Sometimes a Lie Is Fraud, But Sometimes a Lie Is Just a Lie

Lies are generally bad, but not all lies result in legal liability. In a recent case in point, a Delaware LLC member allegedly lied about his reasons for withdrawing from the LLC and about his post-withdrawal plans. After his withdrawal he competed against his former LLC, in contradiction of his prior statements. We can infer that the other members were incensed – shortly thereafter the LLC filed suit against the former member, asserting nine different counts. The Delaware Court of Chancery rejected all nine. Touch of Italy Salumeria & Pasticceria, LLC v. Bascio, No. 8602-VCG, 2014 WL 108895 (Del. Ch. Jan. 13, 2014).

Louis Bascio was one of three members of Touch of Italy Salumeria & Pasticceria, LLC, which operated an Italian grocery in Rehoboth Beach, Delaware. In October 2012 Bascio gave notice to the other members that he intended to withdraw from the LLC.

The LLC agreement provided that any member could withdraw from the LLC by giving written notice, in which case the other members had 60 days to elect to purchase the withdrawing member’s interest in the LLC. Bascio represented at the time of his resignation that he was moving to Pennsylvania to establish a new business there. He said he would not take any action that would be adverse to the LLC’s business and that he would not open any competing business in Rehoboth Beach.

The other members did not exercise their purchase option, and Bascio’s resignation was effective in December 2012. Notwithstanding his assurances about not opening a competing business, 10 weeks later Bascio and his brother opened Frank and Louie’s, a competing Italian grocery, on the same block as Touch of Italy. Touch of Italy and its members filed their lawsuit against Bascio in May 2013.

Touch of Italy alleged nine counts against Bascio: conversion, fraudulent misrepresentation, breach of contract, negligent misrepresentation, fraudulent concealment, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty, prayer for punitive damages, and injunctive relief. In June 2013 Bascio filed a motion to dismiss all claims for failure to state a claim.

As is common in business litigation, the plaintiffs asserted several causes of action based on the same underlying facts. The gist of their allegations was that Bascio “lied about his intention to open a competing Italian grocery in order to deceive the Plaintiffs and to induce their reliance on his misrepresentations, a lie in which [Bascio’s] brother, Frank, participated; and that under cover of this lie, they brought that competing entity into existence.” Id. at *4.

You may be asking yourself, where’s the noncompete? The answer is there was none, as the court repeatedly pointed out. “The Plaintiff’s allegations are best characterized as, in effect, an attempt to replicate the non-compete agreement that the parties failed to include in their LLC agreement; a deficiency that the Plaintiffs, because of changed circumstances, now regret.” Id.

Breach of Contract. The court dismissed the breach of contract claim because Touch of Italy alleged no specific acts of Bascio that would have violated the LLC agreement, either while he was a member or afterwards. The agreement detailed a member’s withdrawal procedure, but withdrawal did not require the consent of other members, and the agreement provided no post-withdrawal restrictions on a former member’s conduct. Id.

Fraud and Misrepresentation. The court dismissed the fraud and misrepresentation claims because fraud and misrepresentation require that the complainant have relied to its detriment on the alleged lies and omissions. But without an alternative course of action there can be no reliance, and the plaintiffs had no right under the LLC agreement to take any other actions, even had they known Bascio’s intentions. The LLC agreement gave Bascio the right to withdraw, and it did not bar him from competing after his withdrawal. The plaintiffs’ attorney even admitted at oral argument that if Bascio had truthfully described his intent to compete, before his departure, the members could have done nothing other than eventually bring their lawsuit. They could have complained, but as the court said, their bootless objections would have been “legally meaningless.” Id. at *5.

Implied Covenant of Good Faith and Fair Dealing. The implied covenant of good faith and fair dealing applies to all LLC agreements, Del. Code Ann. tit. 6, § 18-1101(c), and is intended to prevent a party from denying its contractual partners the benefit of their bargain based on unanticipated circumstances. Id. at *6. But resignation was provided for in the LLC agreement, and post-resignation conduct such as opening a competing business is not unforeseeable. The court accordingly dismissed the implied covenant claim. The court pointed out that covenants not to compete are commonly used to avoid the consequences of post-termination competition. Touch of Italy, 2014 WL 108895, at *6.

Breach of Fiduciary Duties. The court assumed for purposes of Bascio’s motion to dismiss that he owed fiduciary duties to Touch of Italy and its members during his membership. Touch of Italy contended that Bascio was planning to open a competing business while he was a member, but its complaint had no factual allegations of acts that would support such an intention. And Bascio’s fiduciary duties ceased once he was no longer a member.

Conversion. Touch of Italy alleged that it or one of its members owned all assets of the business, listing several categories such as bank accounts, equipment and inventory, and goodwill, and that Bascio had “exercised dominion and control over certain of the above stated assets to the exclusion” of the plaintiffs. Id. at *7 (emphasis in the original). The court dismissed the claim of conversion because the complaint referred only to categories of property and did not specify precisely what property Bascio was alleged to have converted, and alleged only that Bascio had exerted control over “certain” items within the broad categories of property. Touch of Italy had also failed to demand return of the converted property.

