Massachusetts Court Disregards Contribution of Services When Calculating Members' Votes Because LLC's Records Didn't Specify Value of the Services

Members of a Massachusetts LLC can file a derivative lawsuit on behalf of the LLC only if a majority of the members other than the defendant approve the lawsuit. Unless the LLC’s operating agreement provides otherwise, the members’ votes are determined by the value of their contributions as shown in the records of the LLC.

Last month the Massachusetts Appeals Court ruled on a dispute over calculation of the members’ votes on an LLC’s derivative lawsuit. The court refused to include one member’s affirmative vote because his contribution consisted of services for which neither the operating agreement nor the LLC’s records specified a value, notwithstanding that the operating agreement gave him a 31.29% interest in the LLC. Williams v. Charles, 996 N.E.2d 475 (Mass. App. Ct. Oct. 3, 2013). As a result there were not enough votes to authorize the derivative claims, which were dismissed.

Background. Brent Williams and several others were members of Frowmica, LLC, a Massachusetts LLC. The lawsuit began when Williams and another member sued a member-manager of Frowmica for breach of fiduciary duties, misappropriation, conversion, and freeze-out. The claims were made derivatively, on behalf of Frowmica.

The trial court determined that the plaintiffs lacked a majority because they had contributed only 42.5% of the total contributions, and dismissed the derivative claims for lack of standing. The issue on appeal was whether Williams’ contribution to Frowmica, which was in the form of services rather than cash, should be included in calculating the votes in favor of the derivative suit. Id. at 476.

The relevant portion of Massachusetts’ LLC Act states:

Except as otherwise provided in a written operating agreement, suit on behalf of the limited liability company may be brought in the name of the limited liability company by:

(a) any member or members of a limited liability company, whether or not the operating agreement vests management of the limited liability company in one or more managers, who are authorized to sue by the vote of members who own more than fifty percent of the unreturned contributions to the limited liability company determined in accordance with section twenty-nine; provided, however, that in determining the vote so required, the vote of any member who has an interest in the outcome of the suit that is adverse to the interest of the limited liability company shall be excluded[.]

Mass. Gen. Laws ch. 156C, § 56. The Frowmica operating agreement did not address how the members could authorize the LLC’s lawsuit, so the court had to apply Section 56 and determine the unreturned contributions in accordance with Section 29.

Section 29 provides a default rule that profits and losses of an LLC are to be allocated “on the basis of the agreed value as stated in the records of the limited liability company of the contributions of each member to the extent they have been received by the limited liability company and have not been returned.” Mass. Gen. Laws ch. 156C, § 29(a).

Section 2(3) of the LLC Act includes services rendered and obligations to perform services in the definition of contribution. The court agreed with the plaintiffs’ contention that neither Frowmica’s operating agreement nor the statute required that contributions be in cash or property, and that Williams had contributed services to Frowmica.

But the court pointed out that neither Frowmica’s operating agreement nor its other records identified a value for Williams’ contribution of services. Exhibit A to the LLC’s operating agreement showed each member’s initial cash contribution and the member’s percentage interest in the LLC. A cash contribution amount is listed for every member except Williams, for whom a zero is shown. But each member, including Williams, is shown with a percentage interest. Williams’ percentage interest is the second largest, at 31.29%.

The plaintiffs argued that Williams’ 31.29% interest in Frowmica reflected the agreed value of his service contributions to the LLC. That would appear to be a compelling argument, except that Section 20(c) of the LLC Act says that a member may be admitted and may receive an interest in an LLC without making a contribution. The court therefore refused to draw the inference that Williams’ 31.29% interest in the LLC represented the agreed value of his contribution, since he could have received his interest for no contribution. Williams, 996 N.E.2d at 479-80. The court was also unpersuaded by the plaintiffs’ arguments, that the operating agreement’s provisions that called for allocations of profits and losses and for voting on other issues to be determined by the members’ percentage interests, supported voting by percentage interests on deciding to bring a derivative suit. Id. at 480.

Comment. The lesson of this case for lawyers is to cover all of the possible voting situations in an LLC’s operating agreement. Massachusetts’ LLC Act provides for great flexibility in member voting. An operating agreement may grant all members, identified members, or classes of members the right to vote on any matter. Voting may be on a per capita, number, financial interest, class group, or any other basis. Mass. Gen. Laws ch. 156C, § 21(b).

