agreement precluded the manager from filing for bankruptcy on the LLC’s behalf and dismissed the Chapter 11 proceeding.
The BAP began its analysis by noting that “[a] bankruptcy case filed on behalf of an entity without authority under state law to act for that entity is improper and must be dismissed,” and that bankruptcy courts must look to state law to resolve authority issues. Id. at *7. Under the Colorado LLC Act, an LLC’s operating agreement governs the rights and duties of an LLC’s members and managers. Id. The operating agreement language was clear; it expressly barred the LLC from filing a bankruptcy petition.
The manager contended that the operating agreement’s ban on filing a petition was invalid because it had been executed at the creditor’s request and only benefited the creditor. The manager cited numerous cases holding that contractual prohibitions on filing for bankruptcy are unenforceable.
The court distinguished those cases as involving debtor agreements with third parties. “Debtor has not cited any cases standing for the proposition that members of an LLC cannot agree among themselves not to file bankruptcy, and that if they do, such agreement is void as against public policy, nor has the court located any.” Id. at *10. The court found the express restriction on the filing of a bankruptcy petition to be enforceable.
The court also reviewed provisions of the LLC’s operating agreement that required the manager to carry out the LLC’s business “as presently conducted,” and that barred the manger from doing any act that would make it impossible to carry on the ordinary business of the LLC. The court concluded that even without the operating agreement’s express prohibition on filing a petition, the provisions relating to the ordinary business of the LLC, as presently conducted, prohibited the manager from filing a bankruptcy petition.
Although the court upheld the operating agreement’s express bar on any bankruptcy filing by the LLC, it qualified its opinion in a way that introduced some uncertainty about the scope of its opinion:
In addition, Debtor does not point to any record evidence that the May amendment was coerced by a creditor. For that reason, the Court declines to opine whether, under the right set of facts, an LLC’s operating agreement containing terms coerced by a creditor would be unenforceable.
Id. at *10. It’s the word “coerced” that makes one blink. Normally the only reason an LLC agreement would include a prohibition on bankruptcy filings would be that a creditor or some other third party requested it. If “coerced” means that the limitation was put in the LLC agreement at the request of a creditor, this case won’t have much impact.
“Coerced” usually means some undue pressure or threat. Often some element of physical force is involved, which presumably was not the court’s meaning. Is the LLC coerced if a lender offers a loan on terms that require the LLC to include the restriction in its operating agreement? Most lawyers would probably say no, that’s not coercion. Perhaps the court had in mind the type of situation where a company is desperate for a loan and lacks bargaining power.
Assume the bankruptcy courts will generally enforce these restrictions, as the BAP did this case. Can a lender rely on such a restriction in an LLC’s operating agreement? Not standing alone – the operating agreement is an agreement between members, so the members can change their agreement and eliminate the restriction. For the lender to rely on the restriction the lender would need a way to limit the members’ ability to amend the agreement. For example, the lender could be a member or have a representative that would serve as a member, and vote against elimination of the restriction.
A better way, at least if the debtor is a Delaware LLC, may be to rely on Section 18-101(7) of the Delaware LLC Act. That section states: “A limited liability company agreement may provide rights to any person, including a person who is not a party to the limited liability company agreement, to the extent set forth therein.” A Delaware LLC agreement could provide that it could not be amended without the consent of a named third party, such as the lender.
The appointment of a receiver is one of the oldest equitable remedies. A receiver can receive, preserve, and manage property and funds, and even take charge of an operating business, as directed by the court. Appointing a receiver is a powerful remedy, not undertaken lightly by the courts.
The Delaware Court of Chancery in September had to decide if a receiver should be appointed for an LLC whose members were embroiled over claims of breach of fiduciary duty, breach of contract and tortious interference with contractual opportunity. Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113-VCN, 2010 Del. Ch. LEXIS 184 (Del. Ch. Sept. 2, 2010).
The plaintiffs in Ross asked the court for two things: one, to allow them to amend their complaint to add a request for the appointment of a receiver; and two, to immediately appoint a receiver. They wanted a receiver with power to manage the LLC’s affairs, to protect and preserve its assets, and to recover any losses the LLC suffered at the hands of the defendants.
The Ross court made short shrift of the defendants’ argument that the appointment of a receiver was unavailable because it was not authorized by either the Delaware LLC Act or the LLC’s operating agreement:
“The Court has inherent power as a court of equity to grant such remedies as would be just, whether or not such remedies are expressly provided for by statute or contract. There is no reason to conclude that the appointment of a receiver pursuant to the Court's general equity powers would be unavailable under the facts alleged in the proposed Amended Verified Complaint.”