Equity. The court also dismissed Touch of Italy’s requests for punitive damages and for injunctive relief, because they were predicated on the other claims of wrongdoing, all of which were dismissed. The court also noted dismissively that the request for punitive damages was inappropriately pled, because Chancery is a court of equity and therefore cannot award punitive damages. “Traditionally and historically the Court of Chancery as the Equity Court is a court of conscience and will permit only what is just and right with no element of vengeance and therefore will not enforce penalties or forfeitures.” Id. at *8 (quoting Beals v. Wash. Int’l, Inc., 386 A.2d 1156, 1159 (Del. Ch. 1978)).

The court dismissed all claims with prejudice, except that the conversion claim was dismissed without prejudice in order to allow Touch of Italy to amend its complaint to specify the property it alleged was converted.

Comment. The core of the plaintiffs’ complaint was that (a) as Bascio was getting ready to withdraw from Touch of Italy, he lied by telling them that he did not intend to compete after he left the company; and (b) after he left the company he competed. But as the court noted repeatedly, Bascio was not contractually bound not to compete, he complied with the LLC agreement by giving advance notice that he would be leaving the company, and there was no reliance on his misstatements or change of position by the plaintiffs.

The court said it right: sometimes a lie is just a lie and not the basis for a successful lawsuit. Id. at *1.

Ohio Court Says Member's LLC Loan Is Also a Capital Contribution

Debt and equity are normally viewed as distinctly different financing methods – stock versus bonds, for example. In closely held companies the boundaries can be unclear, though, as a recent decision of the Ohio Court of Appeals demonstrated. Germano v. Beaujean, No. WD-12-032, 2013 WL 4790315 (Ohio Ct. App. Aug. 30, 2013).

Background. Christopher Germano and John Beaujean formed an Ohio LLC in 2007 to operate a pizza restaurant franchise. They agreed that Germano would arrange financing for the venture, Beaujean would provide on-site supervision for the restaurant and not charge a management fee, and they would share ownership equally. There was no written LLC agreement.

The parties originally intended to finance the company with bank financing, but later decided that Germano would loan his own funds directly to the LLC. Germano therefore provided a five-year, interest-only loan of $280,000 to the LLC for start-up costs, and the business commenced.

All went well for several years, but in 2010 Beaujean caused the LLC to begin paying himself a management fee, retroactive from the beginning of the business, and to begin paying a bookkeeping fee to a restaurant supply company he owned. He also transferred funds from the LLC’s bank account to a separate account that only he could access.

When Germano learned what Beaujean had done he sued for conversion, breach of fiduciary duty, and breach of the statutory duty of good faith and fair dealing. Beaujean denied the allegations and asked for a determination that he was the only member of the LLC with management authority because Germano’s $280,000 loan did not constitute a capital contribution.

The trial court found that Beaujean was not authorized to charge a management fee or bookkeeping fees, or to transfer the LLC’s funds to a separate bank account. He was ordered to repay all of the management fees and the bookkeeping fees in excess of a reasonable hourly charge.

The trial court also denied Beaujean’s counterclaim that Germano’s $280,000 loan did not constitute a capital contribution, and declared that the two owners each owned 50% of the LLC. Id. at *2.

The Capital Contribution. The Court of Appeals first examined the Ohio LLC Act:

The contributions of a member may be made in cash, property, services rendered, a promissory note, or any other binding obligation to contribute cash or property or to perform services; by providing any other benefit to the limited liability company; or by any combination of these.

Ohio Rev. Code § 1705.09(A) (emphasis added).

Consistent with the statute, the court took a broad view of what was a contribution. The court’s decision turned on two points: Germano did obtain financing for the venture, and the parties had agreed at the time the LLC was formed that Germano’s financing services were a sufficient contribution to the company. Germano, 2013 WL 4790315, at *4. The court found that Germano’s loan benefited the LLC, and under Section 1705.09(A) that benefit constituted a contribution to capital. Id.

The court consequently affirmed the trial court’s ruling that Germano’s financing services, i.e., his loan, constituted a capital contribution and that the two members shared equally in management. Id. at *6.

Comment. The court’s application of Section 1705.09(A) to Germano’s loan, and its finding that the loan was a benefit to the LLC and therefore was a capital contribution, are straightforward as far as they go. The court dropped the ball, however, in jumping from there to its conclusion that the two members shared management 50-50, with no further analysis other than its reliance on the parties’ original oral agreement that they would each be 50% owners.

The court ignored Section 1705.24 of the LLC Act:

Unless otherwise provided in writing in the operating agreement, the management of a limited liability company shall be vested in its members in proportion to their contributions to the capital of the company, as adjusted from time to time to properly reflect any additional contributions or withdrawals by the members.

