Asset Protection Gone Bad

Courthouse News Service

Asset protection typically involves an effort to place assets beyond the reach of creditors. This story involves an asset protection effort that seems to have gone an additional step, namely putting the assets beyond the reach of their owner. If the allegations are proven this looks like a case of out-and-out fraud.

Dissociation from LLC upon Bankruptcy Violates Ipso Facto

Dissociation from LLC upon Bankruptcy Violates Ipso Facto (So says one Court)

     In In re: Dixie Management & Investment, Limited Partners, No. 5-08-6K-73874 (Bankr. W.D.Ark. May 9, 2011), the Court addressed whether the limited partnership, upon its chapter 11 filing, was dissociated as a member from Moberly Investment Group, LLC (“MIG”).  MIG’s operating agreement and the Arkansas statute (§ 4-32-802(a)(4)(B)) provide for dissociation upon bankruptcy.  Dixie was a 62% member in MIG.

     Responding to the assertion of automatic dissociation upon bankruptcy, Dixie argued the operating agreement is an executory contract and that dissociation violated the Bankr. Code § 365(e)(1) ipso facto clause.  Even if not executory, Dixie continued, dissociation would violate the Bankr. Code § 541(c)(1) ipso facto clause.

     Focusing upon § 541 (no evidence having been presented as to whether or not the operating agreement was executory under the Countryman test), the Court observed that Dixie’s interest in MIG became property of Dixie’s bankruptcy estate.  Rejecting automatic dissociation, the Court wrote:

Under § 541(c)(1), Dixie’s membership in MIG continues to exist and constitutes property of the estate, despite the conflicting provisions in the [operating agreement] and contrary state law.

The Court holds that the [operating agreement] language regarding the alleged dissociation of a member based on the filing of its bankruptcy petition is in contravention of the bankruptcy code, specifically § 541(c)(1), and, therefore, is ineffective….  Further, under § 363(l), Dixie is permitted the use and benefit of its interest in the LLC and has the right to continue as a member of the LLC.

Chutzpah – Corporate Services v. Shumaker

Chutzpah – Corporate Services v. Shumaker

     The classic definition of chutzpah is when you kill your parents and then throw yourself on the mercy of the court because you are an orphan.  It is highly doubtful that this defense has ever actually been successful.  It does not work in the corporate context either.

     In this case, a group of individuals and a pair of corporations, VMCI and VSI, used another pair of corporations in a fraudulent scheme against American Express.  American Express Corporate Services brought suit.  VMCI and VSI sought to be dismissed from the suit on the grounds that they had been administratively dissolved and, consequently, were not subject to suit.  Corporate Services v. Shumaker, 2010 WL 4340559 (W.D. Ky. 2010). 

     As the first grounds for dismissal, VMCI and VSI asserted that, consequent to their administrative dissolutions, they could not be named in a suit.  The court dismissed this argument, citing the Kentucky statutes expressly providing that the dissolution of the corporation “shall not prevent commencement of a proceeding by or against the corporation in its corporate name.” KRS § 271B.14-050(2)(e).

     The second asserted basis was that, upon the administrative dissolution of each corporation, their respective registered agents ceased to have authority to accept service.  While the court is entirely correct in its conclusion that administrative dissolution does not terminate the authority of the registered agent, citing in support thereof a 1911 case, it sadly missed the statute that expressly sets forth that rule, namely KRS § 271B.14-050(2)(g) (from January 1, 2011, that same rule is set forth as well at KRS § 14A.7-020(4)). 

     The moral of the story – you can’t use a business entity to perpetuate a fraud, kill the business entity by dissolution and from there assert its immunity from the consequences of its actions.

Erasmus — Prince of the Humanist

Erasmus — Prince of the Humanist

     Today is the anniversary of the birth of Erasmus of Rotterdam, the Prince of the Humanist.  Erasmus devoted his career and his mastery of Latin and Greek to translating and commenting upon sacred texts including a new translation of the Bible and non-sacred literature such as the writings of Seneca.  Along the way he wrote the Colloquies and the Adages, social commentary such as the Praise of Folly and on the need for internal reform of church practices including the Julius Exclusus. 