Id. at *7-8. The plaintiffs were therefore free to amend their complaint to request the appointment of a receiver.
But the plaintiffs were not content to wait for trial – they also moved the court for an immediate appointment of a receiver, alleging that the defendants were in effect looting the LLC and had caused its insolvency through gross mismanagement and self-dealing.
The court was faced with two possible standards. The defendants argued that a receiver could be appointed only under the court’s general equity power. Under that standard a receiver will only be appointed where there is fraud or gross mismanagement, causing imminent danger of great loss that cannot otherwise be prevented. Id. at *23. This is a high bar.
The plaintiffs pointed out that Delaware’s LLC Act provides that in any case not governed by the Act, the rules of law and equity are to govern. They cleverly argued that therefore the standard for appointing receivers under Delaware’s General Corporation Law should apply. DLLCA § 18-1104; DGCL § 291. Under Section 291 a corporate insolvency suffices for the appointment of a receiver, although the courts have required additional facts demonstrating that a receiver is necessary to protect the rights of the company or the moving parties. For an insolvent entity, that standard is usually much less challenging than the “fraud or gross mismanagement” standard.
The Ross court noted that the LLC Act was written long after passage of the corporate statute, that in some cases provisions from the corporate statute were included in the LLC Act, and that therefore the omission from the LLC Act of a provision like Section 291 was intentional and not inadvertent. Ross, 2010 Del. Ch. LEXIS 184 at *18. The court saw no need to engraft the corporate statutory standard on the LLC Act, and ruled that it could appoint a receiver only in accordance with its general equity powers. Id. at *20.
Since the court concluded that it could appoint a receiver only under its equity jurisdiction, the plaintiffs needed to present “clear evidence of fraud, gross mismanagement, or other extraordinary circumstance causing imminent danger of real loss” to succeed on their motion for appointment of a receiver. Id. at *36. As so often happens, setting the standard determined the outcome.
The court reviewed in detail the plaintiffs’ numerous allegations of wrongdoing and the defendants’ contrary assertions, which disputed much of the plaintiffs’ facts and conclusions. With a nice double negative, the court opined that it “cannot conclude that the Plaintiffs have not asserted facts that, if true and accurate, would meet this high standard.” Id. (How could the plaintiffs have asserted true but inaccurate facts?) But because material facts relevant to the plaintiffs’ assertions remained in dispute, the court denied the motion: “it will be necessary to hold a trial in order to further develop the necessary factual record for a fair assessment of their application.” Id.
The Ross court’s approach is an example of a court relying on its equity powers to apply an equitable remedy for an LLC or its members, notwithstanding that the applicable LLC Act does not explicitly call out that remedy. For another example, last year New York and Indiana reached similar conclusions regarding the equitable remedy of a court-ordered accounting, which I discussed here.
LLC members have the right to receive allocations of profits, losses, and distributions (economic rights) and to participate in the LLC’s management. The specifics are determined by the state LLC statute and the LLC agreement. See, e.g., Del. Code ann. tit. 6, §§ 18-503, 18-504, 18-402. The member can also assign its interest in the LLC, unless the LLC agreement provides otherwise. Id. § 18-702. But even if an LLC member assigns its entire interest in the LLC to a third party, the assignee will not necessarily have all the rights of the assignor.
An assignee of an LLC interest will have the economic rights of the assigning member, but the assignee will not have the right to participate in the management of the LLC or to exercise any rights or powers of a member (other than the economic rights) unless the LLC agreement so provides. That is the rule in Delaware and in most other states. See, e.g., id.; Wash. Rev. Code § 25.15.250.
In Rowe v. Voyager HospiceCare Holdings, LLC, 231 P. 3d 1085, No. 101,661, Kan. App. Unpub. LEXIS 452 (Kan. Ct. App. June 18, 2010) (unpublished, mem., per curiam), the Kansas Court of Appeals dealt with a challenge to the validity of an assignment of a member’s interest in a Delaware LLC. Mark Rowe assigned all of his LLC member interest to his wife. The LLC refused to recognize the transfer because it did not consent to Rowe’s wife becoming a member, so Rowe filed a lawsuit for a declaration that he was entitled to make the transfer.