The Frowmica operating agreement called for profit and loss allocations to be made in proportion to the members’ percentage interests, and it called for voting by percentage interests in determining whether to challenge the manager’s performance. In hindsight, a similar provision could have been added to specify that member voting on whether to bring a derivative suit would be in proportion to the members’ percentage interests. Alternatively, a catch-all provision could have been added, to provide that member voting would be in proportion to the percentage interests in the case of any member decision not otherwise enumerated in the operating agreement.

New York LLC Derivative Suit Fails for So Many Reasons

Judge Karas thoroughly dissects the plaintiff’s derivative and other claims in Cordts-Auth v. Crunk, LLC, No. 09-CV-8017, 2011 U.S. Dist. LEXIS 109600 (S.D.N.Y. Sept. 27, 2011). The opinion usefully sheds light on some of the corners of New York law on LLC derivative suits.

Plaintiff Renate Cordts-Auth filed suit on September 18, 2009, asserting: 

●         derivative claims for breach of fiduciary duty, tortious interference with contract,   and legal malpractice;

●         a direct claim for breach of contract; and

●         equitable claims for an accounting, access to records, and a declaratory judgment that she was a member of Crunk, LLC at the time of the claimed wrongdoing.

The defendants moved to dismiss the lawsuit, and for purposes of the dismissal motions the court assumed the truth of the following facts, as asserted in the complaint.

Background.  Cordts-Auth was a long-time employee of Sidney Frank Importing Company (SFIC), and also assisted its owner Sidney Frank in the operation of Crunk, LLC, a New York limited liability company. In 2005 Cordts-Auth was granted Performance Units in Crunk as consideration for her services. Her interest in the Performance Units was limited to the company’s post-grant-date appreciation, based on an appraisal at the time of grant.

Sidney Frank, the CEO of SFIC and Crunk, died in 2006. His daughter Catherine Halstead (Halstead) became Chairwoman of SFIC and manager and principal executive of Crunk. Her husband, Peter Halstead, became an advisor to Crunk’s management, including Cordts-Auth. Two months later, Peter informed Cordts-Auth that Halstead intended to devalue Crunk’s Performance Units and issue new units, to restructure Crunk and re-launch the company with new investors, and to defraud Crunk’s existing investors.

Cordts-Auth informed Halstead of her objections to the restructuring in February, 2007. Shortly thereafter she was removed by Halstead from her positions at SFIC and Crunk. A month later Cordts-Auth, SFIC, and Crunk entered into a separation agreement, under which Cordts-Auth agreed to resign from her positions with the companies and was paid $2 million.

Three weeks after execution of the separation agreement, Halstead wrote to Cordts-Auth. Halstead informed her that Crunk had lost $1.5 million in 2006, that Crunk had been projected to lose its remaining cash investments during the upcoming fiscal year, and that Crunk had been sold to Solvi Brands, LLC as of February 28, 2007, nine days before the date of the separation agreement. Cordts-Auth was informed that she would receive nothing for her Performance Units because the Crunk sale proceeds were less than the minimum required for the Performance Units to have any value. Two months later Crunk was dissolved.

In February 2009 Cordts-Auth requested from the re-launched Crunk an accounting of Crunk’s sale proceeds. In March 2009 she demanded a copy of the sale agreement between Crunk and Solvi, and the identities of all former interest-holders in Crunk and all current interest-holders in Solvi. Her requests were rejected and she filed the lawsuit several months later.

Analysis.  The court began by reviewing Cordts-Auth’s claims to determine whether they were direct (made in her own right) or derivative (asserted on behalf of the LLC). The court applied New York law because Crunk was a New York LLC. Under New York law, a claim is considered to be derivative if the claim is for wrong done to the LLC. Id. at *15. The court viewed Cordts-Auth’s claims for breach of fiduciary duty, tortious interference, and legal malpractice as claims for injury to the LLC, and therefore characterized them as derivative claims.