     He and Sir Thomas More were the best of friends, and the Praise of Folly was written while he was staying with More.

     It’s not that I think a lot of Erasmus, it’s just that I have copies of his portrait hanging in both my house and my office.

     While we are sure that October 28 is the date of his birth, we are not sure of the year.  Strong cases can be made for 1466 and 1469.

Ky S.Ct. Rejects Minority Discounts in Dissenter Rights

Kentucky Supreme Court Rejects Minority Discount in Dissenter

Rights Actions – Shawnee Telecom v. Kathy Brown

            This morning, in Shawnee Telecom v. Kathy Brown, 2009-SC-00574-DG (Oct. 27, 2011), the Kentucky Supreme Court expressly overturned Ford v. Courier-Journal Job Printing Co. and minority discounts in the valuation of the shares of a dissenting shareholder.  Rather, the corporation is to be valued as a whole on a going concern basis, and the shareholder is entitled to their proportionate interest in that total value.

            A detailed analysis of this decision will follow in a day or two, but until then it should be noted that this is an exceptionally well researched and written opinion.  The Court traced the development of dissenter rights and as well traced the history of the circumstances in which they are typically employed, namely squeeze out and similar transactions.  However, even as the Court cited many law review articles on these topics, they failed to reference that of Professor Rutheford B. “Biff” Campbell, Jr., Corporate Fiduciary Duties in Kentucky, 93 Ky. L J. 551, 602-11 ((2004-05).  He had argued against both the Delaware Block Method of valuation and minority discounts, both positions adopted today by the Supreme Court. 

The Argument that Corporations Lack Continuity of Life Soundly Rejected

The Argument that Corporations Lack Continuity of Life Soundly Rejected

One of the greatest and perhaps the most innovative characteristic of the business corporation is that it has continuity of life – while the shareholders may come and go the corporation continues to exist as the same corporation.  This characteristic was recognized in the seminal Trustees of Dartmouth College v. Woodard, 17 U.S. (4 Wheat.) 250, 303 (1819) decision:

“Among the most important are immortality, and, if the expression may be allowed, individuality; property, by which a perpetual succession of many persons are considered as the same, and may act as a single individual.  They enable a corporation to manage its own affairs, and to hold property, without the perplexing intricacies, the hazardous and endless necessity of perpetual conveyances for the purpose of transmitting it from hand to hand.  It is chiefly for the purpose of clothing bodies of men, in succession, with these qualities and capacities, that corporations were invented, and are in use.  By these means, a perpetual succession of individuals are capable of acting for the promotion of the particular object, like one immortal being.”

A recent effort to have a different rule, namely that a change in ownership of a corporation relieves the corporation of its pre-existing obligations, was recently soundly rejected.

Quality Ford Automobile Sales, Inc. v. Ford Motor Credit Company, LLC, No. 2010-CA-000397-MR (Ky. App. July 22, 2011) (Not to be Published) involved a creditor, FMCC, seizing its collateral, namely the inventory of QFAS.  The security agreement at issue was entered into in 1989 between FMCC and QFAS.  In 1997, ownership of QFAS was transferred from its prior owners to Allyn Moore. 

In this suit, Moore/QFAS argued that the security agreement was not valid as a new agreement should have been entered into in 1997 when Moore acquired ownership of QFAS.  “In essence, [QFAS] argues that because of ownership of the dealership changed, the previous contract did not apply.”  Slip op. at 4.  In response the Court wrote: “This argument is without merit.” 

Citing KRS § 271B.3-020(1) (a corporation has perpetual duration) and subsection (g) thereof (a corporation may enter into security agreements), the Court held that the 1989 security was never terminated and, ergo, continued to bind the collateral.

