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.
Delaware Supreme Court Upholds Bar on Derivative Suits by Creditors of Insolvent LLCs
During the past two months I have been on an extended vacation – very nice. Thanks to my colleagues Janet Jacobs and John Laney for guest-authoring posts, here and here.
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 on Both Sides of Transaction Breach Delaware's Entire Fairness Standard
LLC managers tempted by the old saw “no harm, no foul” should read William Penn Partnership v. Saliba, No. 362, 2010, 2011 Del. LEXIS 91 (Del. Feb. 9, 2011). The case shows that LLC managers having a conflict of interest in an LLC’s transaction must do more than ensure that the deal is economically fair to the LLC. They must also use fair procedures and comply with the LLC agreement.
The LLC managers in William Penn were members of the LLC, and they were also investors and directors of a corporation (Buyer) that wanted to purchase the LLC’s motel, its only substantial asset. Two of the other members did not want the motel sold, and if the sale could not be stopped they wanted to purchase the motel themselves. The mangers proceeded to manipulate the LLC’s sale and approval process through repeated material omissions and misrepresentations to the other members, and failed to hold a vote as required by the LLC agreement. The property was sold to Buyer, and the other members sued the managers for breach of fiduciary duties.
The LLC’s operating agreement was silent on the managers’ fiduciary duties, so the court found that they owed the traditional fiduciary duties of loyalty and care to the LLC’s members. William Penn, 2011 Del. LEXIS 91, at **14-15. Because of their financial interest in both the LLC and the Buyer, the managers bore the burden of demonstrating the entire fairness of the transaction. Id. at **15.
The entire fairness standard requires that the fiduciary demonstrate both fair dealing and a fair price in the transaction. Fair dealing involves aspects such as how the transaction was structured, timing, disclosures, and approvals. Fair price addresses the economic and financial aspects of the transaction. Id. at **15-16. The managers argued that the deal was entirely fair because the purchase price was more than the appraised value, but the court pointed out that both elements of the entire fairness test must be satisfied.
The Delaware Supreme Court found ample evidence in the record to support the Chancery Court’s conclusion that the managers breached their fiduciary duties. They prevented a fair and open process by a variety of machinations – withholding full information, providing misleading information, and imposing an artificial deadline on the transaction. Id. at **20.
In order to determine damages, the Chancellor ordered an appraisal of the property. The appraisal came in at $5.58 million, less than the $6.6 million the property had been sold for, leaving the plaintiffs with no conventional damages remedy.
Not to be balked by the rule that litigants normally bear their own legal fees, the Chancery Court used its equitable power and awarded attorneys’ fees to the plaintiffs. The Supreme Court found that there was no abuse of discretion: “The Chancellor’s decision to award attorneys’ fees and costs was well within his discretion and is supported by Delaware law in order to discourage outright acts of disloyalty by fiduciaries.” Id. at **22.
“No harm, no foul” didn’t work – even though the managers’ breach of fiduciary duties did not result in damages to the other members, the court nonetheless stung them with an award of the members’ attorneys’ fees.
Bankruptcy Panel Enforces LLC Agreement's Prohibition on Bankruptcy Filing
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.
Appointment of Receiver Upheld for Delaware LLC
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.
Kansas Applies Delaware Law -- Assignee of LLC Interest Is Not Automatically Admitted as a Member
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.
LLC's Creditors Have Standing to Sue Members for Unlawful Distributions
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.
New York Court Holds Distribution Was Not a Misappropriation
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 Joins the Series LLC Crowd
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?.jpg)
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.
Deadlocks and Puts in Delaware
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.
