Thursday, February 23, 2017

Kentucky Court of Appeals Affirms Piercing the Veil

Kentucky Court of Appeals Affirms Piercing the Veil

      In a decision rendered last Friday, the Kentucky Court of Appeals affirmed the determination that the veil of an LLC should be pierced, primarily on the basis, it would appear, that the company was undercapitalized. Roscoe v. Angelucci Acoustical, Inc., No. 2012-CA-001933-MR, 2014-CA-000536-MR, 2017 WL 655488 (Ky. App. Feb. 17, 2017).
      In 2006, Lexhold Partners II Lot 14-A Exclusive, LLC (“Lexhold Partners”) was awarded the contract to construct a building now occupied by Hewlett-Packard. Although, apparently, the property is owned by the University of Kentucky, Lexhold Partners holds the lease vis-a-vis Hewlett-Packard. In order to affect this project, another LLC, Lexhold Premier Commercial Contractors, LLC (“Premier”), was formed. Upon completion of the project, Premier was dissolved. Roscoe, one of the defendant in this action, was one of the two “managing partners” of each of Lexhold Partners and Premier. It should be noted that, throughout this opinion, partnership and corporate terminology is intermixed even as the decision is about an LLC.
       Premier subcontracted with Angelucci Acoustical, Inc. (“Angelucci”) for the installation of drywall and acoustical ceilings. That subcontract had a price of $396,240.30. The building was completed, and occupancy undertaken, even as Angelucci continued to complete certain tasks. Angelucci alleged that it incurred an additional $88,053.70 in completing those additional task, while Roscoe alleged that they were simply additional punchlist items included in the original purchase price. Angelucci filed suit against Premier, Lexhold Partners and Roscoe seeking those additional amounts. Angelucci sought and was awarded partial summary judgment; that ruling became final, and Roscoe did not appeal.
       Nearly a year later, on bases not fully identified in this decision, the trial court pierced the “corporate” veil of Premier (the general contractor) to hold Roscoe liable on the $88,053.70 (plus interest) judgment. This appeal followed. However, in connection therewith, Roscoe did not file a supersedeas bond. Roscoe thereafter failed to comply with requirements as to judgment discovery and, notwithstanding having entered into a settlement agreement in the amount of only $30,000, he failed to discharge that obligation. After hearing, the trial court issued a judgment against Roscoe totaling $334,785.34, which amount included compensatory and punitive damages and attorney’s fees. Roscoe then filed this appeal.