Ohio Rev. Code § 1705.24 (emphasis added).

Beaujean and Germano had no written LLC operating agreement, so their oral agreement about sharing management 50-50 was ineffective. Under the statute, their management was to be shared “in proportion to their contributions to the capital of the company,” as adjusted from time to time. The determination of their respective management authority therefore could be made only by examining the value of their capital contributions, but the Germano court made no such assessment.

As a side note, there is an interesting interplay between Section 1705.24 and Section 1705.081 of Ohio’s LLC Act, but it doesn’t change the applicability of Section 1705.24. The issue is that Section 1705.081 provides that an LLC’s operating agreement governs the relations between members, except for certain listed statutory requirements. The list of statutory requirements that cannot be overridden by an LLC agreement does not include Section 1705.24. Also, the LLC Act defines an operating agreement to include written and oral agreements. Thus, Beaujean and Germano’s oral operating agreement about sharing management 50-50 would have controlled, except for Section 1705.24’s specific requirement for a written operating agreement.

Determining the value to the LLC of Germano’s loan would not be easy. It’s not the amount of the loan itself, because the loan must be repaid. Likewise, determining the value to the LLC of Beaujean’s management services, which the court saw as his contribution to capital, would be problematic. For one thing, the value of his services would increase over time, as he continued to manage the restaurant without compensation, so under Section 1705.24 his share of management authority would be adjusted and gradually would increase.

Uncertainty Over Delaware LLC Fiduciary Duties To Be Clarified

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.

Delaware Court of Chancery Retains Jurisdiction in Dispute Over LLC Member Redemption Agreements

Delaware’s Court of Chancery is not a court of general jurisdiction, and in a recent case involving an LLC’s redemption agreements, the defendant LLC sought dismissal on grounds that Chancery did not have subject matter jurisdiction. Duff v. Innovative Discovery LLC, No. 7599-VCP, 2012 WL 6097660 (Del. Ch. Dec. 7, 2012) (slip op.). Relying on provisions in Delaware’s LLC Act, the court retained jurisdiction.

Background. Edward Carp and Bruce Duff were members of Innovative Discovery, LLC, a Delaware limited liability company. In February 2012 Carp and Duff entered into two separate but identical Redemption Agreements with Innovative, and the LLC redeemed their member interests. Carp and Duff also caused Delaware Document Imaging, LLC (DDI) to enter into a License Agreement with Innovative. The License Agreement was an exhibit to each of the Redemption Agreements, and was incorporated by reference into the Redemption Agreements. Carp and Duff also entered into separate Consulting Agreements with Innovative.

Later a dispute over the Redemption Agreements arose, and Carp, Duff and DDI filed suit in June 2012 against Innovative in the Delaware Court of Chancery. They asserted claims for breach of the Redemption Agreements, the License Agreement, and the Consulting Agreements. Innovative then filed a motion to dismiss the complaint on grounds that the Court of Chancery lacked subject matter jurisdiction and that venue was improper, and for failure to state a claim.

Court’s Analysis. The court began by recognizing that the Court of Chancery is one of limited jurisdiction and that there are only three ways by which it can acquire subject matter jurisdiction over a case: (1) the invocation of an equitable right, (2) a request for an equitable remedy when there is no adequate remedy at law, or (3) a statute has conferred subject matter jurisdiction. Id. at *4. If part of a controversy involves legal as well as equitable claims, the court has discretion to decide the legal portions of the dispute as well as the equitable aspects. Id.

Innovative argued that the plaintiffs’ complaint was essentially seeking damages for breaches of the agreements and therefore there was no basis for the court’s equity jurisdiction, but the plaintiffs argued that Section 18-111 of the Delaware LLC Act conferred jurisdiction:

Any action to interpret, apply or enforce the provisions of a limited liability company agreement, or the duties, obligations or liabilities of a limited liability company to the members or managers of the limited liability company, or the duties, obligations or liabilities among members or managers and of members or managers to the limited liability company, or the rights or powers of, or restrictions on, the limited liability company, members or managers, or any provision of this chapter, or any other instrument, document, agreement or certificate contemplated by any provision of this chapter, may be brought in the Court of Chancery.

(Emphasis added.) The plaintiffs contended that Section 18-111 provided two bases for Chancery’s jurisdiction over their claim. The first was that their claim for breach of the Redemption Agreements was an action to enforce “the duties, obligations or liabilities of a limited liability company to the members.”

The plaintiffs’ second invocation of Section 18-111 was that their claim for breach of the Redemption Agreements sought to enforce an “instrument, document, agreement or certificate contemplated by any provision of this chapter.” They looked to Section 18-702(e) of the LLC Act, which states that unless otherwise provided in the LLC agreement, “a limited liability company may acquire, by purchase, redemption or otherwise, any limited liability company interest or other interest of a member.”

