Merger Clauses - Why “Boilerplate” Matters

Merger Clauses

(Why “Boilerplate” Matters)

            Recently the Kentucky Court of Appeals was able to dispose of a case based upon the merger clause in the final agreement.

Larry Leedy formed and was the sole shareholder of Lifestar Ambulance Service, an assumed name of L.I.L., Inc. (“Lifestar”).  Several years later he entered into negotiations with Michael Pistole to sell Lifestar.  On December 9, 2003, Leedy and Pistole and Life Ambulance Services, Inc. (“LAS”) entered into a preliminary agreement for confidentiality while Pistole considered the investment.  On January 5, 2004, Leedy (through his agent) and Pistole signed a preliminary purchase agreement pursuant to which Pistole would buy the assets and assume the debts of Lifestar (the opinion does not address whether LAS was a party to this agreement).  That preliminary agreement provided it would be effective until a final purchase agreement was completed.  LAS’ Articles of Incorporation were filed on February 2, 2004.

Once Pistole’s operation of an ambulance services was approved by the fiscal court, Lifestar and LAS entered into a final purchase agreement.  One of the debts assumed was a $164,000 obligation to the IRS.  Ultiately the IRS sought to enforce that obligation against (and here the opinion is less than clear) Leedy’s estate and or his wife Myrtle, she being his heir.  Myrtle then brought suit against Pistole for the amount she paid the IRS in settlement of the claim, asserting that this obligation had been assumed by Pistole.  Pistole defended that he was not personally obligated on that amount; rather, only LAS was a party to the assumption of the obligation to the IRS.

            While the final purchase agreement was between Lifestar and LAS, Myrtle pointed to the preliminary confidentiality agreement and the preliminary purchase agreement, both providing that Pistole was a party.  Further, on the basis that LAS was incorporated after the preliminary agreements were signed, it was argued that Pistole, as promoter, was personally liable on the debts undertaken by the then nonexistent corporation.

The trial court granted Pistole summary judgment, and this appeal followed. Leedy v. Pistole, 2011 WL 2162686 (Ky. App. 2011) (Not to be Published).

Myrtle had two arguments, promoter liability and trust fund liability under KRS § 271B.14-070(4)(b). 

As for promoter liability, Myrtle relied upon the formulations of promoter liability set forth in Pierson v. Coffey, 706 S.W.2d 409 (Ky. App. 1985) and Kennedy v. Fulton Mercantile Co., 108 S.W. 948 (Ky. 1908).  Essentially, an actor purporting to bind a corporation that does not exist is personally liable on the debts created.  The Court of Appeals found, however, that this rule was not applicable.  First, the preliminary purchase agreement provided that it would be effective only until the final agreement was completed.  Second, the final purchase agreement was entered into on LAS’ behalf after its incorporation, Pistole was not individually a party to the final agreement, and that agreement provided in part:

“This constitutes the entire agreement.  There are no other representations or understandings other than those contained herein.”  2011 WL 2162686, *4.

Pistole, not being a party to the final agreement in which LAS agreed to answer for Leedy’s obligation to the IRS, could not be held responsible on that debt.

As an aside, why is the concept of promoter liability being discussed as if it is a notion of the common law?  In 1988 the Kentucky General Assembly adopted a statute on promoter liability.  KRS § 271B.2-040.  “We [the courts] are ever mindful that the ‘judicially created common law must always yield to the superior policy of state enactment and the Constitution.’” Willis v. Louisville/Jefferson County Metro Sewer District, 2020 WL 4137492, *3 (Ky. App. 2010) (citations omitted).  If a common law concept has been reduced to statute, why are cases, rather than the statute, being cited?

The Court disposed of the trust fund argument on the basis that it had not been raised with the trial court and therefore could not be raised on appeal.  Apparently ALS has been sold (the opinion does not address whether it was an asset or a stock sale, but as ALS was administratively dissolved in 2005 it likely was an asset sale), and pursuant to KRS § 271B.14-070(4)(b) Myrtle sought to collect the net sale proceeds that were distributed to Pistole to have them applied against the debt to the IRS.  It would have been a good argument.  See also Bear, Inc. v. Smith, 303 S.W.3d 137, 146-47 (Ky. App. 2010). 

Upcoming from the Kentucky Supreme Court - Valuation in Dissenter Rights Actions

Upcoming from the Kentucky Supreme Court -

Valuation in Dissenter Rights Actions

Shawnee Telecom, Inc. v Kathy Brown, 2009-SC-000574-DG, was argued to the Supreme Court on April 13, 2011.  This case will provide guidance on whether or not a marketability discount may be applied in valuing the shares of a dissenting shareholder.