      With respect to the piercing claim, the decision of the Court of Appeals is somewhat cryptic as to why that was permitted. It appears that facts justifying piercing were as follows:
·         “the two managing members of the Lexhold Partners are the same to managing members of Lexhold Premier, Roscoe and Oliver. They developed Lexhold Premier Commercial Contractors, LLC solely for the purpose of serving as the general contractor for the project. This construction project was the only asset of Lexhold Premier.”; and
·         in two instances, Lexhold Partners was identified as the “owner” of the property (Angelucci was not a party to either of these agreement).
Quoting from the trial court, the Court of Appeals observed that:
As in Inter-Tel, Lexhold Partners caused Lexhold Premiere to be obligated to pay Angelucci for work performed on the subject property and then rendered it unable to pay. Lexhold Partners limited the value of the sole asset of Lexhold Premiere and caused it to bear the brunt of the failure to pay subcontractors while Lexhold Premiere derive the benefit of the improvements to real property by its lease agreement with the landowner and agreement with HP.
Similarly, it appears that the second scenario identified in Inter-Tel applies as all assets that could or should have been part of Lexhold Premiere were moved beyond the reach of legitimate creditors and have been retained largely by Lexhold Partners. Roscoe concedes that Premiere was formed for the sole purpose of trying to escape the hassles and liabilities associated with being a general contractor[,] and he and Oliver wanted to keep the money “in house.” Premiere had no assets other than the $5,247,000 contract with Lexhold Partners and was in Roscoe’s terms a “pass-through.” Moreover, Partners has reaped all of the benefits from this construction project and currently receives revenue from its lease with the sole tenant of the building, Hewlitt-Packard. That was the purpose of its original lease with “Commonwealth of Kentucky for the use and benefit of the University of Kentucky acting by and through the Board of Trustees of the University of Kentucky.” To allow Partners and Roscoe to escape liability under these circumstances would, in fact, sanction fraud and promote injustice against Angelucci and the other subcontractors.
      What steps were undertaken by Roscoe in order to render Lexhold Premier unable to satisfy its obligations, thereby effectuating a fraud, was not detailed by the Court of Appeals. In the underlying opinion and order issued by the Fayette Circuit Court (Judge Goodwine), it had been found that:
[B]oth Lexhold Premier and Lexhold Partners worked on the same project and had no other business. Lexhold Premier’s sole asset was its contract with Lexhold Partners. The two companies have the same member-managers and nearly identical operating agreements. Minutes were not kept for company meetings. Bill Boshong performed work for both entities but Lexhold Partners paid the entire amount of his bill. Derek Roscoe only performed work for Lexhold Partners but was paid by Lexhold Premier as well. Lexhold Partners paid cost attributable to Lexhold Premier, and vice versa. Slip op. at 8.
Then, after reciting a number of other circumstances in which the companys’ assets were apparently intermingled, it was observed that:
It is clear to this Court that Lexhold Partners and/or Roscoe exercise complete dominion and control over Lexhold Premier. Roscoe and/or Oliver provided for or guaranteed 100% of the startup costs to fund Lexhold Premier. They set the contract amount of $5,247,000 that they would pay Lexhold Partners, i.e themselves. There is no evidence that Lexhold Premier followed any corporate formalities; Roscoe and/or Oliver used the companies’ that funds interchangeably and funds from one paid the expenses of the other. Whether premier was paid the $5,247,000 due under its contract with Partners was solely within the discretion of Partners. Roscoe conceded that Premier paid him certain “expenses which connected to his work" on the project. He also conceded that he directed Premier to pay his son sums that he believed were due him. Slip op. at 10.

      The court would go on to find that the assets of Lexhold Premier, the general contractor, had been “moved beyond the reach of legitimate creditors and have been retained largely by Lexhold Partners,” with the result that “Partners has reaped all of the benefits of this construction project and currently receives revenue from its lease with the sole tenant of the building, Hewlett-Packard. … to allow Partners and Roscoe to escape liability under these circumstances would, in fact, sanctions fraud and promote injustice against Angelucci and the other subcontractors.” Slip op. at 11-12. Again, how the assets were moved so as to be unavailable to Angelucci and other creditors is not detailed.
      From that same order it becomes clear that the question of the name of the property owner relates to a challenge to Angelucci’s mechanics lien.
      From the perspective of the law of piercing, this decision is in several respects disturbing. First, while on the facts piercing may have been justified, the Court of Appeal’s affirmance without a detailed recitation of those facts leaves the reader wondering what truly happened. Second, the continued reference to the “corporate” veil in the context of an LLC is simply incorrect and as well glosses over the problem that the courts have not identified whether and to what extent the Inter-Tel Technologies test for piercing will be different for LLCs versus corporations. Third, justifying, at least in part, the piercing of an LLC based upon the failure to satisfy “corporate formalities” is at best confusing. While corporations are obligated to have meetings and keep minutes, the LLC Act does not require either meetings or minutes. If, in this particular case, the operating agreement dictated that meetings would be held and minutes kept, then there may have been a failure to follow a contractually assumed obligation. If that was the case, it was not detailed by either the Court of Appeals or the trial court. Conversely, if there was no such contractual obligation, supporting a ruling on piercing based upon the failure to do what is not required is nonsensical.
      More broadly, the courts’ language with respect to related special-purpose business organizations is very troubling. Blanket statements to the effect that the companies were related and had the same members/management structure, and on that basis piercing was justified, dangerously simplifies proper piercing analysis. It has long been the law that the organization of various business ventures for the purpose of limiting liability (i.e., partitioning various asset pools into different ventures with the intent and objective of exposing each to only a certain class of creditor claims) is an accepted business practice. There is no question that the utilization of these structures in an abusive manner should not be allowed and that piercing should be a possible remedy for that abuse. The structures themselves are not, however, ab initio abusive or improper, and flippant language to the effect that related ventures should, for that reason, be pierced is unjustified. Rather, while related, special-purpose entities may be particularly at risk for violating the rules as to when piercing is justified, there should not be any implication that piercing is justified because of relatedness.