Unreasonable Liquidated Damages = Impermissible Penalty

Unreasonable Liquidated Damages = Impermissible Penalty:
Sohal Properties, LLC v. MOA Properties, LLC

     On October 21, 2011, the Court of Appeals issued its opinion in Sohal Properties, LLC v. MOA Properties, LLC, No. 2010-CI-001833-MR (“To Be Published”), addressing the question of whether the $500,000 “non-refundable” deposit/liquidated damages provision would be enforceable under Kentucky law.  Finding the provision to be in the nature of an impermissible penalty, the provision was struck down.

     MOA Properties, LLC and Motels of America, LLC (their exact relationship is not fully detailed in the opinion) (“MOA”), leased to Sohal Properties the right to operate a Super 8 branded motel in Louisville.  The terms of the lease between MOA and Sohal Properties included the lockbox deposit of all receipts, disbursements from that lockbox to a master account from which withdrawals were made for the monthly rent, accrued property taxes, accruals for insurance and contributions to a capital reserve account.  The balance was, a monthly basis, returned to Sohal Properties.  The lease included as well a requirement that Sohal pay $500,000 (“security deposit”) at its commencement.  Absent default, at the end of the lease term, Sohal was entitled to a return of the funds accumulated in the capital reserve account.  The lease provided as well that Sohal Properties would have a right to acquire the property at the end of the lease term, the acquisition price being $2,700,000.  In the event that Sohal Properties exercised that option to purchase, the $500,000 security deposit, otherwise non-refundable, would be applied to the purchase price. 

      At the end of the lease, Sohal Properties sought to exercise the purchase option but, in the absence of adequate funding (this was early 2009, deep in the credit crunch) it was unable to perform.

      In response to an action filed by MOA seeking possession of the facility  and for various breaches of the lease and related agreements, Sohal Properties filed a counterclaim contending, in part, that the non-refundable nature of the security deposit violated public policy and should be unenforceable.  The trial court granted MOA summary judgment affording it both possession of the property and determination that the security deposit was its to be retained.  The Court of Appeals would reject that second condition. 

       With respect to the non-refundability of the $500,000 security deposit, the Court recited (slip op. at 10-12) the familiar Kentucky law on liquidated damages including Mattingly Bridge Co., Inc. v. Holloway & Son Constr. Co., 694 S.W.2d 702 (Ky. 1985) and United Services Auto Ass’n v. ADT Security Services, Inc., 241 S.W.3d 335 (Ky. App. 2006).  Applying that law, the Court determined that the security deposit of $500,000 was “grossly disproportionate” to any anticipated losses under the lease agreement, noting that there existed other contract terms that minimized the risk of loss.  Ultimately, the Court determined that the security deposit “must be construed as an impermissible penalty or forfeiture rather than as a valid liquidated damages clause.    Although the parties were properly at liberty to fashion a mutually beneficial business transaction, we conclude that it would be unconscionable to allow the forfeiture provided for in this agreement to be enforceable.” 

Saint Crispin’s Day

Saint Crispin’s Day

Today is the anniversary of the Battle of Agincourt, taking place in 1415 between the forces of France and her various allies and the invading English forces under the command of King Henry V.  Shakespeare, by having his character Henry V repeatedly referred to the day of the battle as St. Crispin’s Day, otherwise saved this obscure saint from being lost, save for experts in hagiography, to the mist of history.

The English forces, likely numbering in the range of 7,000, were compelled to do battle with a far superior French force likely numbering in excess of 20,000.  All else being equal, the English force should have expected to be annihilated.  As is typical in the case of significant historical events, however, all things were not equal.  The terrain favored the English, requiring the French forces to attack uphill over a recently plowed field that, consequently to the recent rain, was more mud than dirt.  The French knights and men at arms, slogging their way uphill, were a “target rich environment” for the rain of arrows let loose by the English longbows; assuming Henry’s forces numbered 7,000, likely 5,800 were longbowmen, each releasing four to six arrows a minute.