In Ford v. Courier-Journal Job Printing Co., Inc., 639 S.W.2d 553 (Ky. App. 1982), the Court permitted a 25% discount on the shares held by a dissenter from a sale of substantial (but not all) corporate assets.  No published decision again reviewed the point until 2009.

That case was Shawnee Telecom, Inc. v. Kathy Brown, 2009 WL 2475269 (Ky. App. 2009).  In this opinion, designated “Not to be Published,” the Court of Appeals reversed the trial court for permitting a 25% discount of Brown’s shares, she having dissented from the terms of a squeeze out merger.  Quoting a decision of the Delaware Supreme Count, the Court of Appeals wrote:

To fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders.

After the Court of Appeals’ ruling in Shawnee Telecom, an en banc decision of the Court of Appeals expressly overruled the Ford decision.  Brooks v. Brooks Furniture Mfgrs., Inc., 325 S.W.3d 904 (2010).

The Brooks case, like Shawnee Telecom, involved a squeeze merger.  Curiously, it was Shawnee Telecom, an unpublished and unanimous decision of the Court of Appeals, and not the published en banc ruling in Brooks from which there was a dissent, that was appealed to the Kentucky Supreme Court.  Likewise it is curious that it is the rather more cursory Shawnee Telecom decision, as contrasted with the significantly more in-depth analysis in the Brooks opinion, that comes before the high court.

The Battle of Salamis

The Battle of Salamis

Today is the anniversary of the Battle of Salamis, which took place in 480 B.C.

A decade earlier Darius of Persia invaded Greece.  It was the famous victory at Marathon that put an end to that venture.

Xerxes, successor to Darius, again invaded Greece.  Those of you who saw “The 300” know something of how part of this invasion went.  BTW, while parts of that movie conform to the sources (“then we will fight in the shade”), much of it does not.  For example, Sparta had not one but two kings, and Leonidas had already fallen before the final onslaught and destruction of the Spartan force.  Still they had achieved their objective, namely delaying the Persians.

At Salamis the Greek fleet attacked that of Persia and won a major victory.  The Persian army, fearing that it would be trapped in Greece, largely withdrew.  The remainder met the Greek army the next year at Plataea.  It was at Plataea that the exhortation with which The 300 opens and closes takes place.  That battle was not the set piece that is indicated in the movie, but it did result in a Greek victory. 

There were no more Persian invasions of Greece.

IRS Announces “Voluntary Worker Classification Settlement Program”

IRS Announces “Voluntary Worker Classification Settlement Program”

Distinguishing an “employee” from an “independent contractor” can be an involved and ultimately unsatisfying task.  The IRS uses a test utilizing fourteen factors (unweighted between the factors) in making its assessment, but without explaining the number of factors that do or do not drive the ultimate determination.  The IRS’ prejudice is in favor of classification as an employee versus an independent contractor – employee withholding each pay period and a W-2 are preferred to (maybe) quarterly estimated payments and a Form 1099.

The consequences of a classification audit can be drastic.  In addition to liability for unpaid trust fund (FICA, FUTA) taxes, interest and penalties, the company may find itself out of compliance on 401(K) and other retirement savings and as well health insurance plans and statutes dependent on application to the number of employees such as COBRA or the FMLA.

The IRS has announced a program for the companies to reclassify independent contractors as employees.  The program is restricted to companies that have consistently treated the workers as independent contractors, all Forms 1099 have been properly filed for the last 3 years and the company not be currently under a classification audit.  See Announcement 2011-64.  The toll charge for relief from these retrospective penalties is a penalty of 10% of the trust fund taxes (employer and employee side) for the last year and a statue of limitations extension from 3 years to 6.

Companies with independent contractors whose classification is debatable (and few of them are not) may want to assess whether moving them to employee status under this program is advantageous.

A Corporate Director’s Duty of Loyalty Is Owed to the Corporation

A Corporate Director’s Duty of Loyalty Is Owed to the Corporation

       In 1400 Willow Council of Co-Owners, Inc v. Ballard, 2010 WL 2010521, 2010 Ky. App. LEXIS 94, No. 2008-CA-001155-MR (Ky. App. 2010), the Court of Appeals considered a case primarily involving the degree to which a condominium association would be responsible for certain costs of maintenance to a unit’s windows.  For our purposes, the interesting point of the case is an allegation that the directors owed an individual duty of loyalty to the plaintiff as distinct from the duty of loyalty to the entity.  Specifically, the Court reversed a determination that fiduciary duties had been violated, finding the following jury instruction to have not properly set forth the law:

Is the duty of the Council, acting through its Board of Directors to exercise good faith and loyalty in conducting the business of the Council which includes an obligation to exercise good faith and loyalty in making decisions with respect to all co-owners, including co-owner Patricia Ballard.  If you find, from the evidence, that the Council, acting through its Board of Directors, failed to comply with this duty and that such duty was a substantial factor in causing loss to Patricia Ballard, you shall find for Patricia Ballard.  Otherwise, you shall find for the Council.