Standing.  The court next examined whether Cordts-Auth had standing to maintain the derivative claims. New York law requires that the plaintiff in an LLC derivative suit must have been a member of the LLC both at the time of the offending conduct and at the time the lawsuit is commenced, Id. at *17. (Many states, e.g. Delaware and Washington, have similar requirements.)

Crunk’s operating agreement set forth the requirements for an individual to be admitted as a member. The agreement required that Crunk’s Board determine the nature and amount of the Unit Consideration to be made by the individual, and the Unit Consideration must be received by the LLC. Unit Consideration is defined to be “cash or property” – services are not included. The Board made no such determination in Cordts-Auth’s case, and no Unit Consideration was paid by Cordts-Auth.

Crunk’s operating agreement also required that members holding two-thirds of Crunk’s Class A Units consent in writing to the admission of a member. That never happened. Cordts-Auth pointed out that she was listed on the operating agreement’s exhibit as a member, but the court found that the exhibit did not overcome the operating agreement’s clear membership requirements.

The court concluded that Cordts-Auth never became a member but instead was an assignee, a non-member holder of Performance Units. “Therefore, Plaintiff has failed to adequately plead that she ever attained membership in Crunk, and the Court dismisses her derivative claims on this ground alone.” Id. at *25-26.

Not content to rest on that branch of the analysis, the court also examined Cordts-Auth’s status at the time of filing the lawsuit. Cordts-Auth didn’t dispute the defendants’ contention that she was not a Crunk member when she filed suit, but she asserted that she fell within an equitable exception that applied where the transaction was fraudulent. The court found that although Delaware recognizes the equitable exception, no New York courts had applied a fraud exception to a New York LLC.

But even assuming that New York courts would apply an equitable exception to the continuous ownership requirement, the court found that Cordts-Auth did not fit into the exception. The fraud exception applies if the transaction was fraudulent and the transaction was done merely to eliminate derivative claims. Cordts-Auth alleged that the transaction was fraudulent, but not that its purpose was to eliminate derivative claims. She had no claims pending at the time of the Crunk sale, so eliminating a potential derivative suit was unlikely to have been the motivation for the transaction. Id. at *31.

Another equitable exception can apply if both the acquired company and the surviving company have engaged in wrongful or fraudulent conduct. The court found that Cordts-Auth did not allege any wrongful or fraudulent conduct by Solvi, the surviving company, so this exception did not apply. Cordts-Auth therefore lacked standing to pursue the derivative claims. Id. at *33.

Demand Requirement.  Although the court found that Cordts-Auth did not have standing because she was not a member of Crunk at either of the required times (time of wrongdoing, and time of commencement of suit), it nonetheless proceeded to analyze whether Cordts-Auth had satisfied the demand requirements of a derivative lawsuit, and concluded that she had not.

There are two elements of the demand rule. The first component is procedural. Federal Rule of Civil Procedure 23.1 and the New York Business Corporation Law both require that a complaint which asserts a derivative claim must state with particularity the plaintiff’s efforts to obtain the desired action from the LLC’s managers, and the reasons for not obtaining the action or making the effort. The second component is substantive and addresses whether the demand was adequate to inform the managers of the potential cause of action so they could address the claim.

The defendants also contended that Cordts-Auth had a conflict of interest, because she was asserting on behalf of the LLC its claims against alleged wrongdoers, while at the same time pursuing her own personal claims directly against the LLC. The court dismissed that contention, because Cordts-Auth no longer held any interest in Crunk and would not receive any return as a member from the LLC’s claims.

The court found that Cordts-Auth’s complaint satisfied the particularity requirement, because it had adequate details about her demands and included copies of two demand letters she had sent to the defendants. But the substance of her demand was inadequate because it did not clearly relate to the derivative claims she was seeking to assert. She had demanded documents and information about the Crunk sale but had not mentioned potential causes of action or damages.

Cordts-Auth argued that demand would have been futile, which can excuse a failure to make demand. The court rejected this argument because Cordts-Auth did not fail to make a demand, but rather had made an inadequate demand that was refused by management. “Accordingly, the Court finds that Plaintiff has not satisfied the demand requirement, as required under New York law, and that she therefore may not pursue her derivative claims.” Cordts-Auth, 2011 U.S. Dist. LEXIS 109600, at *48.