Innovative argued for a limited interpretation of § 18-111, contending that the phrase “may be brought” in § 18-111 means that actions of the type described in § 18-111 may only be brought if the claim involved is equitable in nature, and that even if the equity requirement is met, the Court of Chancery has discretion to decline jurisdiction. The court rejected both parts of this argument, holding that there is no requirement for an independent, equitable basis for jurisdiction if § 18-111 is satisfied, and that the court does not have discretion to decline the jurisdiction if § 18-111 is satisfied. The statute’s use of the word “may,” said the court, means that plaintiffs have a choice of filing in the Court of Chancery or in another forum, not that Chancery has discretion to decline jurisdiction when Section 18-111’s requirements are met. Id. at *6.

The court concluded that redemption agreements are explicitly contemplated by § 18-702, and that therefore § 18-111 conferred jurisdiction on the court to hear Carp’s and Duff’s claims for breach of their Redemption Agreements. Id. The court also asserted jurisdiction over the plaintiffs’ remaining claims, under the “cleanup doctrine”: “[i]f a controversy contains any equitable feature by means of which a court could acquire cognizance of it, the court may go on to a complete adjudication.” Id. at *7. The court found the claims for breach of the Redemption Agreements to be closely intertwined with the plaintiffs’ other claims, and that severing those claims would undermine judicial efficiency.

Venue. Innovative argued that the plaintiffs’ claims for breach of the License Agreement should be dismissed because that agreement had a venue clause mandating that the sole venue for any litigation was in California. The plaintiffs pointed out that the Redemption Agreements had language incorporating by reference the terms of the License Agreements, and that the Redemption Agreements had a permissive jurisdiction clause that allowed suit to be brought in Delaware.

The court read the contracts together and found the result ambiguous because of the two conflicting venue provisions. Delaware will not interpret a contractual venue provision to be exclusive unless the contractual language is “crystalline,” and the court therefore refused to dismiss the claims on the License Agreement for being brought in the wrong venue. Id. at *11-12. The court also rejected the motion to dismiss for failure to state a claim. Id. at *11.

Comment. Jurisdiction and venue are fundamental legal concepts, and it’s a treat to see the court’s dissection of them in this case.

Delaware’s Court of Chancery is highly respected for its expertise in corporate and LLC law, and is often attractive to business litigators for its expedited procedures and the absence of juries. But it is a specialized court and not a court of general jurisdiction, and this case is a good reminder that there are limits on its jurisdiction.

The good news for LLC lawyers is that most disputes involving the internal governance of LLCs, such as disputes between members, managers, and the LLC, will fall within the LLC Act’s grant of jurisdiction to the Court of Chancery at Section 18-111. Chancery’s jurisdiction is not exclusive, so a claimant can always choose an alternative forum. Delaware’s General Corporation Law provides a similar grant of jurisdiction for corporate disputes at Section 111.

The venue dispute in this case is an example of a scenario I have seen more than once: inconsistent boilerplate provisions in separate written agreements that cover different aspects of a single transaction. Often the differences in the boilerplate provisions (matters such as governing law, venue, attorneys’ fees, arbitration, etc.) are not the result of considered analysis but simply reflect the fact that the different agreements were prepared by different attorneys working on the deal but not coordinating closely enough. This case shows the result: ambiguity and unenforceability of the exclusive venue provision in the License Agreement.

Attorney Expelled from Mississippi Law Firm Is Not Entitled to Share in Proceeds of Large Contingent Fee - a Deal's a Deal

Freedom of contract is a basic principle of Mississippi’s LLC Act, but freedom of contract includes the freedom to make a bad contract. Case in point: the Mississippi Court of Appeals recently held that the plain language of a law firm’s LLC operating agreement allowed the members to expel attorney David Martindale and pay him only $1,100 for each of his 18 percentage points of his membership interest. That ruling enforced what was a bad bargain from Martindale’s point of view, because it allowed him no share in the firm’s $7,664,000 fee from a long-running contingent fee case that settled seven months after his expulsion. Martindale v. Hortman Harlow Bassi Robinson & McDaniel PLLC, No. 2010-CA-02077-COA, 2012 WL 4497756 (Miss. Ct. App. Oct. 2, 2012).

Background. Martindale practiced law with Hortman Harlow Bassi Robinson & McDaniel PLLC (the Firm) for 14 years. The Firm is a Mississippi professional limited liability company, or PLLC, which is an LLC formed for providing professional services under Article 9 of the Mississippi LLC Act. In 2006 the Firm took on the representation of an injured oil-field worker in a personal injury, contingent fee lawsuit, and devoted nearly all of its resources to the case. Martindale was not involved in the lawsuit, and questioned and criticized the Firm’s expenditures on the case.

The other members of the Firm, relying on the Firm’s operating agreement, expelled Martindale in February 2009 and tendered him a $19,800 check for his membership interest. The operating agreement allowed the members to expel a member by unanimous vote, in which case the Firm was required either to dissolve or to pay the former member $1,100 for each percentage point of his membership interest. The members opted to pay Martindale rather than dissolve.