Another factor was the very size of the French force worked to its disadvantage in that those behind continued pressing forward, hoping for their moment of glory, even while those at the front were being slaughtered.  It was not quite the situation suffered by the Romans at the hands of Hannibal at Cannae, but then likely it was not hugely better.

While comparative casualty figures are effectively impossible to ascertain, it is clear that the French were badly mauled with significantly more casualties than the English.  Further, a significant number of French nobles fell in contrast to only two English nobles.

Today is also the anniversary of the storied “charge of the light brigade” in the Crimean War.  That particular engagement was, for the English forces, significantly less successful.

More from the Ky Supreme Court on Piercing the Veil

Another Piercing case before the Kentucky Supreme Court –

Schultz v. General Electric Healthcare Financial Services, Inc.

       In addition to the Inter-Tel Technologies case currently before the Supreme Court, there is likewise Schultz v. General Electric Healthcare Financial Services, Inc., 2010-SC-183-DG.  This case was argued on August 18.  While the procedural history of the case will no doubt be at issue, GE having been granted a motion to pierce the veil on a judgment on the pleadings, the core question involves whether piercing is justified when the sole shareholder diverted corporate assets to his own benefit rather than for the disposition of the creditor’s claim.  Shades of Bear Inc. v. Smith are obvious.

Property Owner Not an “Up the Ladder” Employer

Property Owner not an “Up the Ladder” Employer

     Old Taylor Partners, LLC v. Rueda, No. 2011-CA-000054-WC (Ky. App. Oct. 14, 2011) addressed the question as to whether a property owner who contracted for demolition would be an “up the ladder” employer liable for workers’ compensation payments to an injured worker.  The Court of Appeals determined in the negative.

     Old Taylor Partners, LLC acquired a former distillery property with the intention of dismantling and selling the building materials and equipment and then developing the property.  It contracted with G&B Demolition LLC to actually perform the demolition services.  Rueda, an employee of G&B, was injured in the course of the demolition and was ultimately determined to be 100% occupationally disabled.  Although not addressed in the opinion, it was presumably the case that G&B Demolition did not maintain the required worker’s compensation coverage.  For that reason, the question came to be whether Old Taylor Partners, LLC was the “up the ladder” employer of Rueda under KRS § 342.610.

     While the ALJ determined that Old Taylor was not an “up the ladder” employer, the Workers’ Compensation Board held to the contrary, basing its opinion on testimony that the purpose of Old Taylor was to demolish and sell the properties of the Old Taylor distillery, determining therefrom that demolition must be a “regular or recurrent” part of its activities.  The Court of Appeals indicates that the Board’s determination was based in part on the fact that Old Taylor could have hired employees to directly do the demolition.

     Ultimately, it was determined that Old Taylor Partners, LLC was not an “up the ladder” employer.  Not having any employees itself, it was “not engaged in the business of employing persons to disassemble physical structures, to move pallets of wood or other materials nor to operate a crane which injured Rueda.”  Slip op. at 6.  Ultimately, the purpose of Old Taylor Partners was to generate a return on investment, not engage in the business of demolition and salvage.  On that basis, it was not Rueda’s employer.

Violating Fiduciary Obligations – Let Me Count the Ways

Violating Fiduciary Obligations – Let Me Count the Ways

     In an Order dated October 13, 2011, the North Carolina Business Court entered a preliminary injunction barring a member-manager of an LLC from further violation of her fiduciary duties.  Lake House Academy for Girls LLC v. Jennings, 2011 NCBC 40 (Order Granting Preliminary Injunction, Oct. 13, 2011).

     Jennings was a member-manager of Lake House Academy for Girls LLC and as well its Executive Director. While in that position she developed and began implementation to open a competing venture, including by hiring away certain of the LLC’s employees.  She also indicated that she was willing to disparage the LLC and its operations to the effect that it would no longer receive referrals. 