Wednesday, February 22, 2017

Bankruptcy Court Refuses to Enforce Contractual Default Rate of Interest

Bankruptcy Court Refuses to Enforce Contractual Default Rate of Interest

      In recent decision from the Bankruptcy Court for the Western District of Kentucky (Judge Lloyd), efforts by the lender to enforce a default rate of interest, that being the original rate of interest +5%, were rejected. In re: Perkins, Case No. 16-10383(1)(12), 2017 WL 439319 (E.D. Ky. Bankr. Feb. 1, 2017).
      BB&T had extended a series of loans, all secured by a farm property.  Important for the ultimate decision, the loans were over secured based on the value of the collateral.
      The loan documents, which were at a variety of interest rates, each provided that, on default, a default contractual rate of interest, that being the original interest rate +5%, would apply. BB&T requested an order from the court to award to get interest at that rate.  In response, the Bankruptcy Court noted that it considers the award of interest “based on the facts inequities of each case.” and that:
Case law establishes that a presumption arises in favor of the contractual rate of interest that is subject to rebuttal based on equitable considerations. The presumption is rebutted where the evidence establishes that the default rate is significantly higher than the pre-default rate without any justification being offered for the difference.

      In this instance, the Court found that that rebuttal was successful.  This rebuttal was based upon the fact that the default rate of interest was this at least double wide had previously been agreed upon.  Essentially, that increased rate of interest did not serve to protect BB&T, as the creditor, from nonpayment.  Rather, the excess value of the collateral had already accomplished that goal. Further, application of the default rate of interest in favor of BB&T would have significantly reduced the size of the estate with the result that it would “materially decrease payment, if not completely eviscerate payments to the unsecured creditors in this case.”

Tuesday, February 14, 2017

New York Shapiro Decision Upheld; a Majority of the Members May Adopt an Operating Agreement

New York Shapiro Decision Upheld; a Majority of the Members
May Adopt an Operating Agreement

      Under the New York Limited Liability Company Act, an operating agreement may be amended by a simple majority of the members (this rule may itself be modified in the operating agreement to, for example, raise the threshold to unanimity). Kentucky has the same majority rule with the same ability to modify it in a written operating agreement. In the Shapiro case, the New York Supreme Court (the trial court) held that, in a three member LLC, all of the members having an equal interest in the company, a majority thereof could adopt a new operating agreement. This case was reviewed in Peter Mahler’s blog New York Business Divorce (HERE IS A LINK to that posting). I reviewed the decision as well, particularly with respect to its application in Kentucky. HERE IS A LINK to that posting.
      Recently, the Appellate Division in New York (the intermediate Court of Appeals) has substantially affirmed (it tweaked the reasoning) the trial court’s decision. Peter Mahler has, as always, provided an outstanding review of the decision; HERE IS A LINK to that discussion.

Monday, February 13, 2017

Kentucky Supreme Court Passes on Reviewing Holding That Shareholders Do Not Owe One Another Fiduciary Obligations

Kentucky Supreme Court Passes on Reviewing Holding That Shareholders Do Not Owe One Another Fiduciary Obligations

      As previously reviewed (HERE ISA LINK to that posting), the Kentucky Court of Appeals has shareholders in a corporation, in their capacity as shareholders, do not stand in a fiduciary relationship with one another. See Conlon v. Haise, No. 2014-CA-001581-MR, 2016 WL 5485531 (Ky. App. Sept. 30, 2016).
      After this decision was handed down, the plaintiff (Conlon) sought review and reversal of this decision by the Kentucky Supreme Court. Last Friday the Kentucky Supreme Court issued its ruling that it would not be reviewing the decision. While it did direct that the decision of the Court of Appeals not be published, as this is the only point decision of a Kentucky court, it may be cited as precedent.