Martindale refused the Firm’s check, and in May 2009 the Firm filed a lawsuit for declaratory relief, asking for a declaration that it had fulfilled its contractual obligations to Martindale. Four months later the contingent fee case was resolved, and the Firm received its fee of $7,655,000.

The Firm moved for summary judgment, contending that the operating agreement provided Martindale’s exclusive remedy for payment after his expulsion. The trial court found the language of the agreement to be clear and unambiguous, and granted summary judgment to the Firm.

Court of Appeals. The Court of Appeals began by reviewing the relevant provisions of the Firm’s operating agreement.

Section 9.5 of Hortman Harlow’s operating agreement states: “Upon the termination of a Member’s Membership Interest under Section 9.1(b) . . . , the other Members may elect either (1) to pay an amount equal to the terminated Members [sic] points as calculated pursuant to Section 9.2(a) less any debt to the company; or (2) to dissolve the Company . . . .” Section 9.2(a) provides the payment formula for a terminated member’s interest in the law firm: “The terminating Member shall receive an amount equal to One Thousand One Hundred and No/100 Dollars ($1,100.00), multiplied by each percentage point of Membership Interest owned by the terminating Member as set forth on Schedule “B” in lieu of his positive capital account balance . . . .”

Martindale, 2012 WL 4497756, at *2. After briefly paraphrasing the statutory language, the court found that “the only reasonable interpretation of sections 9.2(a) and 9.5 is that the parties intended for these sections to provide a member’s exclusive right to compensation upon his or her expulsion.” Id. at *3. The court therefore found the contract to be unambiguous.

Martindale argued that Section 13.10 of the operating agreement preserved his right to equitable relief, by stating that “rights and remedies [under this agreement] are given in addition to any other rights the parties may have by law, statute, ordinance or otherwise,” and that he had several grounds for equitable relief. Id. at *4.

Equity. Martindale pointed to Section 79-29-306(3)(a) of the prior LLC Act (which applied at the time of his termination): “A court of equity may enforce a limited liability company agreement by injunction or by such other relief that the court in its discretion determines to be fair and appropriate in the circumstances.” He contended that that section and two prior Mississippi cases entitled him to a more favorable equitable remedy. The court dismissed that argument, pointing out that § 79-29-306(3)(a) and the prior cases only apply if there is a breach of the operating agreement. Id.

Intrinsic Fairness. Martindale also claimed that under the Mississippi doctrine of “intrinsic fairness,” the Firm should have treated him in an “intrinsically fair” manner. This rule requires that actions of a majority stockholder toward a minority shareholder in a closely held corporation must be “intrinsically fair” when the majority stockholder stands to benefit, and the rule applies to LLCs. Id. at *5. The court, however, found “no indication they breached this duty in administering his proper payout under the contract.” Id. Martindale got the benefit of his bargain: “While Martindale’s payout is meager in light of the large settlement after his expulsion, we find Martindale received what he initially bargained for under the firm’s operating agreement.” Id.

Implied Duty of Good Faith and Fair Dealing. The court likewise dispatched Martindale’s argument that the Firm’s failure to pay him the fair value of his interest breached the Firm’s implied duty of good faith and fair dealing under the operating agreement. The court found that a party does not breach the implied covenant of good faith and fair dealing when it takes only those actions authorized by the contract. “Because Hortman Harlow could not have acted in bad faith by exercising a contractual right, we find the firm did not breach its implied duty of good faith and fair dealing under the operating agreement.” Id. at *6.

Having rejected all of Martindale’s arguments for equitable, fair, or good-faith treatment, the court affirmed the trial court’s ruling, enforcing what the Court of Appeals found to be the plain and unambiguous language of the operating agreement.

The Dissent. Three of the nine judges of the Court of Appeals dissented from the majority’s opinion. A dissenting opinion in a court of last resort, as U.S. Supreme Court Chief Justice Charles Evans Hughes wrote, “appeal[s] to the brooding spirit of the law, to the intelligence of a future day, when a later decision may possibly correct the error into which the dissenting judge believes the court to have been betrayed.” Alex Kozinski & James Burnham, I Say Dissental, You Say Concurral, 121 Yale L.J.Online 601, 602 (2012). In the Martindale case, the Court of Appeals is not a court of last resort. If David Martindale appeals to the Mississippi Supreme Court, the dissenting opinion should, like a searchlight, illuminate a more complete view of the Firm’s operating agreement than is apparent from the majority’s opinion.

The dissenting opinion includes a more extensive quotation of the relevant provisions from the Firm’s operating agreement, which is helpful. The analysis of the dissent begins with this: When a member is expelled by a unanimous vote of the other members and the members elect to pay the expelled member for his interest rather than dissolve the LLC, then under Section 9.5 they must pay the expelled member “an amount equal to the terminated Member[’]s points as calculated pursuant to Section 9.2(a) less any debt to [the] Company.” Id. at *8 (emphasis added).