Turning to the language of the statute (more on that below), the Court noted that:

KRS 273.215 specifies the standards to be followed by directors of a nonprofit corporation.  Of particular relevance to this case is KRS 273.215(1) which states:

A director of a nonprofit corporation subject to the provisions of KRS 273.161 to 273.387 shall discharge his duties as a director, including his duties as a member of a committee:

(a) in good faith;

(b) on an informed basis; and

(c) in a manner he honestly believes to be in the best interests of the corporation.

      It was the Court of Appeals that italicized “corporation” in its recitation of the statute.  Interpreting this provision, the Court wrote:

We read KRS 273.215(1) to mean directors in Kentucky owe their allegiance to the corporation (or in this case, the Council) as a whole, and not to individual members/shareholders (or in this case, co-owners like Ballard).  This is a reasonable interpretation since co-owners could have competing agendas, none of which may be in the best interests of the Council.

       A pair of thoughts follow from this direction.  First, if the duty of loyalty is owed exclusively to the corporation, and there exists no duty of loyalty to the members, as individuals, of the nonprofit corporation, it would follow that a suit complaining of a breach of loyalty must be derivative, and not direct, in nature.  Second, in that KRS § 273.215(1) is identical in terminology to KRS § 271B.8-300(1) (and it bears noting that the two statutes were adopted in the same 1988 General Assembly), presumably this holding is equally applicable in the context of a business corporation.

       As to the Court actually referencing and discussing the particulars of the statutory formulation of the fiduciary duty, such is too often missing from decisions of this nature.  Rather, the typical formula is a bland conclusion that the actor was subject to and violated a duty of loyalty.  As I have elsewhere observed:

A simple statement that a person is a fiduciary and therefore owes a duty of loyalty is misleading because it is incomplete.  The duty of loyalty is not a monolithic, self-defined and self-effective rule or series of rules; rather, different duties of loyalty are applicable under different circumstances.  A bare declaration that a person is a fiduciary subject to a duty of loyalty and that his conduct violated the duty ignores the crux of the question; that is, the nature of the duty of loyalty as relating to particular facts and circumstances.  The only way the duty of loyalty can be properly evaluated is by making an inquiry that includes interpretation of the applicable agreement and of the particular governing statute and applying the same to the unique facts and circumstances of the case.

Thomas E. Rutledge & Thomas Earl Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Ark. L. Rev. 473, 499-500 (2010).  These requirements, I posit, are consistent with the direction of the United States Supreme Court:

But to say that a man is a fiduciary only begins analysis; it gives direction to further inquiry.  To whom is he a fiduciary?  What obligations does he owe as a fiduciary?  In what respect has he failed to discharge these obligations?  And what are the consequences of his deviation from duty?

S.E.C. v. Chency Corp., 318 U.S. 80, 85-86 (1943).

            It should be noted that the Kentucky Supreme Court, on September 14, 2011, granted discretionary review in this case, and that the application for discretionary review included this point of the Court of Appeals’ opinion.  Essentially, Ballard seeks a determination that common law fiduciary duties of “candor and good faith” are individually owed by the directors to the members.  Motion for Disc. Review at 2, 13.  1400 Willow’s response is that “The legislature settled this question clearly when it enacted KRS 273.215(1).”  Response to Motion for Disc. Review at 10.  The argument continued with “The legislature explicitly and clearly defined the ‘duties’ of a director of nonprofit corporations that are organized under Chapter 273,” noting that a broad statute addresses the subject matter of the common law, the statute suspends the common law.”  Id. at 11, 12, citing Aetna Ins. Co. v. Comm., 51 S.W. 624 (Ky. 1899).

       My view is (no surprise here) that 1400 Willow has what must be the prevailing argument.  The various formulae employed in our business entity statutes define the existence of duties, who owes those duties, to whom are those duties owed, and the standards required for holding one culpable for breach.  The legislature well knows how to leave the duties openended (e.g., KRS § 362.1-401(1) (“includes”)). 