Substance of Claims.  After holding that Cordts-Auth’s derivative claims failed both because she lacked standing and because she had not satisfied either of the demand requirements (particularity and adequacy), the court then discussed the substance of some of her derivative claims in a long footnote 14. Id. at *48-53. The court didn’t rule on those issues, but expressed its skepticism about their viability.

Cordts-Auth claimed that both Crunk and Solvi breached fiduciary duties that they owed to her. Under New York law, corporations do not owe fiduciary duties to shareholders. Apparently no New York court has addressed the analogous issue for LLCs, but the court found it reasonable to extend the corporate rule to LLCs. Neither Crunk nor Solvi owed fiduciary duties to Cordts-Auth, so there could be no breach of fiduciary duties.

Cordts-Auth claimed that Solvi and the Solvi investors had tortiously interfered with her Crunk operating agreement, by inducing Crunk to sell its assets to Solvi in violation of the operating agreement. The court found it doubtful that Cordts-Auth could demonstrate that the Solvi investors induced the sale of Crunk to Solvi merely by investing in Solvi, and questioned whether the sale constituted a breach of the Crunk operating agreement.

Cordts-Auth also asserted a constructive trust claim, on the theory that her Performance Units were wrongfully transferred, but the court rejected that claim because the Performance Units were not transferred but were canceled when Crunk was dissolved.

Breach of Contract.  Cordts-Auth asserted a direct claim, in her own right, for breach of contract against Crunk and Halstead. She alleged that their failure to give her notice of Crunk’s impending sale to Solvi violated Crunk’s operating agreement.

The court dismissed Cordts-Auth’s breach of contract claim against Crunk because Crunk was not a party to its operating agreement, which is an agreement between the Crunk members. “The plain language of the Crunk Agreement, and common sense, make clear that Crunk was not a party to the Crunk Agreement, and therefore could not have breached it.” Id. at *54.

(A Delaware LLC, in contrast, is bound by its operating agreement and therefore could be in breach of its own operating agreement. “A limited liability company is bound by its limited liability company agreement whether or not the limited liability company executes the limited liability company agreement.” Del. Code Ann. tit. 6 § 18-101(7).)

The court also dismissed Cordts-Auth’s breach of contract claim against Halstead. Cordts-Auth claimed that Halstead was obligated to give a “Drag Along Notice” of the impending Crunk sale. The Drag Along Notice only applied, however, if a majority of the selling Crunk members wished to force a minority to participate in a sale of their member interests. The Crunk sale was an asset sale and not a sale of member interests, so the Drag Along Notice did not apply. Further, Halstead had an optional right, but not an obligation, to give a Drag Along Notice. (No notice was required if Halstead did not exercise her Drag Along Right.) The court dismissed Cordts-Auth’s claim: the Drag Along Notice did not apply to Crunk’s asset sale and Halstead was not obligated to give the notice in any event, so there was no breach.

Accounting, Books and Records, and Declaratory Relief.  Cordts-Auth asked for an accounting of the proceeds from Crunk’s sale. The court dismissed that claim, because a party seeking an accounting must establish the existence of a fiduciary relationship, and Cordts-Auth was not ever a member of Crunk and therefore failed to establish the existence of a fiduciary relationship. Additionally, her accounting claim named only Solvi and Crunk, and as the court previously noted, a New York LLC owes no fiduciary duties to its members.

Cordts-Auth also asked for access to Crunk’s books and records, and a declaratory judgment that she was a member of Crunk at the time of sale. Those claims were dismissed because only LLC members have rights to the LLCs books and records, and the court had already determined that Cordts-Auth had not been and was not a member of Crunk.

Conclusion.  All of Cordts-Auth’s claims were dismissed, and her derivative claims were dismissed on several grounds. The opinion will bear study by any New York practitioner analyzing a client’s potential LLC derivative suit.

 

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.

Delaware Court Interprets LLC Act to Bar Derivative Suit by Creditor of Insolvent LLC

 

The Delaware Court of Chancery decided earlier this month 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. CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220 (Del. Ch. Nov. 3, 2010). The court’s lengthy opinion is nicely summarized by Francis Pileggi, here.