An examination of Section 9.2(a) shows that it does more than provide a means to calculate how much must be paid to the departing member; it also characterizes the payment as being “in lieu of his positive capital account balance.” It is this phrase that the majority relied on. But Section 9.2(a) is part of a paragraph dealing with payments on the death or retirement of a member:

Section 9.2   Payments to Terminated Members. Upon termination of a Member’s interest because of death or retirement, the Member shall be entitled to receive from the Company the amounts set forth below:

(a)   The terminating Member shall receive an amount equal to One Thousand One Hundred and No/100 Dollars ($1,100.00) multiplied by each percentage point of Membership Interest owned by the terminating Member as set forth on Schedule “B” in lieu of his positive capital account balance.

Id. at *7. Section 9.5 only refers to the calculation method of Section 9.2(a), and if the words “in lieu of his positive capital account balance” were deleted, the calculation would be the same.

The dissent also makes the point that under Section 9.4 of the operating agreement, a disabled member’s interest is terminated “and such Member shall be entitled to receive the payments as provided under Section 9.2 of this Agreement.” Id. at *9. The dissent points out that the difference between “as calculated pursuant to Section 9.2(a)” and “as provided under Section 9.2” is meaningful and at the least creates an ambiguity.

The dissent appears to have the better view of the operating agreement’s payment provisions for an expelled member.

Delaware Court Corrects Error in LLC Agreements' Waterfall Provisions

Reformation is an equitable remedy that courts use to “reform” or correct a mistake in a written agreement, to conform it to what the parties actually intended their agreement to say. The Delaware Court of Chancery recently reformed the cash distribution waterfall provisions of the limited liability company agreements for three real estate joint ventures in ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, No. C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).

Background. Investors and Developer entered into five real estate deals in 2007 and 2008, each structured as an LLC. In each deal the Investors put up 99% of the cash and Developer put up 1%. Each agreement provided that when the LLC’s property was sold, the sale proceeds would be distributed to the members according to a hierarchy that established the order in which funds would be distributed, often called a “waterfall.” The waterfall from the first two deals, using simplified language, was:

(a)        First, 99% to Investors and 1% to Developer until each has received an 8% preferred return (similar to an annual interest rate) on its invested capital;

(b)        Then 99% to Investors and 1% to Developer until each has received the return of its invested capital; and

(c)        Then 20% to Developer, and 80% to be divided 1% to Developer and 99% to Investors.

In other words, both parties receive interest on their investment, then they get their investment back, and then they share, not based on the 99%-1% ratio of invested capital, but based on a ratio that gives the Developer a higher percentage return. The higher level of return to the Developer, after the threshold amounts are paid out, is intended as an incentive for the Developer. It is often referred to as a “promote” by real estate professionals. The above waterfall has a 20% promote.

When the parties negotiated the third of the five deals, they agreed on a two-tiered promote. This was similar to the waterfall above, except that the final level, which defines the promote, shifts to a higher promote percentage for the Developer after a specified amount has been distributed. In the example above, the third level would have a limiting cap added, and a fourth level would be added with the higher promote.

The Mistake. Unfortunately, in the process of preparing the written LLC agreement for the third deal, the return of capital paragraph was mistakenly placed after the first promote paragraph. That’s a much better deal for the Developer, which would receive the first portion of its promote before the parties get their capital returned. Thus the Developer could get its promote even if the overall deal were a loss and did not return any of the parties’ invested capital. This written agreement was approved and signed by the parties, even though it was not what they had negotiated.

This mistake happened because the responsible partner at the Investors’ law firm, who was heavily involved in the first transaction, turned the second deal over to an inexperienced associate lawyer. The terms of the second transaction mirrored the terms of the first, but when the terms of the waterfall changed in the third transaction the associate accidentally placed the key paragraph in the wrong position. The partner either did not read the final agreement or did not notice the mistake, and the error remained in the final agreement.

The court found that the in-house lawyer at the Developer knew of the mistake and knew that it was favorable to Developer, but said nothing about it to the Investors’ counsel. The executive in charge of the deal for the Investors reviewed the agreement, but did not notice the mistake and signed the agreement.

To compound the error, in short order the parties entered into two more real estate ventures, using the same structure and copying the same erroneous waterfall language. In both cases the waterfall as written by the Investors’ lawyer was not what the parties negotiated, the Developer knew of the mistake and knew that it was favorable to Developer, the Developer said nothing, and the Investors did not catch the mistake.

This situation inevitably led to conflict, which was precipitated by the Developer’s exercise of a put right in one of the three LLC agreements with the mistaken waterfall. The Developer’s buyout price under its put right was based on the agreement’s distribution provisions and the venture’s fair value.

The venture was underwater, since it had a fair market value of $35.5 million and the Investors had invested $47.3 million. As written, the waterfall entitled the Developer to $1.83 million, but as negotiated, the waterfall would have entitled the Developer to only $348,000. The result would be that instead of the Investors and the Developer sharing the loss 99%-1%, the Developer would make a 282% profit and the Investors would lose roughly 30% of their investment. Id. at *10.