     Under the North Carolina LLC Act, a manager has a statutory fiduciary obligation to discharge his or her duties as a manager “in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in the manner the manager reasonably believes to the be in the best interest of the [LLC].” N.C. Gen. Stat. § 57C-3-22(b).  The statute as well provides a statutory duty of care which tracks the rules that exist under the Uniform Partnership Act.  See N.C. Gen. Stat. § 57C-3-22(e).

     Often cases alleging breach of fiduciary duty come down to judgment calls because the propriety of the actor’s conduct vis-à-vis the standard is somewhat unclear.  Perhaps that conduct should be permitted or perhaps it should be sanctioned.  In this instance, the Court found that there was no ambiguity and for that reason issued a preliminary junction.  Reciting the conduct that justified the determination that Jennings had breached her fiduciary duties, the Court noted:

·                    She e-mailed proprietary documents of the LLC to her husband;

·                    She advised LLC employees of her intent to leave and solicited employees to terminate their further employment with the company;

·                    She solicited current employees of the LLC to leave and join her in the new venture;

·                    She contacted a real estate agent and charged him to locate a property from which the new venture could operation;

·                    She caused that real estate agent to submit a letter of intent with respect to the lease of the property from which the new venture would operate;

·                    She directed individuals, including current customers, to a website setting forth disparaging comments about the staff at the existing venture;

·                    She entered into contracts with respect to the operation of the new venture, including a lease for the new facility;

·                    She executed an employment agreement with a former employee of the LLC after having soliciting him to resign; and

·                    After refusing to return a company issued laptop, she deleted nearly every document therefrom before finally returning it pursuant to Court order.

All of these actions were taken while Jennings was still a member-manager of the LLC.

     Here in Kentucky, we have the Steelvest and Aero Drapery decisions, both of which in the corporate context clearly forbid conduct of this nature.  Likewise, this conduct clearly violates the statutory duty of loyalty that exists in our partnership and LLC acts.  That said, it was certainly nice of Mrs. Jennings to provide us with such a useful roadmap as how to clearly violate those duties.

Class Action Arbitration Oral Argument Rescheduled

Class Action Arbitration Oral Argument Rescheduled

     As previously noted, 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. 

     The matter is going back to the Kentucky Supreme Court (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.

     This case was originally scheduled to be argued on October 19.  It has been rescheduled for January 18.

Meyer v. Christie: Another Court Confuses the Holder of a Charging Order with an Assignee

Meyer v. Christie:  Another Court Confuses the Holder of a

Charging Order with an Assignee

     The good news is that the outcome described in this case cannot come about in Kentucky – our statute expressly precludes it.  Sadly, it expressly precludes it because a prior Kentucky court made the same mistake.

     Meyer v. Christie involves a relatively run-of-the-mill application for a charging order by which to enforce a judgment.  Meyer v. Christie, 2011 WL 4857905 (D. Kan. October 13, 2011).  However, the Court got wildly off base in discussing the effect of that charging order, ultimately equating (incorrectly) holding a charging order with being an assignee of the LLC.

     Initially, the defendant argued that the charging order could not be entered because the operating agreement of the LLC at issue provided that an interest therein may not be assigned.  In response thereto, the Court properly noted that the Kansas LLC Act provides that the charging order is the judgment creditor’s exclusive remedy, noting as well that the holder of a charging order “has the rights of an assignee.”  It was here that the train came off the tracks; the defendant was asserting that the charging order violated the limitation on assignability and the Court noted the holder of a charging order has the rights of an assignee.  From here, it was no small step for the Court to make the error in its analysis, determining that the holder of the charging order is an assignee.  This mattered because Kansas has an atypical provision to the effect that the assignee of the sole member of the LLC has the right to participate in its management and affairs.  Kan. Stat. Ann. § 17-76,112(f).  Ergo, the holder of the charging order was equated with an assignee and, pursuant to the statute, is now permitted to participate in the LLC’s management and affairs.