The court noted that Delaware law applied, although the opinion never discusses the Delaware LLC Act. The court treated the dispute as one purely of contract interpretation. Because the Delaware Act’s default rules on assignment of LLC interests can all be overridden by the terms of the LLC agreement, the ruling would have been unchanged even if the court had reviewed and analyzed the Act’s provisions.
Rowe’s LLC agreement barred members from assigning or transferring their interests in the LLC without the prior consent of the LLC’s Board, except for transfers within a Family Group. Rowe’s transfer to his wife was within his Family Group and his wife had agreed in writing to be bound by the LLC agreement, as it required, so the court found that the assignment was permitted by the LLC agreement.
The LLC agreement also provided that an assignee “shall become a substituted Member entitled to all the rights of a Member if and only if the assignor gives the assignee such right and the Board has granted its prior written consent to such assignment and substitution.” The court found the requirement of Board approval to admit the transferee as a substituted member to be a separate requirement that applied even for transfers within a Family Group. Since the Board had not approved of Rowe’s assignment to his wife, she did not become a substituted member. The transfer of the economic rights of Rowe’s LLC interest was valid but did not result in his wife being admitted as a member and having the governance and other rights of a member.
The Court of Appeals concluded by affirming the trial court, holding that Rowe’s assignment of his interest in the LLC was not barred by the LLC agreement, but that his wife only succeeded to the economic rights and was not admitted as a member.
It is an odd thing, this split between economic rights on the one hand and voting, management, and other rights on the other hand. Shares of stock are not treated that way – the buyer of a share will automatically be able to vote the share. Shares of stock are presumed to be fully alienable. Corporate articles or bylaws may limit the transferability of stock, but that is uncommon.
Of course an LLC agreement could make the member interests freely transferrable, including management and voting rights, but that is rarely done. Although courts often view LLCs as similar to corporations, in this one respect the partnership heritage of LLCs looms large. In partnerships the presumption historically was that partnerships were close relationships, where partners pick their co-partners and control the admission of new partners.
That approach is reflected in the state LLC statutes. In fact, the first LLC statute for many states was based on the state’s existing limited partnership statute. I know from lawyers who were involved in the process that that was true in the case of the Washington LLC Act, RCW Chapter 25.15.
Implied Duty of Good Faith and Fair Dealing Does Not Impose a Confidentiality Obligation on Delaware LLC Members
Many limited liability company agreements do not include confidentiality provisions. That may be because the company expects to have agreements with its employees and consultants that include confidentiality obligations. Or it may be that the parties and their lawyers simply don’t address it in the formation of the LLC. In any event, members who invest in an LLC but don’t work for it are in many cases bound only by an LLC agreement with no confidentiality restrictions.
LLC managers are sometimes surprised to discover that their LLC agreement does not obligate the company’s members to hold the LLC’s information in confidence. This may become an issue when there is a dispute with a member and the member requests information from the company. Many state LLC statutes give members the right to obtain certain records and information from the LLC, and the state acts don’t usually require that the member keep the information confidential. E.g., Del. Code Ann. tit. 6, § 305; Wash. Rev. Code § 25.15.135.
A canny LLC manager might logically ask, “Isn’t there any sort ofimplied obligation that the member keep company information confidential?” Many states imply a duty of good faith and fair dealing in contracts, either by statute or as part of the state’s common law. E.g., Del. Code Ann. tit. 6, § 18-1101(e) ( limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing); Badgett v. Sec. State Bank, 116 Wn.2d 563, 569, 807 P.2d 356 (1991) (there is in every contract an implied duty of good faith and fair dealing).
Earlier this year the Delaware Court of Chancery dealt with a claim that the implied covenant of good faith and fair dealing imposed confidentiality obligations on an LLC member. Kuroda v. SPJS Holdings, L.L.C., No. 4030-CC, 2010 Del. Ch. LEXIS 57 (Del. Ch. Mar. 16, 2010). The case was complex. As the court said:
This is round two of a bout between sophisticated, experienced parties who have woven a complex web of overlapping contracts, agreements, and duties that the Court must now untangle and interpret in order to make sense of who among these sophisticated parties owes whom what. Plaintiff seeks money he alleges defendants owe to him pursuant to a limited liability company agreement.
The counterclaims include misappropriation of trade secrets, breach of fiduciary duty, breach of the implied covenant of good faith and fair dealing, and breach of contract.
Kuroda, 2010 Del. Ch. LEXIS 57, at *1, 2.
