Montana Court Rejects LLC Agreement's Arbitration Clause
Arbitration of contract disputes is not generally required unless the parties agree to arbitration in their contract. LLC founders will therefore often include mandatory arbitration clauses in their LLC agreement. These are intended to require all disputes about the LLC to be arbitrated instead of being tried in court.
Montana Arbitration Clause. Arbitration clauses are usually enforceable. The Montana Supreme Court, however, recently refused in a case of first impression in Montana to enforce an LLC agreement’s arbitration clause. Gordon v. Kuzara, 2010 MT 275, 358 Mont. 432 (December 21, 2010). The plaintiff in Gordon sought judicial dissolution of the LLC, and the defendant filed a motion to compel arbitration based on the arbitration clause in the parties’ LLC agreement. Peter Mahler has nicely described the case and the court’s reasoning in his New York Business Divorce blog.
The gist of the court’s holding was that arbitration was not mandatory because the arbitration language in the LLC agreement did not cover a request for judicial dissolution. The contract said that arbitration was mandatory if any member was “challenging this agreement, any activity conducted pursuant to this agreement, or any interpretation of the terms of this agreement.” Gordon, 358 Mont. at 432.
That language is broad, but the dissolution petition was not based on a right granted by the LLC agreement. The LLC agreement had no provision requiring judicial dissolution, and the request for a dissolution order was instead based on the statutory remedy under the Montana LLC Act. Mont. Code Ann. § 35-8-902. Although the petitioner cited examples of conduct by the other member to show that the LLC was no longer economically feasible, the court concluded that the request for dissolution was based on the statutory remedy, not the LLC agreement. Gordon, 358 Mont. at 437.
Idaho Attorneys’ Fees. Arbitration is not the only contractual dispute resolution procedure that can turn out to be unavailable when dissolution is sought. Last year I posted about a case in Idaho, Henderson v. Henderson Investment Properties, LLC, where an attorneys’ fees clause in an LLC agreement was not enforced.
The trial court awarded attorneys’ fees in Henderson based on the LLC agreement’s attorneys’ fees clause, which covered actions brought to enforce any provision of the LLC agreement. The Idaho Supreme Court reversed the trial court’s award because the plaintiff did not seek to enforce the LLC agreement, but instead sought judicial dissolution, a statutory remedy.
Drafting Lessons. Both the Montana case and the Idaho case involved contractual clauses that were not enforced because they were not written broadly enough to encompass a petition for the LLC’s dissolution. One case involved a clause requiring arbitration, the other involved a clause requiring the loser to pay the winner’s attorneys’ fees.
In my post on the Henderson case I discussed how the attorneys’ fees clause could have been written to cover a dispute over dissolution, by adding language along the lines of “or to interpret or enforce any rights under the [State] Limited Liability Company Act.” The attorneys’ fees clause would then apply to either a dispute over the terms of the LLC agreement or to a dissolution petition. The broader language I suggest should have changed the result in Gordon, as well.
Another approach would be to add an express reference to dissolution in the attorneys’ fees clause or arbitration clause, as suggested by Peter Mahler in his post. That would remove all doubts about whether dissolution is covered, but would not extend to disputes over other statutorily granted rights that often are not referred to in the LLC agreement. For example, LLC statutes usually require that certain documents and records be provided to members on request.
Nebraska and Wyoming Enact the Revised Uniform LLC Act
The National Conference of Commissioners on Uniform State Laws (NCCUSL) was formed in 1892 to promote uniformity in state laws by providing states with proposed legislation. NCCUSL’s record has been mixed, but it has had notable successes in the area of commercial and business law. Examples include the Uniform Commercial Code (in cooperation with the American Law Institute), the Uniform Partnership Act, and the Uniform Trade Secrets Act.
LLC law has not been one of NCCUSL’s shining successes. NCCUSL released its first Uniform LLC Act (ULLCA) in 1995, after almost all the states had already adopted LLC statutes. ULLCA has since been adopted by only eight states.
In 2006 NCCUSL released a revised version, the Revised Uniform Limited Liability Company Act (RULLCA). In 2008 RULLCA was enacted by Idaho and Iowa.