       If the General Assembly is not able to make determination as to the rules in corporations, then there cannot be proxy voting (at common law proxies were forbidden), approval of a merger by majority vote (at common law a merger required the approval of all shareholders), a heightened standard of culpability (see KRS § 271B.2-020(2)(d); id. § 271B.8-300(5)) for violation of the duty of care or a near elimination of the doctrine of ultra vires (KRS § 271B.3-040; id. § 273.173).  Besides, isn’t setting the rules for corporations what section 190 of the Kentucky Constitution says the General Assembly is to do?  At a practical level, if the statutes are not going to be applied as written, who will even know what are their rights and who will even know what is expected of them?

Pompey the Great

Pompey the Great

Today is the anniversary of the assassination of Pompey the Great on his (almost) arrival in Egypt.  Having lost the Battle of Pharsalus to Julius Caesar, he fled to Egypt hoping for refuge and the opportunity to raise a new army.  The Egyptians, knowing that Caesar would be on Pompey’s heals, arranged for his assassination before he reached the shore.  For those of you who enjoyed the HBO series Rome, while Pompey was killed in sight of his wife, there were more assassins than the one depicted, and it took place in the boat, not as Pompey walked to shore.

Today is also the anniversary in 1066 of the arrival of the troops of William of Normandy (soon to be “the Conqueror”) in England.  This is the last successful invasion of England.

Delaware Court Applies Enhanced Scrutiny, Invalidates Vote Blocking Provision of Preferred Stock

Delaware Court Applies Enhanced Scrutiny, Invalidates Vote Blocking

Provisions of Preferred Stock

Although the directors of Xurex, Inc., a company with at best a painful history, acted with subjective good faith when they authorized additional equity classes that served to dilute certain voting blocks and thereby provide stability to management, applying strict scrutiny, the directors were found to have violated their fiduciary obligation of loyalty.  Johnson v. Pedersen, ___ A.3d ___, 2011 WL 4435806 (Del.Ch.).

Without reciting the history of the company’s financial woes and abrupt changes in management, the company was without cash, entirely dependent on one licensee for income, had suffered several abrupt changes in the board and was subject to further changes by reason that a majority of the shares were held by two shareholders.  Attempting to raise new equity, a Series B Preferred class was proposed.  Pursuant to the Board’s authority under a blank check provision, the Series B was defined as being voting and while any Series B shares are outstanding the consent of a majority of the of its holders, “voting separately as a single class, shall be required for the approval of any matter that is subject to a vote of the Corporation’s shareholders….”

The battle over the Series B Preferred came to a head when the acquirer of its sole customer sought to gain control, though a proxy contest, of Xurex.  While the challenger had proxies for more than half of the total equity, they held proxies for only 13% of the Series B Preferred.  If the right to block shareholder action as embodied in the terms of the Series B was valid the proxy contest would fail, but if it was invalid then once again control of Xurex would pass to a new board.

The Court (V.C. Laster) applied the intermediate stage of enhanced scrutiny analysis, it applying “where the law provides shareholders with a right to vote and the directors take action that intrudes on the space allotted for stockholder decision-making.”  2011 WL 4435806, *10, quoting Reis v. Hazelett Strip-Castings Corp., 2011 WL 4346913, *8 (Del. Ch. 2011).  The Court went on to observe:

When tailored for reviewing director action affecting a stockholder vote, enhanced scrutiny requires that the defendant fiduciaries bear the burden of persuading the Court that their motivations were proper and not selfish, that they did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way, and that the directors’ actions were reasonably related to a legitimate objective. If the fit between means and end is not reasonable, then the directors fall short. When the vote involves an election of directors or touches on matters of corporate control, the directors must support their decisions with a compelling justification. The shift from “reasonable” to “compelling” requires that the board establish a closer fit between means and end. Moreover, in such a context, there is one justification that the directors cannot invoke: they cannot claim that the stockholders may vote out of ignorance or mistaken belief about what course of action is in their own interests.  Id. (citations omitted). 

Determining that the director’s duty of loyalty has been violated and that the holders of the Series B Preferred were not entitled to a class voting right, the Court wrote:

The incumbent directors could not act loyally and deprive the stockholders of their right to elect new directors, even though they believed in good faith that they knew what was best for the corporation ….  The right to choose who should be members of the Xurex board did not belong to the Xurex directors; it belonged to the Xurex stockholders.  2011 WL 4435806, *11.

Ability to Bring Claim Not Terminated by Administrative Dissolution

Ability to Bring Claim Not Terminated by Administrative Dissolution

In Petro Energy, Inc. v. Witham, No 2009-CA-002316-MR (Ky. App. Sept. 2, 2011) (Not To Be Published), the Court addressed the ability of an administratively dissolved corporation to bring a counter-claim.