Kuroda provided consulting services to an investment firm LLC in which he was a non-managing member. He later left the company, started a competing investment firm, and allegedly used investor lists and market strategies from the first company in his own business. Francis Pileggi has provided a compete synopsis of the case here, and Larry Ribstein has commented on the court’s treatment of the fiduciary duty elements of the case here.
Kuroda was a party to a consulting agreement with the LLC containing confidentiality provisions. The defendants, however, did not base their trade secret misappropriation claim on the consulting agreement because it would have required arbitration in Japan. The defendants instead argued that the LLC agreement’s implied covenant of good faith and fair dealing imposed a confidentiality obligation on Kuroda.
The court described the implied covenant of good faith and fair dealing as inhering in every contract, and requiring a contract party to refrain from arbitrary or unreasonable conduct that would prevent the other party to the contract from receiving the “fruits of the bargain.” Kuroda, 2010 Del. Ch. LEXIS 57, at *39. The court noted that the implied covenant does not constitute a free-floating duty on contracting parties, but instead is used to ensure that the parties’ reasonable expectations are fulfilled. The implied covenant has a narrow purpose and is therefore only rarely invoked successfully. Kuroda, 2010 Del. Ch. LEXIS 57, at *39, 40.
The court refused to invoke the implied covenant of good faith and fair dealing to create a confidentiality obligation in the LLC agreement. Noting that the defendants used confidentiality provisions in other documents related to the LLC, but not in the LLC agreement itself, the court said “any use of the implied covenant to insert a contractual duty of confidentiality into the LLC Agreement would be an override of the express terms of that agreement.” Kuroda, 2010 Del. Ch. LEXIS 57, at *40, 41.
An LLC manager seeking to prevent a member from disclosing or using the LLC’s information might wonder whether state trade secret law would impose a duty of confidentiality on the member. In most states the Uniform Trade Secrets Act (USTA) will apply. (According to the National Conference of Commissioners on Uniform State Laws, 47 states have adopted the USTA.)
Business people often think that any private or semi-private information about an LLC, its members or its business is legally protected. The USTA does not reach that far, however. For there to be an actionable misappropriation under the USTA, the member must have acquired the information by improper means, or acquired the information under circumstances giving rise to a duty to maintain its secrecy or limit its use. Del. Code Ann. tit. 6, § 2001. A non-managing LLC member may have been legitimately exposed to the LLC’s information, or may have obtained the information from the LLC by making a request under the state statute, and without a contractual commitment there will not be a duty. The result is different if the member is a manager, because then the manager’s fiduciary obligations will create a duty to not disclose the LLC’s information.
Even if the member is a managing member, not all LLC information will be a protectable trade secret. To be a trade secret under the USTA, the information must derive independent economic value from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use. It must also be the subject of efforts that are reasonable under the circumstance to maintain its secrecy. Id.
So, trade secret law may not protect the LLC’s information unless the members have a contractual obligation not to disclose or use the information. And the Kuroda case underscores the need for express confidentiality provisions in the LLC agreement. Lawyers who assist clients in the formation of LLCs should consider adding confidentiality provisions to their LLC checklists and form agreements.
The Colorado Court of Appeals held last month that creditors as a group have standing to sue members of an LLC who receive distributions knowing that the distributions were made when the LLC was insolvent. Colborne Corp. v. Weinstein, No. 09CA0724, 2010 Colo. App. LEXIS 58 (Colo. App. Jan. 21, 2010).
The Colorado LLC Act bars LLCs from making distributions to members if the LLC’s liabilities would exceed its assets after the distribution. Colo. Rev. Stat. § 7-80-606(1). The Act also provides that a member who receives a distribution in violation of the rule, with knowledge of the violation at the time of the distribution, is liable to the LLC to return the amount of the distribution. Colo. Rev. Stat. § 7-80-606(2).
The Act only speaks of the member’s liability to the LLC – it says nothing about rights of the LLC’s creditors. Can an LLC’s creditor sue a member directly for knowingly receiving an improper distribution under Section 606 of the Act? That was the question in Colborne.
The Court of Appeals pointed out that a similar provision in the Colorado Business Corporation Act (CBCA) had been interpreted to give creditors standing to directly sue a corporation’s directors. See Paratransit Risk Retention Group Ins. Co. v. Kamins, 160 P.3d 307 (Colo. App. 2007). The CBCA holds corporate directors liable to the corporation for authorizing distributions if the corporation would be insolvent after the distribution. Colo. Rev. Stat. § 7-108-403. The Paratransit court held that the corporate creditors had standing to sue the directors directly for authorizing improper distributions.