     The provision that the holder of a charging order has the rights of an assignee is not intended to be an affirmative grant but rather a limitation.  An assignee has quite limited rights vis-à-vis the partnership or LLC.  The intention of “has the rights of an assignee” is to indicate that, inter alia, the holder of a charging order has only the limited rights of an assignee. 

     Fortunately, a similar result cannot happen in Kentucky.  In Hubbard v. Talbott Tavern, Inc., No. 2003-CA-001468-MR, 2006 WL 2089308 (Ky. App. 2006), the Court of Appeals upheld a trial court order that “assigned” to the judgment creditor the judgment debtor’s membership interest in each of three LLCs and further directed that the judgment creditor be dissociated and cease to be a member of each of those companies.  The order of dissociation was based upon KRS § 275.280(1), it providing that a member is dissociated upon making an “assignment for the benefit of creditors.”  In response to this decision, the charging order provision of the LLC Act was amended to provide “A charging order does not of itself constitute an assignment of the [LLC] interest.”  KRS § 275.260(3).

     For an expansive review of the charging order as it appears in Kentucky’s LLC and partnership acts, see Thomas E. Rutledge & Sara Sloane Wilson, An Examination of the Charging Order under Kentucky’s LLC and Partnership Acts (Part I), 99 Kentucky Law Journal Online 85 (2011); (Part II), 99 Kentucky Law Journal Online 107 (2011).

Good Faith and Fair Dealing

Good Faith and Fair Dealing

In Gresh v. Waste Services of America, Inc., 738 F. Supp.2d 702, 710-11 (E.D. Ky. 2010), the court set forth the effect of the obligation of good faith and fair dealing:

Second, under Kentucky law, parties have a duty in carrying out a contract to act in good faith, sincerely and without deceit or fraud.  Pearman v. W. Point Nat’l Bank, 887 S.W.2d 366, 368 n. 3 (Ky. Ct. App. 1994).  This is generally observed as the covenant of good faith and fair dealing implied in every contract.  Ranier v. Mount Sterling Nat’l Bank, 812 S.W.2d 154, 156 (Ky. 1991).  A breach of the implied duty of good faith and fair dealing is an impossibility where a contract has not yet been formed.  Quadrille Bus. Sys. v. Ky. Cattlemen’s Assoc., Inc., 242 S.W.3d 359, 364 (Ky. Ct. App. 2007).  “A contracting party impliedly obligates himself to cooperate in the performance of this contract and the law will not permit him to take advantage of an obstacle to performance which he has created or which lies within his power to remove.”  Ligon v. Parr, 471 S.W.2d 1, 3 (Ky. 1971) (quoting Gulf, Mobile & Ohio R.R. Co. v Ill. Cent. R.R. Co., 128 F. Supp. 311, 324 (N.D. Ala. 1954)).

The Battle of Dyrrhechium – Don’t I Know You From Somewhere?

The Battle of Dyrrhechium – Don’t I Know You From Somewhere?

     While the story of the Battle of Hastings (October 14) usually continues with a discussion of the Norman-French political and to a certain extent cultural conquest of England, it is interesting to consider the fate of certain of the losers. 

     The core of Harold’s army was a corps of household troops named the housecarls.  They fought with the Norwegian battle ax, often with a shaft of four feet in length.  While it is true that in the Middle Ages it would not be surprising for a person to be born, live and die within a few miles of the same spot, all too often it is assumed that such limited travel was typical.  Likely it was not. 

     After Hastings, some of Harold’s housecarls traveled to Byzantium and there joined the Byzantine Emperor’s Varangian Guard.  According to some sources, some of those housecarls, now as members of the Varangian Guard, fought at the Battle of Dyrrhachium on October 18, 1081, a battle which took place in modern day Albania.  Who were they opposing but Norman invaders?  According to those same sources, certain of the troops who fought as mercenaries for William (now the Conqueror) in England in 1066 now faced off against the Varangians, former housecarls of Harold. 