In 1993 the Withams purchased from the Wilsons real property that was subject to a number of encumbrances, including Wilson’s promissory not in favor of Citizens Bank of Albany.  That note was later assigned to Petro Energy.  The Wilsons were the sole shareholders of Petro Energy.

In 2005 the Withams brought an action to determine what liens on the property were valid, to which Petro Energy answered, asserting its note and mortgage were valid and enforceable.  The trial court dismissed Petro energy’s claim, a determination that was reversed by the Court of Appeals. 

Although it requires some reading between the lines, it appears that the trial court dismissed Petro Energy’s claims on the grounds that it was dissolved, the Court of Appeals noting the Withram’s argument the an administratively dissolved corporation may not bring a counterclaim, citing in support 19 Am.Jur.2d Corporations § 2896. Rejecting this argument, the Court quoted portions of KRS § 271B.14-050, the statute defining what is (and is not) the effect of a corporation’s dissolution.   Specifically:

·                    A dissolved corporation continues its corporate existence and may:

·                    collect its assets;

·                    do every other act necessary to wind up and liquidate it business and affairs; and

·                    Dissolution does not:

·                    transfer title to the corporation’s property;

·                    prevent the commencement of actions by and against the corporation in its name; or

·                    terminate the authority of the registered agent.

At one time the common law directed that a corporation’s dissolution was its legal death (civiliter mortuus).  Dissolution transferred title of the corporation’s property, terminated its ability to sue or be sued, and as well terminated its debts.  See, e.g., 16A William Meade Fletcher, Fletcher Cyclopedia of the Law of Private Corporations § 8113.  These principles have been long abandoned, a fact recognized by Kentucky’s then highest court when it observed that the purpose of statutes providing for the extension of corporate existence after dissolution “is to abrogate the common law rules relative to the reversion of corporate real estate, escheat of its personal property, and the extinguishment of the debts owed by and to it.”  Greene v. Stevenson, 175 S.W.2d 519, 523-24 (Ky. 1943).

As the Court of Appeals correctly determined from its application of the current statutory formulae, a corporation, after dissolution, continues to exist as a corporation with the capacity to sue and be sued and to collect its assets.

It is worth wondering what may be the additional back-story on the status of Petro Energy.  Under Kentucky law, there exists no requirement that a corporation’s winding up and liquidation be completed within a set period of time.  Kentucky has also abolished any outer limit on seeking reinstatement after administrative dissolution.  See also Montague and Muehlenkamp, Kentucky Corporate Law Developments, 21 N. Ky. L. Rev. 413, 414 (1994).  Assuming Petro Energy has not acted to notify its creditors (KRS § 14A.7-030(1)(e)) and otherwise wind up, it could reinstate, an action that relates back to the administration dissolution with the effect that the dissolution “had never occurred.”  KRS § 14A.7-030(3).

Inspection of Records in a Delaware LLC

Chancery Explains What Documents are Required to be Produced by an LLC to a Member for Valuation Purposes

The Crisis in Funding of State Courts

Symposium on State Court Funding

Last Friday the Kentucky Law Journal sponsored an outstanding symposium on the crisis in state court funding.    A short piece in the online version of the Atlantic Monthly (http://www.theatlantic.com/national/archive/2011/09/at-state-courts-budgets-are-tight-and-lives-are-in-limbo/245558/ ) provides a summary of the issue.

The various articles will be forthcoming in the KLJ, it celebrating its 100^th year in 2011-12.

Upcoming from the Ky Supreme Court - Class Action Arbitration

Upcoming from the Ky Supreme Court – Enforcement of

Class Arbitration Waivers

In Schnuerle v. Insight Communications Co., L.P., ____ S.W.3d ____, 2010 WL 5129850, 2010 Ky LEXIS 288 (Ky. 2010), the Kentucky Supreme Court, in reliance upon a decision of the 9^th Circuit Court of Appeals (Discover Card), struck down a waiver of class action arbitration set forth in a consumer contract.  Subsequent to that ruling, in ATT Mobility LLC v. Concepcion, 563 U.S. ____ (2011), the United States Supreme Court upheld waivers of class action arbitration, specifically overruling the Discover Card decision relied upon by the Kentucky Supreme Court. 

This matter is going back to the Kentucky Supreme Court to be argued on October 19 (2008-SC-789).  There will be consideration as to whether the Concepcion decision does or does not require a reversal of the Kentucky Supreme Court’s in Schnuerle to the effect that the waiver of class action arbitration as set forth in the agreement with Insight Communications will or will not be enforceable.