Earlier this year Nebraska and Wyoming enacted RULLCA, doubling the number of RULLCA states from two to four. Nebraska’s new law was signed by the governor on April 1, 2010. It becomes effective January 1, 2011 and has a two-year transition period. The new Wyoming Act was signed by the governor on March 8, 2010 and became effective July 1, 2010, with a four-year transition period.
There is significant variation among the current state LLC laws, other than those of the eight states that enacted ULLCA, and the four states that have now adopted RULLCA. Many were originally modified versions of the states’ limited partnership laws, while some were copied in part from other states’ laws, from ULLCA, and from the ABA’s 1992 Prototype Limited Liability Company Act.
RULLCA has been criticized. Larry E. Ribstein, An Analysis of the Revised Uniform Limited Liability Company Act, 3 Va. L. & Bus. Rev. 35 (2008). Professor Ribstein has referred to it as “the incredibly misguided Revised Uniform Limited Liability Company Act,” here. His view is that RULLCA “threaten[s] to impose substantial risks and costs on limited liability companies … that there is little reason for states to adopt the Act, and that practitioners should be wary about advising clients to form under it.” Id.
The major criticisms of RULLCA include the following issues. Ribstein, supra, at 78-79.
- Unworkable provisions on shelf registration, i.e., creating an LLC with no initial members
- No provisions for series LLCs
- An overly broad definition of the elements of the operating agreement
- Unclear rules on the agency power of members and managers
- Broader fiduciary duties than the traditional duties of loyalty and care, with uncertain boundaries, and intricate restrictions on operating agreement waivers of fiduciary duties
RULLCA is a valuable resource for states looking to review and revise their LLC statutes, but its prognosis for becoming widely adopted looks bleak.
Given the relatively recent appearance of LLCs on the legal stage, a variety of state approaches may not be such a bad thing. Over time, case law will play out against the statutory backdrops, LLC statutes will be revised based on business needs and the results of litigation, and lawyers and business people can in effect vote with their feet by forming LLCs using whatever states’ laws best fit their needs.
Idaho LLC Member Owes No Fiduciary Duty to LLC's Manager
The Idaho Supreme Court has again examined the fiduciary duties of LLC members, in High Valley Concrete, L.L.C. v. Sargent, 2010 WL 2681188 (Idaho July 8, 2010). Last year the Idaho Supreme Court analyzed fiduciary duties between LLC members in Bushi v. Sage Health Care, PLLC, which I discussed here. In Bushi the court concluded that managing members of an LLC owe each other fiduciary duties.
In High Valley the LLC’s manager claimed that the sole member owed a fiduciary duty to the manager. High Valley was organized by Cary Sargent and Doyle Beck as an Idaho LLC. They initially planned for Beck to have a 51% interest and Sargent to have a 49% interest in the company. Ownership certificates for both were drawn up and signed, and each made his initial contribution to the LLC. Beck then requested that all of the LLC units be issued to him so that he could have the tax losses until the company became profitable – “then we’ll clear up - we’ll change the paperwork back.” High Valley, 2010 WL 2681188 at *1. Sargent agreed to the change, so Beck became the sole member and Sargent the manager.
Sargent was later fired, and the LLC sued Sargent for conversion, fraud, and breach of fiduciary duty. Sargent, the manager, in turn sued Beck, the sole member, for breach of fiduciary duty. Sargent claimed that he was damaged by the loss of his contributions to High Valley. At trial the LLC was awarded judgment on its claims against Sargent, and Sargent was awarded judgment on his fiduciary duty claim against Beck. Beck appealed.
The court began by noting that fiduciary relationships usually involve one party placing property or authority in the hands of another, or being authorized to act on behalf of the other. Id. at *4. The court described a fiduciary as one who is in a superior position to the other, where the other reposes special trust and confidence in the fiduciary. Examples include partners, principal and agent, attorney and client, and the executor and beneficiary of an estate. Id. at *5. Arm’s-length business transactions, standing alone, do not give rise to a fiduciary relationship.