Tuesday, January 31, 2017

Erroneous Declaration of Diversity Jurisdiction Could Cost the Plaintiff

Erroneous Declaration of Diversity Jurisdiction Could Cost the Plaintiff


In the decision from earlier this month, the United States District Court for the Southern District of New York opined with respect to a belated determination by the plaintiff that, in fact, diversity jurisdiction did not exist in a lawsuit that has been pending for 19 months. While the court dismissed the action without prejudice so that it could be re-filed in state court, it is considering sanctions against the plaintiff.  Errant Gene Therapeutics, LLC v. Sloan-Kettering Institute, 15-CV-2004, NYLJ 1202777366266 (S.D.N.Y. Jan 18, 2017).

Errant Gene Therapeutics, LLC (“Errant Gene”) brought suit, based upon the existence of diversity jurisdiction, against Sloan-Kettering. In connection therewith, Errant Gene made certain representations to the court as to the existence of diversity jurisdiction. On that basis, the suit proceeded for some 19 months. At the end of that period, Errant Gene advised the court that, in fact, diversity jurisdiction was lacking because one of the members of one of its member LLCs was in fact a New York resident. At the time of the prior representation of diversity jurisdiction, that person was inaccurately identified as being a resident of Delaware.

Sloan-Kettering resisted the effort to dismiss the case on the basis of the lack of diversity, but the court correctly determined that it must do so. “Under the circumstances, the Court has no choice but to GRANT Errant Gene’s motion. Accordingly, this action is DISMISSED WITHOUT prejudice to refile in state court.”

The court was not, however, done with this matter. Rather, noting that it has authority to amongst other things impose sanctions under FRCP Rule 11, it directed that:

Particularly in light of Errant Gene’s somewhat imprecise descriptions of both its original inquiry into its citizenship and its recent discovery of the lack of citizenship (not to mention it’s rather sluggish presentation of the pertinent facts to the Court, it is hereby ORDERED that Errant Gene and its counsel show cause, within 14 days, why Errant Gene and/or its counsel should not be sanctioned pursuant to Rule 11(c) for misrepresenting to the Court, in sum and substance, that Errant Gene was not a citizen of New York for purposes of diversity jurisdiction and allowing the litigation to proceed for months on the basis of that inaccurate statement.

What will happen in this particular case remains to be seen. Regardless, a court issuing a show cause order of this nature is a good reminder of the importance of a detailed assessment of the existence of diversity jurisdiction.

      My thanks to Peter Mahler for the lead on this case.

Monday, January 30, 2017

Kentucky Court of Appeals Addresses the Distinction between an Independent Contractor and an Employee

Kentucky Court of Appeals Addresses the Distinction between an Independent Contractor and an Employee

      In a December, 2016 decision, the Kentucky Court of Appeals again waded into the question of whether a particular person, based upon the manner in which they perform services, is properly characterized as an independent contractor or as an employee. On the facts here presented, the court found that an individual engaged in the delivery of newspapers was, as a matter of law, an independent contractor and not an employee. Armstrong v Martin Cadillac, Inc., No. 2015-CA-001892-MR (Ky. App. December 22, 2016).
      This dispute arose out of an automobile accident and related claims by the estate of Jonathan Elmore, one of the deceased in the accident, who was at the time of the accident was delivering the Daily News paper. One question was whether Elmore, delivering the papers, was an employee of the publisher, News Publishing, LLC, in which case liability under respondeat superior could attach, or rather was he an independent contractor?
      After reviewing the manner in which particular individuals are contracted with to deliver papers, including the fact that the carriers purchase the paper at a bulk rate and in effect resell to generate a profit, the court applied the 10 factor test set forth in the Restatement (Second) of Agency § 220. The Court of Appeals affirmed the lower court's determination that the relationship between News Publishing and Elmore was that of an independent contractor. On that basis, the newspaper publisher was not responsible for the consequences of the accident.