The Ky Constitution and Corporate Law

Section 190 of the Kentucky Constitution

Except as otherwise provided by the Constitution of Kentucky, the General Assembly shall, by general laws only, provide for the formation, organization, and regulation of corporations. Except as otherwise provided by the Constitution of Kentucky, the General Assembly shall also, by general laws only, prescribe the powers, rights, duties, and liabilities of corporations and the powers, rights, duties, and liabilities of their officers and stockholders or members.

Manager Appoints an Attorney to Represent the LLC in the Manager's Lawsuit Against the LLC

Manager Appoints an Attorney to Represent the LLC in the Manager's Lawsuit Against the LLC


This discussion from Doug Batey (Stoll Rives in Seattle) demonstrates what can happen when the implications of an agreement are not fully thought out in application.  One member of an LLC in effect conveyed control of the LLC to the other member for the period that the second member's loan to the LLC was outstanding.  The second member, as a creditor, called the note, and then on behalf of the LLC retained counsel to negotiate a resolution of the issue.  The first member's challenge to this was rejected. 

Like Doug, I don't disagree with the ultimate outcome.  
Also, I see the position of the attorney hired to be impossible. 

Upcoming from the Ky Supreme Court - Piercing the Veil

Upcoming from the Ky Supreme Court – Piercing the Veil

Inter-Tel Technologies v. Linn Station Properties, 2009-SC-819 was argued on August 18, 2011.  The case involves a double pierce (through to the corporate grandparent) for liability on a default judgment on a lease.

The briefs (available from the Northern Ky – Chase collection at http://chaselaw.nku.edu/library/electronic_resources/oral_arguments.php) are a great resource on the law (or at least two contrasting views on the law) of piercing.

Choice of Entity Matters: Daywear and Eveningwear

Choice of Entity Matters:  Daywear and Eveningwear

Electing to be organized in a particular form is effectively an election of what standard form agreement will govern the internal relations between the venture and its constituents.  Depending upon your position and circumstances, whether that election is, at a particular time and place, advantageous or disadvantageous to your objectives is simply a fact of life.  In Beatty v. Melody Lake Ranch Club, Inc., No. 2003-CA-001652-MR (Ky. App. Apr. 15, 1005) (Not to be Published), an unsuccessful effort was made to rewrite the history of the choice of entity.

Melody Lake Ranch Club, Inc. was in 1967 incorporated under then KRS ch. 271.  Persons owning land within the boundaries of the club became shareholders, receiving one share of stock for each $100 of investment made.  Fast forward 22 years to 1999, when several shareholders sought dissolution of the corporation, citing its “poor financial conditions” and failure to provide certain of the recreational facilities that it was chartered to provide.  On this basis, the plaintiffs asserted that the corporation was “insolvent” and should be dissolved and liquidated under Section 273.330 of the Kentucky Nonprofit Corporations Act.  KRS § 273.330(1)(a)5 provides that a nonprofit corporation may be liquidated upon a showing “that the corporation is unable to carry out its purposes.”

In response, the corporation argued that not only was it not insolvent, but that KRS § 273.330 is not applicable, it being a business corporation, and therefore any dissolution proceeding must come about under KRS ch. 271B.

The trial court found that the corporation’s dissolution would be governed by the business, and not the nonprofit, corporation act in that the latter act applies only to nonstock corporations, evidence from the Secretary of State indicated that the corporation was organized under the business corporation statute, and because of federal income tax returns, presumably on the form for a business corporation, had been filed for each year.

Affirming the trial court’s determination, the Court of Appeals found that the election to be organized as a business corporation was conclusive.  The plaintiffs asserted that had the nonprofit corporation statute existed at the time of the club’s incorporation (in fact, the nonprofit corporation statute was enacted a year and a half after the corporation’s formation), they would have organized under that statute.  The Court said, in effect, “Yeah, but you didn’t.”  Rather, the Court found that the corporation was clearly formed under the business corporation act, and that being the case, any dissolution is to be governed by that statute, not the nonprofit corporation statute.

As has oft been noted, different forms of business organization provide different rules for different factual situations.  That the outcome in a particular circumstance in one form of organization is different from what would be the outcome were those facts applied in a different form of organization in no manner indicates that one form or the other is deficient.  Recall (and for those of you too young to recall, it is on YouTube) the Wendy’s commercial featuring the Soviet fashion show and the great distinctions between “daywear” and “eveningwear.”  That is not where we are and it is not where we want to be.  Different outcomes are the intended consequence of a robust menu of organizational forms; if that were not the case then we would have no need for alternative forms.  Appreciating those distinctions is what is important in the choice of entity election, in the drafting of organizational documents and, crucially, when the courts come to resolve disputes in business entities.