The court had previously held in Bushi that LLC managing members owe each other fiduciary duties. But the High Valley court found that Sargent was not a member. Sargent had the opportunity to obtain a membership interest at the time of the LLC’s formation, but instead he allowed Beck to become the LLC’s only member. Bushi was therefore not applicable.
None of the other indicia of a fiduciary relationship were present. There was no indication that Sargent had any reason to believe that Beck was acting in Sargent’s interest. And although Beck had discussed reinstating Sargent’s 49%, Sargent testified that Beck was not holding Sargent’s 49% for him. Finding none of the control, property transfer, or “superior position” attributes of a fiduciary relationship to be present, the court held that no fiduciary relationship existed.
What is novel about this case is the role reversal. Usually members raise fiduciary duty claims against managers, not the other way round, as in High Valley. The managers, after all, are the ones in control of the LLC. It’s that control of the other party’s assets or business that lies at the heart of most fiduciary relationships.
It’s unclear from the court’s opinion what was the basis of the jury’s finding of a breach of fiduciary duty by Beck. The jury may have believed that Beck’s initial statements about later re-establishing Sargent’s 49% amounted to a sort of trust arrangement, a promise to hold the 49% for Sargent and to later restore the 49% to him. But the Idaho Supreme Court relied on the following bit of Sargent’s testimony:
Q. Did you understand that Beck was going to hold your 49 percent for you?
A. No. I understood that I – that the ownership would remain the same, that he was just doing it for his personal tax purposes or his business’ tax purposes.
Id. at *1. That “no” answer appears to have torpedoed Sargent’s case. I suspect that with further questioning by his counsel, Sargent could have made clear that there was more to the arrangement than his brief answer indicated. But that’s the thing about trial testimony – you don’t get a second crack at it after the trial is over.
How Not to Draft an Attorneys' Fees Clause
Many LLC operating agreements include a fee-shifting provision, a clause that requires the losing party in litigation between members to pay the prevailing party’s reasonable attorneys’ fees. These fee provisions are usually relegated to the boilerplate sections near the end of the operating agreement, and often don’t get much attention when the agreement is being prepared. A ruling last month from the Idaho Supreme Court shows that if the attorneys’ fees clause is not carefully crafted, it may not work the way the parties intended.
In Henderson v. Henderson Investment Properties, L.L.C., No. 35138, 2010 WL 569890 (Idaho Feb. 19, 2010), the Supreme Court reversed the trial court’s award of $21,552 in attorneys’ fees. The LLC in the case was formed by a husband and wife and their son and daughter-in-law to operate a sandwich shop. Acrimony later developed between the generations, and the father brought suit to dissolve the LLC. The Idaho LLC Act allows a court to order dissolution if actual or threatened irreparable harm results either from member deadlock or from illegal, oppressive or fraudulent acts of the controlling members. Idaho Code Ann. § 53-643.
Mr. Henderson alleged both deadlock and illegal, oppressive or fraudulent acts, with resulting irreparable harm. The trial court dismissed the complaint, holding that although there had been a deadlock it had not resulted in actual or threatened irreparable injury, and that there had been no illegal, oppressive or fraudulent acts. The trial court also awarded attorneys’ fees to the son and daughter-in-law, based on this provision in the LLC’s operating agreement:
In any action or proceeding brought to enforce any provision of this Agreement, or where any provision is validly asserted as a defense, the successful party is entitled to recover reasonable attorneys’ fees in addition to any other available remedy.
The Supreme Court analyzed that language and reversed the award of attorneys’ fees because it found that the plaintiff did not seek “to enforce any provision of the Agreement,” as required by the clause. The plaintiff instead sought dissolution, which is a statutory remedy.
If the parties had been asked about this clause when they signed their operating agreement, they probably would have interpreted it to mean that in any litigation about their rights and duties as members, the winner would have been entitled to recover its reasonable attorneys’ fees.
This clause did not work that way because it applied only to contractual disputes, i.e., disputes over the terms of the operating agreement. The clause did not apply to any of the rights of members that are defined by the statutory provisions of Idaho’s LLC Act. In this case the dispute was over dissolution, a purely statutory remedy. The irony is that if the operating agreement had simply parroted the language of the statute’s dissolution remedy, Idaho Code Ann. § 53-643, then under the court’s reasoning the defendants would have been entitled to attorneys’ fees.