Friday, January 27, 2017

Delaware Supreme Court Emphasizes the Gap-Filling Role of the Implied Covenant of Good Faith and Fair Dealing

Delaware Supreme Court Emphasizes the Gap-Filling Role of the Implied Covenant of Good Faith and Fair Dealing
      In a decision rendered last week, the Delaware Supreme Court reviewed the gap-filling role of the implied covenant of good faith and fair dealing, emphasizing that it addresses lacuna between negotiated terms in order to give full effect to the agreement. In this instance, notwithstanding asserted compliance with the express terms of the agreement, the plaintiff's case could go forward because the defendant’s actions, even if the in strict compliance with the agreement’s express terms, did not satisfy the obligation of good faith and fair dealing.  Dieckman v. Regency GP LP, No. 208, 2016, 2017 WL 243361 (Del. Jan. 20, 2017.
      The underlying transaction involved a merger between two limited partnerships, both within the same family of a master limited partnership. In that transactions of this nature are anticipated, the partnership agreement contained a pair of mechanisms for addressing the conflict. First, the proposed transaction could be negotiated and approved by an independent committee. In the alternative, the transaction could proceed if it received the approval of a majority of the unaffiliated limited partners. In this instance, a belt and suspenders approach was (purportedly) employed. First, a two-person independent conflicts committee was charged to oversee the transaction. Thereafter, a comprehensive proxy statement (not required by the partnership agreement) was distributed to the limited partners soliciting their consent to the transaction based, in part, upon the independent review of the conflicts committee.
      When a limited partner challenged the transaction, it was defended on the basis that it had received the approval of both the independent conflicts committee and a majority of the unaffiliated limited partners, and on that basis the transaction was not subject to further scrutiny. While the Chancery Court accepted that argument, it was rejected by the Delaware Supreme Court. With respect to the independent conflicts committee, the Supreme Court found that it was not, at least for the standards employed in connection with a motion to dismiss, independent. Rather, of the two members, one of them had begun review of the transaction while still affiliated with the general partner. In fact, the persons comprising the committee had to effect certain resignations in order that they could become “independent”, and immediately after approving the transaction they were rehired to positions that would have created a conflict. Also, the standard for independence included that for members of an audit committee of a company listed on the New York Stock Exchange, but those standards were never satisfied.

As with the contract language regarding Unaffiliated Unit Holder Approval, this language is reasonably read by Unit Holders to imply a condition that a Committee has been established whose members genuinely qualified as unaffiliated with the General Partner and independent at all relevant times. Implicit in the express terms is that the Special Committee membership be genuinely comprised of qualified members and that deceptive conduct not be used to create the false appearance of an unaffiliated, independent Special Committee.
The plaintiff has agreed that the LP Agreement’s safe harbor provisions, if satisfied, would preclude judicial review of the transaction. But we find that the plaintiff has pled sufficient facts to support his claims that those safe harbors were unavailable to the General Partner. Instead of staffing the Conflicts Committee with independent members, the plaintiff alleges that the chair of the two-person Committee started reviewing the transaction while still a member of an Affiliate board. Just a few days before the General Partner created the Conflicts Committee, the same director resigned from the Affiliate board and became a member of the General Partner’s board, and then a Conflicts Committee member.
Further, after conducting the negotiations with ETE over the merger terms and recommending the merger transaction to the General Partner, the two members of the Conflicts Committee joined an Affiliate’s board the day the transaction closed. The plaintiff also alleges that the Conflicts Committee members failed to satisfy the audit committee independence rules of the New Your Stock Exchange, as required by the LP Agreement. In the proxy statement used to solicit Unaffiliated Unit Holder Approval of the merger transaction, the plaintiff alleges that the General Partner materially misled Unit Holders about the independence of the Conflicts Committee members. In deciding to approve the merger, reasonable unit holder would have assumed based on the disclosures that the transaction was negotiated and approved by a Conflicts Committee composed of persons who were not “affiliates” of the general partner and who had the independent status dictated by the LP Agreement. This assurance was one a reasonable investor may have considered a material fact weighing in favor of the transaction’s fairness.