Statutory Construction

“The plain meaning of the statutory language is presumed to be what the legislature intended, and if the meaning is plain, then the court cannot base its interpretation on any other method or source.”  Revenue Cabinet v. O’Daniel, 153 S.W.3d 815, 819 (Ky. 2005). 

The Positive Law Election to be Member- or Manager-Managed

The Positive Law Election to be Member-Managed or Manager-Managed

Whether a LLC is “member-managed” or “manager-managed” is determined exclusively by reference to the option elected in the Articles of Organization – every Kentucky LLC must state that it is one or the other.  See KRS § 275.025(1)(d). As such, the determination of whether the LLC is one or the other is not made by a substantive review of the inter-se management structure defined in the operating agreement.  Rather, “Irrespective of the provisions of the operating agreement, whether a LLC is ‘manager-managed,’ as that phrase is used in the Act, depends on whether the articles of organization so provide.” Prototype LLC Act § 401, comment. As the Articles of Organization require a declaration of whether the LLC will be managed by managers or by the members, and the terms and provisions of the Articles of Organization are of public record, all parties dealing with the LLC may ascertain and are deemed to have notice of the election made by the LLC.  KRS § 275.025(7)(b).  See also Thomas E. Rutledge, The 2007 Amendments to Kentucky Business Entity Statutes, 97 Ky. L.J. 229 at 244 (2008-09).

The Kentucky Law Journal Online

The Kentucky Law Journal Online

I wanted to bring to your attention that the Kentucky Law Journal has this past year started an online only journal.  Its mission statement provides in part:

Kentucky Law Journal Online publishes short articles (approximately 5000 words or less) on topics of interest to legal professionals in the Commonwealth written by practitioners, scholars, judges, and students.

We are interested in analysis and commentary on a wide range of legal topics:

·                    recent court rulings and judicial opinions;

·                    national or international trends with an impact in Kentucky;

·                    intersections between the legal profession and other fields of study, including public policy, education, religion, economics, social sciences; or

·                    issues currently affecting the practice of law in Kentucky.

To date the KLJ Online has published:

·                    An Examination of the Charging Order Under Kentucky’s LLC and Partnership Acts, by Thomas E. Rutledge & Sarah Sloan Wilson, published in two parts, 99 Ky. L.J. Online 85 (2011) and 99 Ky. L.J. Online 107 (2011)

·                    The Impending End of the Jural Rights Doctrine in Kentucky Jurisprudence, by Greg N. Stivers & Scott D. Laufenberg, 99 Ky. L.J. Online 50 (2011)

·                    Adverse Domination - Tolling the Statute of Limitations in Kentucky Business Organizations, by Mary C. Garris, published in two parts, 99 Ky. L.J. Online 36 (2011) and 99 Ky. L.J. Online 50 (2011)

·                    Carbon Capture and Storage - Seven Unanswered Questions, by David S. Samford, 99 Ky. L.J. Online 23 (2011)

·                    The Kentucky Condominium Act, by Scott W. Brinkman, published in two parts, 99 Ky. L.J. Online 1 (2011) and 99 Ky. L.J. Online 13 (2011)

The (Purported) LLC Without an Operating Agreement

The (Purported) LLC Without an Operating Agreement

An LLC may exist without a formal written operating agreement, in which case it will be governed by the default rules of the LLC Act and in the degree permitted the oral and course of conduct agreement of the members.   To the extent no contrary provision is set forth in the operating agreement, the terms of the LLC Act are incorporated into and become part of every operating agreement.  KRS § 275.005 (“A [LLC] may be organized under this chapter”) (emphasis added).  Consequently, it is not possible for an LLC to “not have an operating agreement.”  Rather, at minimum every LLC has an operating agreement comprised of the terms of the Articles of Organization and the LLC Act.  See Racing Investment Fund 2000, LLC v. Clay Ward Agency, Inc., 320 S.W.3d 654, 657 (Ky. 2010) (“If the members of a particular LLC do not adopt a written operating agreement or adopt one that is silent on certain matters, KRS Chapter 275 contains default provisions that will govern the conduct of the entity’s business and affairs.”).  See also Spires v. Casterline, 4 Misc.3d 428, 435 - 36, 778 N.Y.S.2d 259, 265-66 (N.Y.Sup., 2004) (“The statute clearly allows the members to enter into an Operating Agreement wherein the members can agree to certain terms, conduct, and provisions for operating the business. However, when there is no Operating Agreement, or such agreement does not address certain subjects, then the entity is bound by the minimum requirements set forth in the Limited Liability Company Law. In this situation, the entity is required to operate according to the statutory provisions. These statutory default provisions of the Limited Liability Company Law become the ‘Operating Agreement’ of the limited liability company.”)

