Kentucky Court Says Member Has Standing for Some but Not All Claims Against Other LLC Members

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Kentucky Court Says Member Has Standing for Some but Not All Claims Against Other LLC Members

Standing is a legal doctrine that focuses on, among other things, whether a potential plaintiff is the right party to bring a lawsuit. The claimant must be the real party in interest, i.e., it must benefit directly if the action is successful.

A trial court’s dismissal for lack of standing of an LLC member’s claims against the other members was recently reversed in part by the Kentucky Court of Appeals. The Court of Appeals’ examination of the claims nicely contrasts those that gave the plaintiff standing with other claims where standing was lacking. Chou v. Chilton, No. 2009-CA-002198-MR, 2014 WL 2154087 (Ky. Ct. App. May 23, 2014).

Background. Ram.Chou Construction, LLC (RC LLC) was formed by Li An Chou and Richard, Mark, and William Chilton. The Chiltons owned and operated a separate company focused on large-scale public construction projects. Chou, born in China and raised in Taiwan, had operated several import and export businesses but was unfamiliar with the construction industry.

RC LLC was formed to qualify as a Minority Business Enterprise (MBE), so that it could obtain preferences when bidding on public construction projects. Chou had a 51% member interest in order to qualify the LLC as an MBE. Chou was responsible for obtaining MBE certification, and the Chiltons promised to teach Chou the construction business.

RC LLC had some success bidding on construction projects, but problems arose. According to Chou’s complaint, the Chiltons caused RC LLC to use the employees, equipment, accounting department, and payroll services of the Chiltons’ other construction company. The Chiltons also transferred funds between the two companies without authorization or documentation.

Eventually RC LLC lost its MBE certification because it lacked documentation to show that it was a separate entity and not merely a conduit for the Chiltons’ other construction company. At that point the Chiltons terminated Chou and moved RC LLC’s funds to their main construction company.

Chou then filed a lawsuit in his own name against the Chiltons, claiming fraud, breach of fiduciary duty, breach of the duty of good faith and fair dealing, and misappropriation of funds. He also asked the court for a dissolution of RC LLC and an accounting, and for an award of punitive damages. The trial court determined that RC LLC was the real party in interest and that Chou as an individual lacked standing, and accordingly dismissed his complaint.

Court of Appeals. Referring to court rules and prior case law, the court summarized the standing rule as follows: a lawsuit must be prosecuted in the name of the real party in interest, which is the party that will be entitled to the benefits of the suit if successful, i.e., to “the fruits of the litigation.” Id. at *3 (quoting Taylor v. Hurst, 216 S.W. 95 (Ky. Ct. App. 1919)). The court then reviewed each of Chou’s claims.

Dissolution – Standing. The Kentucky LLC Act authorizes the court to dissolve an LLC “in a proceeding by a member if it is established that it is not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement.” Ky. Rev. Stat. Ann. § 275.290(1) (emphasis added). Chou was a member and was authorized by the statute to seek the LLC’s dissolution, so he was therefore the real party in interest and had standing. Chou, 2014 WL 2154087, at *3.

Accounting – Standing. A dissolved LLC must be wound up and liquidated, and its net assets must be collected and either liquidated or distributed in kind. Ky. Rev. Stat. Ann. § 275.300(2). Thus an accounting would be “the natural next required step in the dissolution of the company.” Chou, 2014 WL 2154087, at *3. Because Chou had standing to seek a dissolution, he had standing to seek an accounting as well.

Breach of Fiduciary Duty – No Standing. Earlier Kentucky case law established that managing members of an LLC owe a fiduciary duty to the other LLC members. Patmon v. Hobbs, 280 S.W.3d 589, 595 (Ky. Ct. App. 2009). But the Chiltons were not RC LLC’s managing members – the operating agreement established Chou as the only managing member. Because the Chiltons were not managing members they owed no fiduciary duties to Chou, so he had no standing to assert the fiduciary duty claim. Chou, 2014 WL 2154087, at *4.

Misappropriation – No Standing. The funds and business opportunities that Chou claimed were misappropriated belonged to RC LLC, not to Chou. Any recovery for their misappropriation would belong to the LLC and not to Chou, so he had no standing to assert this claim. The fact that he might benefit indirectly from a recovery by the LLC was not adequate to give him standing to assert the claim. Id.

Fraud and Breach of the Covenant of Good Faith and Fair Dealing – Standing. Under earlier Kentucky case law, there is an implied covenant of good faith and fair dealing in every contract. Chou claimed that the Chiltons breached the implied covenant in the LLC’s operating agreement. As a party to the contract, Chou would be entitled to any recovery for the Chiltons’ breach of the contract. The operating agreement also provided that any member could sue the other members for fraud, so Chou would be entitled to any recovery on his fraud claim. He was therefore the real party in interest and had standing to assert claims for fraud and for breach of the implied covenant of good faith and fair dealing. Id.

Punitive Damages – Standing. The court referenced earlier Kentucky case law for the rule that a claim for punitive damages cannot survive if there is no underlying claim for compensatory damages. The court had already held that Chou had standing for his claims for compensation for fraud and for breach of the implied covenant of good faith and fair dealing, so he also had standing to seek punitive damages. Id.

The Dissent. Judge Thompson’s dissent from the majority’s holding that Chou had no standing for his fiduciary duty claims points out three problems with the majority opinion.

First, Chou’s complaint alleged that Chou’s appointment as managing member of RC LLC was only a formality done for qualifying RC LLC as an MBE, and that in reality the Chiltons managed the LLC and acted on its behalf. As the majority noted, “[a] breach of fiduciary duty generally occurs between a principle [sic] and an agent.” Id. at *4. The Chiltons acted as agents for RC LLC and so owed the members fiduciary duties.

Second, the majority ignored Section 275.170 of the Kentucky LLC Act, which extends fiduciary duties to members as well as managers:

 (2)     The duty of loyalty applicable to each member and manager shall be to account to the limited liability company and hold as trustee for it any profit or benefit derived by that person without the consent of more than one-half (1/2) by number of the disinterested managers, or a majority-in-interest of the members from:

   .…

 (b)        Any use by the member or manager of its property, including, but not limited to, confidential or proprietary information of the limited liability company or other matters entrusted to the person as a result of his or her status as manager or member.

Ky. Rev. Stat. Ann. § 275.170(2) (emphasis added).

Third, the dissent pointed out that the Patmon opinion, which the majority relied on, referred to the duties of managing members because the defendant was the managing member of the LLC, but Patmon did not exclude members from fiduciary duties.

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