Texas Court Follows Form Over Substance In Sorting Out Different Fiduciary Duties in Multi-Level LLC and Partnership
The Texas Court of Appeals struggled to reconcile conflicting fiduciary duty rules between two related entities, an LLC and a limited partnership, in Strebel v. Wimberly, No. 01-10-00227-CV, 2012 WL 112253 (Tex. App. Jan. 12, 2012).
Douglas Strebel and John Wimberly started a tax advisory business and formed Black River Capital, LLC, a Delaware limited liability company, in 2003. The business prospered, and on December 8, 2005 they restructured the business and amended and restated the LLC agreement. Strebel and Wimberly were the LLC members, with profit sharing ratios of 60% and 40% respectively. They and their wives were the managers, and Strebel was the Managing Manager and CEO with broad decision-making and management powers. Strebel was required to consult with the other managers before making certain major decisions, and to obtain Wimberly’s consent before taking certain other specific actions, including changes to Wimberly’s profit sharing ratio.
At the same time, they formed a new Texas limited partnership, Black River Capital Partners, LP, and transferred all of the LLC’s business assets to the limited partnership (LP). The LLC was the LP’s general partner, with broad power and authority to control the LP, and had a 1% profit share. The limited partners were Strebel, Wimberly, Strebel’s wife, and Eric Manley. Later Steve Houle also became a limited partner.
The LLC and the LP had completely different fiduciary duty rules. The LLC’s operating agreement stated that “the Managers shall have fiduciary duties to the Company and the Members equivalent to the fiduciary duties of directors of Delaware corporations.” Id. at *3 (emphasis added) . In stark contrast, the LP’s partnership agreement stated that “the General Partner shall have no duties (including fiduciary duties) except as set forth in th[e] Agreement,” and there were no other relevant provisions. Id. (emphasis added).
Problems between Strebel and Wimberly began to develop later. Strebel was in the driver’s seat as Managing Manager of the LLC, which in turn was the general partner of the LP. He also held a majority of the limited partners’ voting rights in the LP. Using his authority, Strebel retroactively reduced Wimberly’s profit share in the LP, and caused the LP in 2007 to award a $3 million bonus to himself and another $1 million in bonuses to limited partners Houle and Manley. Wimberly received no bonus. Id. at *5. Unhappy with these developments, Wimberly sued Strebel in 2007, alleging breach of fiduciary duty, unjust enrichment, oppression of a minority member, defamation, and breach of contract.
A jury trial returned a verdict in Wimberly’s favor. The jury found that Strebel had breached his fiduciary duties and awarded Wimberly damages of $2.9 million. Id. at *6. The trial court had instructed the jury that Strebel owed Wimberly fiduciary duties in his management of the business of the “Black River Entities,” because of their relationship at the LLC level (Strebel as Managing Manager and Wimberly as member) and at the LP level (both were limited partners). Id.
The Court of Appeals analyzed the fiduciary duties separately at the LLC level and at the LP level. Id. at *8. The court began with the LLC. Strebel had contended that the words in the LLC agreement “the Managers shall have fiduciary duties to the Company and the Members” meant that fiduciary duties were owed to the Members collectively, and that therefore no fiduciary duties were owed to any Member individually. Id. After a surprisingly lengthy discussion, the court disposed of that argument and pointed out that such an interpretation would in effect delete the words “and the Members” from the LLC agreement. The court agreed with the trial court that the LLC agreement imposed on Strebel, as the Managing Manager, fiduciary duties of due care, good faith, and loyalty to Wimberly as an individual member of the LLC. Id. at *9.
The limited partnership agreement, on the other hand, was clear that the LP’s general partner (the LLC) owed no fiduciary duties to the LP or its limited partners. The trial court had found, however, that Strebel owed Wimberly a fiduciary duty because they were both limited partners. The LP agreement was silent on whether there were any fiduciary duties between the limited partners. After a lengthy discussion of prior cases and a Baylor Law Review article, the court concluded: “We reconcile these cases by holding that status as a limited partner alone does not give rise to a fiduciary duty to other limited partners.” Id. at *13.
The court’s determination that there were no fiduciary duties owed by the LP’s general partner or any limited partner effectively destroyed Wimberly’s cause of action, because the court focused only on the harm to Wimberly directly resulting from the actions of the LLC as it controlled the LP, and ignored the obligations of the LLC’s manager to its members as he directed the LP’s activities:
[W]e conclude Wimberly’s claims relate to actions taken by Strebel as the controlling manager of the general partner (i.e., Black River, LLC) against Wimberly as a limited partner in Black River LP while operating under the LP agreement. The contractual disclaimer of fiduciary duties in the Black River LP Agreement thus forecloses Wimberly’s recovery on his breach of fiduciary duty claim.
Id. at *15. The court reversed the trial court’s finding on the breach of fiduciary duty claim, and remanded for further proceedings on Wimberly’s oppression of a minority member claim. Id. at *18.
Unfortunately, the court’s analysis exalted form over substance. The LLC’s only business was to control the LP – all of the LLC’s assets had been assigned to the LP. The LLC’s Managing Manager Strebel owed the LLC’s members the duties of good faith and loyalty. How could the LLC’s manager satisfy the duty of loyalty he owed to the members other than ensuring, as the LLC directed the LP, that the LP’s limited partners who were also LLC members were treated fairly and in good faith?
The court in its analysis relied on the chestnut that applying the LLC’s fiduciary duties to the actions taken by its manager in directing the LP “would render meaningless the express disclaimer of fiduciary duties in the limited partnership agreement under which that the parties were operating.” Id. at *17. But that’s not correct, because three of the limited partners (Manley, Houle, and Strebel’s wife) were not members of the LLC, and for them the disclaimer was highly meaningful.
This case shows the analytical difficulties that can arise in sorting out the obligations of managers in multi-entity, multi-level structures. It’s also a lesson for the lawyer advising clients about such structures to be wary of inconsistent standards and obligations.
The Tax Court has again ruled against the Internal Revenue Service in a case on the deductibility of a member’s LLC losses. Newell v. Commissioner, T.C.M. 2010-23 (Feb. 16, 2010). Last year I wrote about the three prior cases, here.
In these cases the IRS has taken the position that its regulations require a presumption that LLC losses are “passive activity losses” (passive losses). Under the regulations this presumption is difficult to overturn, so in many cases LLC losses are treated as passive losses. And for most taxpayers, passive losses are far less useful than active losses (losses not resulting from passive activities). Taxpayers generally prefer to use losses to offset taxable income, but passive losses can only be used to offset income from other passive activities, and not against income such as wages, interest, and dividends.
The Tax Court ruling in Newell is consistent with the prior cases in its interpretation of the IRS’s regulations. The regulations create a presumption that losses incurred by a limited partner in a limited partnership are passive losses, and make it difficult to overcome the presumption. The IRS has taken the position that a member of an LLC should be treated like a limited partner of a limited partnership for purposes of the regulation. The courts, including the Tax Court last month in Newell, have rejected the IRS’s argument.
This latest case should give additional comfort to LLC members, that they should be able to use LLC losses to offset “active” income such as wages. LLC members will still need to demonstrate that they materially participate in the LLC’s management, but they will be able to use the more flexible rules of the IRS’s regulations, without the need to overcome the presumption against material participation.
The IRS could of course change these regulations to explicitly treat LLCs in the same way that limited partnerships are treated. Because LLCs are relatively new, the IRS may still be trying to figure out how to deal with them while limiting the potential for abuse.