     Normans versus Saxons, this time in Albania.  Not everyone stayed close to home.

L3Cs and B-Corps

L3Cs and B-Corps

     A recent article in The New York Times (A Quest for Hybrid Companies That Profit, but Can Tap Charity, Oct. 12, 2011, B1) sadly rates a grade of “D.”

     Notwithstanding this barely passing grade, the article is to be commended for at least two points.  First, it did not simply repeat the propaganda lines of the L3C promoters.  Second, it is to be well commended for quoting my friend Bill Callison and his explanation for why these new structures are not necessary.

     Still, the grade is the consequence of the article failing to properly describe the structures being discussed and, secondly, a failure to fully explicate their purported justifications.

     As to the first failing, it was set up by the first line of the article, it stating “A new type of company….”  Having suggested that there is singular type of company in consideration, the article then goes on to discuss all of flexible-purpose companies, Benefit Corporations and L3Cs.  Of course, these are each radically different, each purporting to respond to a different pressure.

     The second failing was in not distinguishing between the structures being discussed.  As to the L3C, it is a (in my view an entirely illegitimate) mechanism by which it is (incorrectly) suggested that these structures will be more able to receive a Program Related Investment from a foundation than they would absent a L3C structure.

     In contrast, the flexible-purpose and the B Corporation are each intended to be corporate structures (not LLCs) in which the statutory obligation of the directors to maximize return to the shareholders is reduced.  IMHO, the case has not been made that either of these separate structures is necessary, i.e., there has not been a showing that these aims cannot be achieved within the existing business organization statutes.

Tax Day

For those of us who file on extension, today is Tax Day.  As always I am reminded of the words of (I think)Arlo Guthrie,

“I’m proud to as an American to be paying taxes, but I could be just as proud for half as much.”

An LLP is Not a Registered Organization

An LLP is Not a Registered Organization –

A Short Morality Play

            Bank, your client, extended a substantial line of credit Hotshot and Bigmouth, a local (and highly profitable) mass-tort law firm.  The firm is organized in Delaware as a limited liability partnership (LLP), a fact you ascertained from the Secretary of State’s website and the LLP’s statement of foreign qualification.  KRS § 362.1-1102.  As part of documenting and closing the loan, you dutifully filed in Delaware an all assets UCC-1 against Hotshot and Bigmouth, LLP.  The line of credit was nearly immediately drawn down in full.

            That closing took place a week ago today.  As you were leaving the office last Friday you heard in the elevator that Hotshot and Bigmouth had each been indicted for defrauding clients in connection with the settlement of a diet drug class action.  So why is it now that today you are cleaning out your office and facing a job search is a dismal market?

         While Hotshot and Bigmouth LLP may be organized in Delaware as a limited liability partnership, it does not follow that UCC filings made against them are to be made in Delaware.  Under the UCC, the UCC-1 financing statement against a “registered organization” (See UCC § 9-102(a)(70); KRS § 355.9-102(1)(br) (“‘Registered organization’ means an organization organized solely under the law of a single state of the United States and as to which the state or the United States must maintain a public record showing the organization to have been organized.”)) is filed in its jurisdiction of organization (See UCC § 9-307; KRS § 355.9-307(5) (“A registered organization that is organized under the law of a state is located in that state.”)).  Your problem is that a LLP is not a registered organization in that it is not created by a state filing.  Rather, a partnership, for which no state filing is required, elects to be an LLP and, subsequent to that election, is the same entity that it was before.  See RUPA § 201(b); KRS § 362.1-201(2).  A valid UCC-1 filed against Hotshot and Bigmouth LLP must be filed in the jurisdiction of the partnership’s chief executive office.  See UCC § 9-307(b)(3); KRS § 355.9-307(2)(c).  While there is a question as to whether that office is in Ohio or Kentucky (the firm maintained offices in each city), it certainly was not Delaware.  As such, no valid UCC-1 having been filed against the assets of Hotshot and Bigmouth LLP in connection with the line of credit, the Bank in effect extended an unsecured loan.  See UCC § 9-307; KRS § 355.9-307(2)(c). 