The Colborne court found the reasons for extending standing to creditors to be as applicable to LLCs as they were to corporations. The purpose of Section 606 is to protect the LLC’s creditors, said the court, and to not allow creditors to sue members directly would “substantially undercut the purpose of a statute enacted to protect creditors from self-dealing managers and members.” Colborne, 2010 Colo. App. LEXIS, at *9.
The Court of Appeals had previously held that managers of an insolvent LLC owe the LLC’s creditors a limited fiduciary duty to abstain from favoring their own interests over those of the creditors. Sheffield Servs. Co. v. Trowbridge, 211 P.3d 714 (Colo. App. 2009). The Colborne court applied the Sheffield rule and held that Colborne Corp.’s complaint alleged sufficient facts to state a claim, even though the complaint did not explicitly allege that the managers favored their interests over Colborne’s.
The court held in conclusion that creditors of an insolvent LLC (a) have standing as a group to sue members of the LLC for knowingly receiving unlawful distributions, under Section 7-80-606 of Colorado’s LLC Act, and (b) are owed a limited fiduciary duty by the LLC’s managers to abstain from favoring their own interests over those of the creditors.
Many state LLC statutes have provisions similar to Section 606(2) of the Colorado Act. E.g., Del. Code Ann. tit. 6, § 18-607; Wash. Rev. Code § 25.15.235. But neither Delaware nor Washington has case law interpreting whether an LLC creditor has standing to sue a member for knowingly receiving an unlawful distribution, i.e., when the LLC was insolvent.
Colborne is interesting because the court found a remedy for LLC creditors based on the statute, even though the language of the statute only obligates the members to return unlawful distributions to the LLC. Section 606 says nothing about creating a cause of action for the LLC’s creditors. The court relied heavily on Section 606’s perceived policy of protecting creditors, and analogized to the similar result on the corporate side. Still, one might have thought that if the Colorado legislature wanted to allow creditors of an LLC to sue members directly for the return of distributions, it could have said so.
Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.
Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.
According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.
Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.
Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.
Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.
The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.
The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.
Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.
The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.
Texas has joined the seven other states that have authorized series LLCs. The Texas bill authorizing series LLCs was signed by Governor Perry in May and will become effective on September 1, 2009. S.B. 1442. The states that currently authorize series LLCs are Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee and Utah.
Most state LLC acts allow an LLC to provide for classes of members with different member rights per class. But a series LLC can go further by establishing multiple series of assets, members and managers. The debts and obligations of a series will be enforceable only against the series’ assets, and will not be enforceable against the other series in the LLC or against the LLC generally, and vice versa. The members associated with a series can be given separate rights and duties with regard to the assets of the series.
The separation of assets and partitioning of liabilities between series, all within one LLC, can avoid many of the inefficiencies and costs associated with multiple related entities. For example, a series LLC could be used to hold multiple parcels of real estate, each in a separate series and all within the one LLC. Or, separate divisions of a business could be held by one LLC, but with each division in a separate series.
The Texas statute is similar in many respects to the Delaware act. Both authorize an LLC’s operating agreement to establish one or more designated series. Both acts provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if
(a) the records of the series account for its assets separately from the assets of any other series or the LLC generally,
(b) the operating agreement states the liability limitations, and
(c) the certificate of formation gives notice of the limitations on liability.
Each series may in its own name sue and be sued, contract, and hold title to its assets, including real estate and personal property.
Series LLCs can be useful, but there are legal uncertainties involved in their use. Series LLCs are relatively new – Delaware was the first state to authorize series LLCs, in 1996, and there is almost no case law on them. Major areas of uncertainty involve taxation, bankruptcy, and doing business in multiple states.
There are many open tax questions with regard to series LLCs. Although the Internal Revenue Service issued a Private Letter Ruling in 2008 and clarified that each series’ federal tax characterization is determined independently, other state and federal tax questions remain.
It is unclear whether an LLC series will be treated as a debtor in federal bankruptcy court, or whether the bankruptcy court will ignore the series and only consider the entire LLC. The result may depend on whether the relevant state law will treat the series as a separate entity with its own liability shield.