Many important rights of LLC members, such as sharing of profits, rights to distributions, and rights to certain records of the LLC, are controlled by provisions in Idaho’s LLC Act. The Act allows some of those provisions to be waived or modified in the operating agreement, while others are non-waivable. That approach is typical of other states’ LLC statutes.
Under an attorneys’ fees clause like that in Henderson, and under that court’s reasoning, the right of the winning party to get a judgment for attorneys’ fees will depend on whether the dispute was governed by the LLC statute or by specific terms in the operating agreement. That does not seem like the result most business people would intend when they put an attorneys’ fees clause in their operating agreement.
A better solution, of course, is to use a broader attorneys’ fees clause. One example I’ve seen is:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement or to interpret or enforce any rights under this Agreement, [the prevailing party may recover.]
The language “any controversy arising out of this Agreement” may be broad enough to cover both contractual and statutory claims, although it is perhaps susceptible to the argument that statutory rights not referred to in the operating agreement do not “arise out of” the agreement.
I've also seen another approach that would have changed the result in Henderson, but it may be too broad for some situations:
In the event that any dispute between the Company and the Members or among the Members should result in litigation, [the prevailing party may recover.]
This language literally applies to “any dispute” between members, which could cover a dispute between members that has nothing to do with the LLC. A more natural interpretation would limit the scope of the clause to member disputes that have something to do with the LLC, i.e., with their status as members of the LLC. But to be safe, something like the following might be best:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement, or to interpret or enforce any rights under this Agreement or the [name of State] Limited Liability Company Act, [the prevailing party may recover.]
Some LLC operating agreements require that disputes be settled by binding arbitration instead of litigation. A recently-published treatise on drafting operating agreements for Delaware LLCs has a nice treatment of arbitration and attorneys’ fees, among other things. John M. Cunningham & Vernon R. Proctor, Drafting Delaware Limited Liability Company Agreements: Forms and Practice Manual (2009).
In the model operating agreements provided by Cunningham and Proctor, arbitrable matters include “material matters: (1) That arise under or relate to this Agreement or that relate to the LLC…” Cunningham & Proctor, supra, at Form 6.1, § 30.3. Their model agreement then goes on to assign attorneys’ fees to the nonprevailing party:
To the extent that an arbitrator determines that a party to an arbitration has failed to prevail in that arbitration, the arbitrator shall allocate to that party the costs of the arbitration, including reasonable attorneys’ fees and fees payable to the arbitrator.
Cunningham & Proctor, supra, at Form 6.1, § 30.11(c). This approach allows the arbitration to cover any dispute related to the operating agreement or the LLC, and applies the “loser pays” rule to the entire arbitration. This approach would avoid the type of problem dealt with in the Henderson case.
The clause at issue in Henderson, and the court’s ruling, show in microcosm why contract drafting is difficult. The unexpected scenario can rise up to swat the drafter. I’ll wager that when the parties put together their operating agreement in the Henderson case, they paid little or no attention to the exact words of the clause. Before any disputes arose I’m sure they would have said that any dispute directly related to the LLC was intended to be covered by the “loser pays” rule of the clause. But yet it wasn’t.
It was not a case of the language being unclear (although some might argue that); it was primarily a case of the language not reaching far enough in its scope. The Henderson case is an object lesson in vignette form for lawyers who draft contracts. The lesson? Know the underlying law and the context in which you’re drafting, and don’t rely too quickly on language taken from other contracts.
Bankruptcy Court--Dissolution of an Idaho LLC Does Not Transfer the LLC's Assets or Terminate the LLC
The debtor corporation, Aldape Telford Glazier, Inc. (ATG), was the sole member and manager of two Idaho LLCs. ATG filed a Chapter 7 bankruptcy case, listed a number of assets of its two subsidiary LLCs in the schedule of ATG’s personal property, and did not list its member interests in the two LLCs. The two LLCs had been previously dissolved, and each had filed articles of dissolution which recited that “[a]ll assets revert to sole member.” In re Aldape Telford Glazier, Inc., No. 09-00834-TLM, slip op. at 3, 2009 WL 2216594 (Bankr. D. Idaho July 23, 2009).