 

This blog post focuses on only one aspect of the opinion – its treatment of the interplay between the LLC Act’s statutory provisions and the judicially-created, derivative-suit remedy available to the courts under their general equity jurisdiction. My thesis is that the court gave unduly short shrift to the equitable underpinnings of the derivative suit.

The CML ruling is in contrast to the rule for corporations. Creditors of an insolvent corporation do have standing in Delaware to bring derivative claims. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).

The CML conclusion surprised many practitioners. The court itself admitted the “awkward fact” that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing [a derivative] suit.” CML, 2010 Del. Ch. LEXIS 220, at *12.

The result is surprising because it is inconsistent with the corporate rule and with the policy behind that rule. The policy of the corporate rule was noted by the court: “When a corporation is insolvent, the creditors become ‘the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’” Id. at *6 (quoting Gheewalla, 930 A.2d at 102).

That policy applies as much to an insolvent LLC as it does to an insolvent corporation. If the entity is insolvent, the members’ or shareholders’ economic interest in the LLC or corporation has been wiped out. The creditors then in effect stand in the shoes of the members or shareholders.

The CML court’s conclusion turned on its analysis of Sections 18-1001 and 18-1002 of the Delaware LLC Act:

 

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.

 

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.

 

(Emphasis added.) The court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as mandating that the plaintiff must be a member or an assignee of a member. CML, 2010 Del. Ch. LEXIS 220, at *7-8.

The court did not discuss Section 18-1002’s references to “a member or an assignee.” Creditors of an insolvent LLC, like assignees of member interests in a solvent LLC, hold the economic interest in the LLC and become the principal constituency injured by fiduciary breaches. It’s hard to see why such a creditor should not be treated like an assignee of the members’ interests. And assignees are explicitly granted standing in Section 18-1001 to initiate a derivative suit.

The court also did not discuss in any detail the equity-court origins of the derivative-suit remedy. The court’s disregard of the history of the derivative suit led it to conclude that Sections 18-1001 and 18-1002 are the sole source of authority for an LLC derivative suit. CML, 2010 Del. Ch. LEXIS 220, at *8-9.

That analysis contrasts with the court’s view of Section 327 of the Delaware General Corporation Law (DGCL). Section 327 states: “In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law.” The CML court characterized Section 327 as not creating the right to sue derivatively and as not saying that only stockholders can sue derivatively. CML, 2010 Del. Ch. LEXIS 220, at *10 (citing Schoon v. Smith, 953 A.2d 196, 204 (Del. 2008)).

The reason why Section 327 does not create the right to sue is that the derivative-suit remedy was a judicial creation. Schoon describes at length how the right of shareholders to sue derivatively originated in the equity courts in order to prevent a failure of justice, and how the shareholder derivative suit was later restricted by Section 327 to prevent strike suits. Schoon, 953 A.2d at 201-03.

Delaware courts have applied equitable remedies to LLCs even when the remedy is not set forth in the LLC Act, pursuant to the courts’ general equity powers. E.g., Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113-VCN, 2010 Del. Ch. LEXIS 184 (Del. Ch. Sept. 2, 2010) (appointment of a receiver). Consistent with those cases, Delaware presumably would have applied the derivative-suit remedy to LLCs even if Delaware’s LLC Act made no mention of derivative suits.

The long history of the derivative-suit remedy and the courts’ willingness in general to assert equitable remedies imply that the LLC Act should not be viewed as the sole authority for LLC member derivative suits. And if so, one should read Sections 18-1001 and 18-1002 together, interpreting them much as DGCL Section 372 has been interpreted. Under that reading, the “must” in Section 18-1002 is seen as applying the contemporaneous ownership requirement to the subset of derivative suits instituted by an LLC member, and Section 18-1002 does not close the courthouse doors to a creditor bringing a derivative suit in the name of an insolvent LLC.

The CML court was troubled by the fact that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” CML, 2010 Del. Ch. LEXIS 220, at *12. The court never answered the obvious question – why is that? The answer is that the court’s perfunctory treatment of the history of the derivative-suit remedy and its disregard of its own general equity jurisdiction resulted in an outré and anomalous conclusion.

Oregon Clarifies LLC Derivative Suit Requirements

The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.

 

The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.) 

 

The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna.

Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).

 

The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.

 

The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.

 

Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.

 

The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.

 

The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.

 

The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.