The Developer demanded the higher amount based on the language of the waterfall. The Investors examined the agreement and determined that it was in error and was not in accordance with what they had negotiated. The Investors had what their executive called “a very, very tough conversation” with their law firm, and put the law firm on notice of a malpractice claim. Id. The executive said at trial that he was “incredibly upset that this had happened because it was clear what the document said, and that it was just wrong.” Id.

The Lawsuit. The Investors filed suit and sought an order reforming the waterfall provisions in the three disputed LLC agreements to match what had been negotiated. The Developer counterclaimed, seeking to enforce the agreements as written. The trial lasted four days and included nine fact witnesses, two expert witnesses, 300 documentary exhibits, and 25 deposition transcripts.

The court applied the doctrine of unilateral mistake, which allows reformation of a contract if the party seeking reformation can show by clear and convincing evidence that it was mistaken and that the other party knew of the mistake but remained silent. The plaintiff must show that there was a specific prior contractual understanding that conflicts with the terms of the written agreement. Id. at *13.

After a detailed review of the evidence, the court found that the Investors had demonstrated by clear and convincing evidence that they were entitled to reformation of the three LLC agreements. The court also dismissed the Developer’s defenses that (a) the Investors’ representative had not read the agreements, (b) the Investors had ratified the agreements, and (c) the Investors had unclean hands. The court accordingly rewrote the waterfall provision, placed the corrected language in its opinion, and ordered the two other disputed LLC agreements to be corrected in the same way. Id. at *21.

The court also awarded the Investors their attorneys’ fees, under the contractual fee-shifting provisions of the disputed agreements. The Developer argued that the Investors had not incurred any attorneys’ fees because the Investors’ law firm was not billing for its fees. (The same law firm that had made the mistakes in the three agreements represented the Investors in the lawsuit. Presumably it was not charging for the litigation because without its mistakes on the three agreements there would have been no litigation.) The court found that the arrangements between the Investors and their law firm to allocate the litigation costs did not affect the Developer’s obligations under the fee-shifting provision in the agreements. Id. at *20.

For a more detailed review of the court’s analysis, see Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here.

Comment. This strikes me as a surprising case. Not because of the legal doctrine of reformation or the court’s legal analysis, but because of how the business transactions played out and the roles of the lawyers involved.

For one thing, lawyers and business people who work on large real estate ventures such as these know that the waterfall provisions are not boilerplate – they are at the heart of the deal. Who puts how much money into the deal and who gets how much out are major components of what real estate partnerships and LLCs are all about.

For another thing, waterfall provisions, and especially the ones in this case, are not all that hard to read. They are a series of fairly short clauses in reasonably simple language that specify an algorithm to pay out the cash from the venture to the members. The sequential order of those clauses is key to how the waterfall works. Getting the paragraphs out of order is roughly comparable to getting a divide and an addition out of order in an algebraic expression. The result will usually be wrong.

These truisms make the mistakes that took place here, on both sides, rather startling. I say on both sides because the Investors’ law firm made the drafting mistakes, but the Developer’s lawyer made a mistake in judgment by not revealing the drafting mistake.

The drafting mistakes appear to reflect a classic organizational blunder by the Investors’ law firm. A senior partner turns over responsibility for a series of transactions to an associate lawyer who lacks the experience to understand the terms of the waterfall. The associate makes the mistake, and then the partner either doesn’t read the agreement or if she did, doesn’t focus on the key terms of the waterfall. The Investors’ representative relies on the partner at the law firm, and the partner relies overmuch on the inexperienced associate.

The Developer’s attorney, on the other hand, showed bad judgment in not revealing the error. The court found that he was a sophisticated and experienced real estate venture attorney who recognized the error but intentionally remained silent in order to capture an undeserved benefit for the Developer. Id. at *15.

As Francis Pileggi pointed out in his blog post, here, the court did not address the legal ethics issues in its opinion. But even setting that aside, in deals of this magnitude it’s foolish to think that a fundamental drafting error, inconsistent with what the parties clearly had agreed on, will not be discovered when it comes to light and would cost the other party a lot of money unless corrected. And as the court’s opinion shows, basic contract law can provide relief in this type of situation.

This is not a case where the lawyers appear at their best.

Delaware Court of Chancery Pores Over Fiduciary Duty Claims Against LLC Manager

The Delaware Court of Chancery last month issued a lengthy and thorough analysis in a dispute over an LLC manager’s claimed breaches of fiduciary duties. Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012).

The dispute arose because the LLC’s manager and majority owner (along with his family) took steps to squeeze out the minority investors in order to obtain ownership of the LLC’s valuable golf course. The court’s lengthy catalog of the manager’s activities shows a manager bent on ridding the LLC of the disfavored minority. Professor Ann Conaway in her blog described the manager as “a devilish manager of an LLC who acted every bit the part of Lord Voldemort determined to ‘do in’ his members,” here. The court’s unremarkable holding, given the facts, was that the manager breached his fiduciary duties of loyalty and care. Auriga, 2012 WL 294892 at *25.

