Concealment of Breach of Fiduciary Duty Tolls the Alabama Statute of Limitations

Here’s a case for you. Plaintiffs invest $2.5 million in an LLC formed to purchase real estate, and guarantee a $7.5 million loan to the LLC. The LLC buys the real estate for $10 million from Ray Jacobsen, an affiliate of the LLC’s managers and its original investors. No one informs the new-money investors that Jacobsen bought the real estate for $5 million just days before selling it to the LLC for $10 million.

The plaintiffs alleged (a) that the LLC’s managers and original investors (the defendants) were well aware of Jacobsen’s “flip” of the property, (b) that the defendants never disclosed this information to the plaintiffs, (c) that the plaintiffs justifiably relied on the defendants’ silence by forgoing independent investigation, and (d) that the plaintiffs learned of the fraud later by happenstance. DGB, LLC v. Hinds, No. 1081767, 2010 Ala. LEXIS 116 (Ala. June 30, 2010).

The investors sued for damages, claiming fraud and breach of fiduciary duty and asking for dissolution of the LLC. The defendants contended that the claims were barred by the statute of limitations. The trial court dismissed almost all of the investors’ claims, and the plaintiffs appealed.

The defendants argued that the claims were barred by Alabama’s two-year statutes of limitations, Ala. Code §§ 6-2-38(l), 8-6-19(f). The plaintiffs in turn invoked the fraud savings clause of Ala. Code § 6-2-3:

In actions seeking relief on the ground of fraud where the statute has created a bar, the claim must not be considered as having accrued until the discovery by the aggrieved party of the fact constituting the fraud, after which he must have two years within which to prosecute his action.

If applicable, this exception would save the plaintiffs’ claims of fraud and breach of fiduciary duty, because their lawsuit had been filed within two years of their discovery of Jacobsen’s double-dealing, although it was more than two years after the original real estate deal.

The court simply applied the savings clause to the fraud claims, but the fiduciary duty claims were examined more closely. The court ruled that fraudulent concealment of wrongful acts is enough to invoke the fraud savings clause, even if the cause of action was for something other than fraud. DGB, supra, at *15, 16. Since the plaintiffs had alleged concealment of the defendants’ real estate flip, their claims survived.

The court never explicitly discussed what is necessary to make the concealment “fraudulent.” Presumably it means that there was some degree of mens rea, i.e., a guilty mind or intent.

Statutes of limitation are more than mere technicalities. They prevent old, stale claims from popping up many years after the original event. Memories fade, evidence may be lost, and witnesses may die or be missing. But in this case the court’s application of the fraud rule, along with its extension of the time for bringing the lawsuit, was the right result. As the court said, “A party cannot profit by his own wrong in concealing a cause of action against himself until barred by limitation. The statute of limitations cannot be converted into an instrument of fraud.” DGB, supra, at 11, 12 (quoting Hudson v. Moore, 194 So. 147, 149 (Ala. 1940), overruled on other grounds by Ex parte Sonnier, 707 So. 2d 635 (Ala. 1997)).

The investors also asked the court to order the dissolution of the LLC. The Alabama LLC Act allows for judicial dissolution of an LLC “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” Ala. Code § 10-12-38. This provision is similar to those of the Delaware LLC Act and the Washington LLC Act. Since dissolution can be granted “whenever” it is not reasonably practicable to carry out the business in conformance with the charter, the court found that there was no basis for applying the statute of limitations to a request for a dissolution. DGB, supra, at *10.

Deadlocks and Puts in Delaware

LLCs sometimes reach a point where the owners or managers disagree on business issues and find themselves unable to reach agreement on any course of action. This can happen because the members or managers have equally balanced voting power or because their LLC agreement requires a supermajority vote that neither side can reach. A long-running deadlock can be a huge problem for a business, since it will keep the company from responding to business changes. What’s the owners’ remedy then?

 

Sometimes the LLC agreement will have a solution. For example, the agreement may have a “cut and choose” provision, so that either side can initiate a buyout process that will leave one or the other with full ownership of the company. That may or may not be practicable, and in many cases the agreement simply has no answer for a deadlock.

If the agreement has no solution for deadlock, the parties are forced back to their state’s LLC statute. In Fisk Ventures, LLC v. Segal (Jan. 13, 2009), one member of a Delaware LLC asked the Court of Chancery to order dissolution, citing Section 18-802 of Delaware’s LLC Act. This section is short and sweet:

 

On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.

 

NCCUSL’s Revised Uniform LLC Act and many state statutes have similar provisions. Note that the operative word is “may” – the court has discretion. And the test is not one of oppression or wrong-doing, but simply a question of carrying on the business in conformity with the agreement. 

 

In Fisk, the LLC agreement provided for a five-member Board to manage the LLC. One faction had three Board members; the other faction had two. (One side was dominated by the founder, the other by subsequent investors.) The agreement required a vote of 75% of the Board for most actions, including dissolution, and neither side could muster four Board members. The agreement provided no mechanism for resolving a stalemate. For five years the two factions had been in disagreement about financing and other issues. The result: five years of deadlock.

 

The court found that as a result of the deadlock and the Company’s inability to raise capital, the company had “no office, no employees, no operating revenue, and no prospects of equity or debt infusion,” and that there was effectively no business to operate.

 

Dr. Segal, however, argued that the LLC agreement did provide a means of navigating around the deadlock, because the agreement granted Fisk Ventures, the plaintiff seeking dissolution, a “put” right. The put meant that Fisk could require the company to buy Fisk’s interest in the company for its fair value. The agreement provided for the price to be determined by an independent valuation, and to be paid either in cash at closing or in time payments over two years, based on the amount. Exercise of the put was at Fisk’s discretion.

 

The court found that the existence of Fisk’s optional put right did not resolve the deadlock, and refused to force Fisk to exercise its put. The court analyzed the put as an independent, economic right that was not a remedy for the deadlock. In the court’s words, “it would be inequitable for this Court to force a party to exercise its option when that party deems it in its best interests not to do so.” The court emphasized the primacy of freedom of contract under Delaware’s LLC Act: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Section 18-1101(b).

 

Once the court had concluded that Fisk’s put was not relevant to whether it was “reasonably practicable to carry on the business” in conformity with the LLC agreement, and given the dismal five-year history of the company, the court easily found that the company should be dissolved. Under the LLC Act, of course, once dissolved the company would have to be wound up in accordance with Section 18-801.

 

The 75% supermajority requirement may have been intended to prevent a bare majority from dominating or oppressing the minority, but here it led to a different type of bad result. The agreement did not provide for a way to resolve a deadlock, and the put apparently turned out to be an unsatisfactory mechanism for its holder. 

 

The obvious moral for founders and investors (and their counsel) is to think hard about the contingencies when the LLC is being formed and when new investors come in. Concentrate not only on the upside of the proposed business deal but also on the alternative scenarios, and address the potential for deadlock. This is basic risk analysis – not easy, as evidenced by our recent history, even for highly experienced investors and business people. There’s no substitute for probing the parties’ assumptions and asking the hard questions.