Further, the qualification that the LLC does not have a “written” operating agreement is incorrect.  To state the obvious, both the Articles of Organization and the LLC Act are in writing.

The 2011 Amendments to Kentucky's Business Entity Laws

A review of the amendments adopted by the 2011 General Assembly to various of Kentucky's business entity statutes has been published by Bench and Bar and is available at:

http://www.kybar.org/425

The same article is also posted on SSRN.com.

Kentucky Adopts the Economic Loss Rule

In Giddings & Lewis, Inc. v. Industrial Risk Insurers, 2011 WL 2436154 (Ky. 2011), the Kentucky Supreme Court adopted the “Economic Loss Rule.”  Under this rule, claims for economic loss that are based in tort are barred, it being the law of contracts that should address the allocation of risk.  Decided in the context of the malfunction and destruction of a piece of custom machinery that had functioned for many years (and well beyond the warranty period), the decision’s effect is that there could be no claim against the manufacturer for claims arising in tort such as implied warranty and strict liability. 

It remains to be seen whether and how this rule will be applied in the context of consumer products. 

An Interest in an LLC is Personal Property, Except …

An Interest in an LLC is Personal Property, Except …

The Kentucky LLC Act is quite explicit on the point – an interest in an LLC is personal property.  KRS § 275.250.  The statute provides as well that the property of the LLC is not the property of the members.  KRS § 275.240(1).

In order to receive a commission on a land sale in Kentucky, one must be licensed as a broker.  KRS §§  324.020(1), (2).

Assume that ABC, LLC holds assets including real property.  May Broker (not licensed as a real estate broker) collects a commission when he successfully arranges a sale of the LLC interest in ABC, LLC?  Based upon the fact that the assets being sold, the LLC interests, are personal property and of themselves give rise to no interest in the LLC’s property (see also Baker v. Erpenbeck (In re Erpenbeck), 2004 Bankr. LEXIS 739, at *8 (Bankr. E.D. Ky. April 1, 2004) (holding that property of LLC is not property of the members; members have no equitable interest in LLC’s property)), it would appear that the commission is due and owing.  Appearances, however, can be deceiving.

In Lairsen v. Figuerado, 2010 WL 1740881 (E.D. Ky. 2010), relying upon Kirkpatrick v. Lawrence, 908 S.W.2d 125, 128 (Ky. App. 1995), the Court (Judge Hood) held that no commission could be paid on the sale of LLC interests when the LLC’s asset included real property.

“Where … the business has an interest in real estate as one of its major assets, Kentucky courts have announced the bright-line rule that a person negotiating the sale for another party must be licensed as a real estate broker to be entitled to any commission on the sale.”

The Court stuck down as well efforts to recover in quantum meruit and on the basis that there existed an oral partnership for the sale of the LLC interest.  As to the alleged oral partnership, it was rejected on the basis that as the subject of the oral partnership was an interest in real property (held through an LLC), the statue of frauds (KRS § 371.010(6), (8) and (9)) applied.  In that the partnership agreement was not in writing, it could not be enforced.

            Let the broker beware!

Choice of Entity Matters

The Delaware Courts have again addressed the simple fact that Choice of Entity Matters. 

In CML V, LLC v. Bax, 6 A.3d 238, 249 (Del. Ch. 2010), the Chancery Court wrote:

 “[T]here is nothing absurd about different legal principles applying to corporations and LLCs.”

Affirming the Chancery Court, the Delaware Supreme Court wrote:

 “[I]t is hardly absurd for the General Assembly to design a system promoting maximum business entity diversity.  Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.”

__ A.3d __, __, 2011 WL 3863132, at *4 (Del. 2011).

            Analogy is a dangerous tool as it can often lead to incorrect conclusions.  The fact that in one form of organization there may be Rule A does not mean that in another form of organization there should be Rule A; in fact that other form may use Rule B.  Each form of organization as modified by its organic documents needs to be understood as its own construct. 

Introduction & Disclaimer

The purpose of this blog is to serve as a forum for the review and discussion of points of business law, and in particular business entity law, of interest to practitioners in Kentucky.  Contract law and statutory construction will of course be involved as well.  Comments and discussion of decisions and developments from other states will likewise appear, but with the standing caveat that decisions from other states simply may not apply in Kentucky consequent to our different statutory formula. 

In no way is an attorney-client or other confidential relationship created by this blog.  While I certainly strive to be accurate in these postings, YOU need to consult with an attorney as to the facts of your particular situation; YOU cannot assume that what is here written applied to YOUR situation.