The court’s discussion and analysis, on the other hand, were remarkable. Not for the court’s legal conclusion, but for its comprehensive and detailed review of the Delaware LLC Act and the Delaware case law on LLC fiduciary duties. The court’s conclusion was consistent with prior Delaware case law: “[O]ur Supreme Court, and this court, have consistently held that default fiduciary duties apply to those managers of alternative entities who would qualify as fiduciaries under traditional equitable principles, including managers of LLCs,” unless those duties are clearly waived or modified in the LLC’s operating agreement. Id. at *2.

In explaining its decision, the court reviewed (i) the Delaware LLC Act; (ii) the lack of any language in the Act establishing fiduciary duties for LLC managers; (iii) the Act’s authorization in Section 18-1101 that, to the extent a member or manager has duties including fiduciary duties, those duties may be expanded, restricted, or eliminated by the LLC agreement; and (iv) the history of revisions to Section 18-1101. The court analogized the LLC Act to Delaware’s General Corporation Law and noted the Delaware Supreme Court’s application of fiduciary duties to Delaware corporations notwithstanding the absence of any definition or creation of fiduciary duties in the DGCL.

The court also examined Section 1104 of the LLC Act, which provides that “[i]n any case not provided for in this chapter, the rules of law and equity … shall govern.” Del. Code Ann. tit. 6, § 18-1104 (emphasis added). The court found fiduciary duties to be grounded in equity and therefore to be mandated by Section 1104. Auriga, 2012 WL 294892 at *8.

The facts are complex, and the court’s lengthy analysis is multi-part, thorough, and detailed. The brief description above is only a high-level overview. For a more detailed review of the Auriga opinion, I recommend Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here, and Peter Mahler’s post on his New York Business Divorce blog, here.

A part of the opinion that I found particularly interesting is the court’s discussion of the difference between the implied covenant of good faith and fair dealing, and the fiduciary duties of loyalty and care. Both are equitable gap-fillers, but they operate in different ways. The implied covenant of good faith and fair dealing applies only “when the express terms of the contract indicate that the parties would have agreed to the obligation had they negotiated the issue.” Auriga, 2012 WL 294892 at *10. In other words, the implied covenant operates only in cases where the language of the contract as a whole suggests an obligation and points to a result, but does not provide an explicit answer. Id. at *10 n.57. Fiduciary duties, in contrast, provide a framework to govern the discretionary actions of business managers acting under the enabling framework of the LLC agreement. Id. *10.

One part of the opinion will likely be of more interest to litigators than to business lawyers – the court’s award of attorneys’ fees to the plaintiffs. In civil litigation such as the Auriga case, each party normally bears its own legal fees. (This is sometimes referred to as the American Rule, and is in contrast to the English Rule, under which the loser pays the winner’s attorneys’ fees.)

Delaware recognizes an exception to the American Rule when a litigant has acted in bad faith. Id. at *29. The Auriga court awarded the plaintiffs one half of their reasonable attorneys’ fees and costs – the award because of the defendants’ bad faith, and the one-half limit because the plaintiffs’ efforts in the litigation were “less than ideal in terms of timeliness or prudent focus.” Id.

The court said the bad-faith exception should not be lightly invoked and requires clear evidence of the wrongdoer’s subjective bad faith. The court found plenty of evidence, though: “The record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue. Rather than focus on only bona fide arguments, Gatz and his counsel simply splattered the record with a series of legally and factually implausible assertions.” Id. The court also considered the defendants’ pre-litigation conduct, as well as violations of the discovery rules.

The procedure mandated by the court for determining the attorneys’ fees appears designed to streamline the process. The plaintiffs must simply submit an affidavit with the amount of their “reasonable attorneys’ fees and costs.” Id. The court will then consider that amount to be reasonable unless the defendants’ legal counsel produces their own billing records in support of an argument that the plaintiffs’ attorneys’ fees are too high. And in case there was any doubt about the court’s attitude, the court remarked that “[i]n objecting to the amount of the fee, Gatz and his counsel should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it.” Id. at *29 n.184.

The Auriga case is fascinating for a host of reasons: (a) the court’s detailed and lengthy review of Delaware’s LLC fiduciary duty law, (b) the emphasis on the origins of fiduciary duty principles in equity (the Delaware Court of Chancery, like the original English version, is a court of equity), (c) the discussion of the implied covenant of good faith and fair dealing, (d) invocation of the principle that uncertainties in damages are resolved against the breaching fiduciary, (e) the award of attorneys’ fees, and (f) the court’s colorful language. The opinion has already generated significant commentary in the blogosphere, and in the future it will undoubtedly be the subject of law review articles and continuing legal education seminars.

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.

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.

 

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.

 

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.

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.