Including Texas there are now eight states whose LLC acts authorize series LLC, but that leaves 42 other states with no series provisions in their acts. It is not at all clear what the courts of a non-series state would do when faced with a claim by a local creditor against an out-of-state series LLC formed under the laws of, say, Delaware. Will the non-series state honor the series structure and respect the internal liability shield? Would a non-series state even allow a series of an LLC formed under the laws of another state to register to transact business in the non-series state?
The law of series LLCs is an infant, still a little unsteady on its feet. But at one time LLCs were new and LLC law was the infant. There were many articles back then pointing out the uncertainties and risks of using LLCs when they were first adopted by Wyoming in 1977 and later by other states. Many conservative lawyers recommended against using LLCs in the early years of their authorization by the various states, but eventually all the states authorized LLCs. Today LLC law is more mature and LLCs are the most popular entity form for new businesses. History predicts that the question for series LLCs is not whether they will become routinely used, but when.
LLCs sometimes reach a point where the owners or managers disagree on business issues and find themselves unable to reach agreement on any course of action. This can happen because the members or managers have equally balanced voting power or because their LLC agreement requires a supermajority vote that neither side can reach. A long-running deadlock can be a huge problem for a business, since it will keep the company from responding to business changes. What’s the owners’ remedy then?
Sometimes the LLC agreement will have a solution. For example, the agreement may have a “cut and choose” provision, so that either side can initiate a buyout process that will leave one or the other with full ownership of the company. That may or may not be practicable, and in many cases the agreement simply has no answer for a deadlock.
If the agreement has no solution for deadlock, the parties are forced back to their state’s LLC statute. In Fisk Ventures, LLC v. Segal (Jan. 13, 2009), one member of a Delaware LLC asked the Court of Chancery to order dissolution, citing Section 18-802 of Delaware’s LLC Act. This section is short and sweet:
On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.
NCCUSL’s Revised Uniform LLC Act and many state statutes have similar provisions. Note that the operative word is “may” – the court has discretion. And the test is not one of oppression or wrong-doing, but simply a question of carrying on the business in conformity with the agreement.
In Fisk, the LLC agreement provided for a five-member Board to manage the LLC. One faction had three Board members; the other faction had two. (One side was dominated by the founder, the other by subsequent investors.) The agreement required a vote of 75% of the Board for most actions, including dissolution, and neither side could muster four Board members. The agreement provided no mechanism for resolving a stalemate. For five years the two factions had been in disagreement about financing and other issues. The result: five years of deadlock.
The court found that as a result of the deadlock and the Company’s inability to raise capital, the company had “no office, no employees, no operating revenue, and no prospects of equity or debt infusion,” and that there was effectively no business to operate.
Dr. Segal, however, argued that the LLC agreement did provide a means of navigating around the deadlock, because the agreement granted Fisk Ventures, the plaintiff seeking dissolution, a “put” right. The put meant that Fisk could require the company to buy Fisk’s interest in the company for its fair value. The agreement provided for the price to be determined by an independent valuation, and to be paid either in cash at closing or in time payments over two years, based on the amount. Exercise of the put was at Fisk’s discretion.
The court found that the existence of Fisk’s optional put right did not resolve the deadlock, and refused to force Fisk to exercise its put. The court analyzed the put as an independent, economic right that was not a remedy for the deadlock. In the court’s words, “it would be inequitable for this Court to force a party to exercise its option when that party deems it in its best interests not to do so.” The court emphasized the primacy of freedom of contract under Delaware’s LLC Act: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Section 18-1101(b).
Once the court had concluded that Fisk’s put was not relevant to whether it was “reasonably practicable to carry on the business” in conformity with the LLC agreement, and given the dismal five-year history of the company, the court easily found that the company should be dissolved. Under the LLC Act, of course, once dissolved the company would have to be wound up in accordance with Section 18-801.
The 75% supermajority requirement may have been intended to prevent a bare majority from dominating or oppressing the minority, but here it led to a different type of bad result. The agreement did not provide for a way to resolve a deadlock, and the put apparently turned out to be an unsatisfactory mechanism for its holder.
The obvious moral for founders and investors (and their counsel) is to think hard about the contingencies when the LLC is being formed and when new investors come in. Concentrate not only on the upside of the proposed business deal but also on the alternative scenarios, and address the potential for deadlock. This is basic risk analysis – not easy, as evidenced by our recent history, even for highly experienced investors and business people. There’s no substitute for probing the parties’ assumptions and asking the hard questions.