The trustee sought dismissal of the bankruptcy case on the grounds that ATG was attempting to impermissibly combine the financial affairs of separate legal entities, thus creating in effect a “joint petition” of ATG and the two LLCs. (Joint filings of a bankruptcy case are not allowed except in the case of spouses. Fitzgerald v. Hudson (In re Clem), 29 B.R. 3 (Bankr. D. Idaho 1982).)
The bankruptcy court applied Idaho state LLC law and determined that LLC property belongs to the LLC and not its members (Idaho Code § 53-633(1)), that on dissolution an Idaho LLC continues to exist and to own its property until it has wound up its business and affairs and distributed its property (Idaho Code §§ 53-644, 53-646), and that the statements in the articles of dissolution that the LLCs’ assets reverted to their members were ineffective. In re Aldape, slip op. at 7-9.
ATG argued that the trustee could “handle the process of identifying and segregating the physical assets and accomplishing the wind up process for both LLCs,” or that the trustee could file Chapter 7 petitions for the LLCs. The court rejected those suggestions as unreasonable and inconsistent with the Bankruptcy Code. Id. at 11-12.
ATG’s approach, i.e., the statements in the LLCs’ articles of dissolution about assets reverting to the sole member and the inclusion of the LLCs’ assets in ATG’s asset schedule in the Chapter 7 filing, shows some confusion over the effects of dissolution. Under Idaho’s LLC Act, dissolution of an LLC is simply a change of its status, not a termination of its existence. ATG attempted unsuccessfully to treat the dissolution as a termination of the LLCs’ existence and as a conveyance of the LLCs’ assets to their member.
The approach of the Idaho statute—LLC dissolution as a change of status requiring that the business be wound up, debts paid and liabilities provided for, and any remaining assets distributed to members—is widely used by the states. E.g., Washington, Delaware. The Revised Uniform Limited Liability Company Act uses the same approach.
Idaho's First Case on LLC Fiduciary Duties
The law of fiduciary duties in LLCs is not well settled. For example, less than half of the states have reported opinions on fiduciary duties in LLCs. Cases of first impression on basic fiduciary duty issues in LLCs will be arising for a long time to come.
State courts, when first faced with a claim of breach of fiduciary duty by an LLC manager or member, normally look initially to the state’s LLC Act. Many state LLC Acts have provisions setting fiduciary standards. For example, Ohio’s LLC Act requires managers to act in good faith, in (or not opposed to) the best interests of the company, and with the care of an ordinarily prudent person.
The Idaho Supreme Court recently addressed member fiduciary duties for the first time, in Bushi v. Sage Health Care, PLLC (March 4, 2009). Applying Idaho’s pre-RULLCA LLC Act, the court found no prescribed fiduciary duties in the Act. (In 2008 Idaho enacted RULLCA into law, which does contain express fiduciary duty language, but it does not become effective until July 1, 2010.)
Looking further afield, the justices found that the majority of courts considering the issue have concluded that LLC members owe one another the fiduciary duties of trust and loyalty. In the cases referred to in the Idaho opinion, the courts analogized LLCs to partnerships. The court concluded that under Idaho’s LLC Act, managing members of an LLC owe each other fiduciary duties.
This is not a surprising result. In fact, it’s hard to imagine a state court finding that LLC members with managing authority, or nonmember managers, do not have fiduciary duties of good faith, loyalty, and care akin to those of partners in a partnership or directors in a corporation. But the Idaho case is a good example of a court looking first to its statute, and upon not finding an answer, looking to persuasive precedent and the reasoning used by other courts.
We can anticipate later, more difficult questions involving matters such as the scope of a member’s or manager’s fiduciary duties, the extent to which the members can agree by contract to limit or exclude each other’s fiduciary duties, and whether claims for breach of fiduciary duties can be brought by a member or only derivatively in the name of the LLC. But those are discussions for a later date.