      Hence, your employment status. 

The Battle of Hastings

The Battle of Hastings

     Today marks the 945^th anniversary of the Battle of Hastings.

     1066 has already been a tumultuous year in England.  On January 5, Edward the Confessor died, leaving the English throne to Harold Gowinson.  William of Normandy, also known as William the Bastard, claimed that he had been designated as Edward’s successor and that Harold had once promised him that he, Harold, disclaimed any claim on the throne, leaving it instead to William.  In addition, Harold Hardrada asserted a claim to the English throne.

     Sometime in September, Harold Hardrada had landed his troops in the north of England.  After fast marching his troops north, the invading army of Harold Gowinson met the army of Harold Hardrada at the Battle of Stamford Bridge (September 25).  The invading army was defeated.  Learning of William’s invasion in the south, Harold had to turn his army around and fast march it south in order to respond to this new threat.  That forced march was some 240 miles each way. 

     The Battle of Hastings was largely a stalemate with the trend in favor of the English defenders when, perhaps apocryphally, Harold was struck in the eye with an arrow.  Regardless, it is clear that Harold fell, that the battle went to William, and that by Christmas William was accepting the homage of various English nobles.

     The famous arrow in the eye may be a later invention.  It is not mentioned in the earliest accounts of the battle.  In addition, in medieval iconography, an arrow in the eye is the punishment afforded a perjurer.  Having gone against his oath to leave the throne to William, some might have felt it poetic justice, even if not based in reality.

The Arrest of the Knights Templar

The Arrest of the Knights Templar

     Today marks the widespread arrest throughout France and elsewhere of the Order of  Poor Fellow-Soldiers of Christ and Temple of Solomon, better known as the Knights Templar.

     Founded shortly after the First Crusade as a monastic order, the mission of the Templars was to provide protection to pilgrims coming to the Holy Land and otherwise protect the Latin Kingdom.  Eventually, the Order developed a rather sophisticated banking organization.  For example, one proposing to travel from England to the Holy Land could contribute funds with the Templars in England, receiving in return what was essentially a letter of credit against which the individual could make withdrawals as they travelled through Europe and ultimately to the Holy Lands.  The military component of the Order, although not high in actual numbers, was considered highly effective – after the Battle of Hattin, Saladin ordered the execution of all captured Templars.

     With the eventual loss of the Holy Land territories by the turn of the 14^th century, the Templars were without a reason for existence.  At the same time, Philip IV of France, anxious to expropriate Templar property, was able to fabricate numerous salacious allegations against the Templars, leading to their mass arrest on October 13, 1307.  Ultimately Pope Clement V, then resident in Avignon, issued a bull directing that Templars, wherever located, should be arrested.  The remnants of the Order, other than those executed on spurious charges of heresy, were eventually either pensioned or absorbed into other military orders such as the Knights Hospitaller or the Teutonic Knights.

     A papal finding determined that the Templars were not guilty of the many charges against them including idolatry and heresy.  Their actual failing was having lost their mission while being at least perceived as being wealthy while a king needed funds.

    Notwithstanding the efforts of numerous modern authors, the Templars did not possess the Holy Grail, irrespective of whether that was a physical cup or, as suggested in one particularly fanciful book, an oblique reference to Mary Magdalene and, ultimately, the line of Merovingian kings.

No Indemnification When Employee Did Not Act in Good Faith

Ridley v. Sullivan and the Obligation to Have Acted

in Good Faith in Order to Receive Indemnification

            Ridley was a registered representative of Hilliard-Lyons and as well worked as a portfolio manager at the Hilliard-Lyons Trust Company.  Ridley began dating Sullivan in 1996 and began managing her investments maintained at both Hilliard-Lyons and at the Trust Company.  They married in 1997.  Ridley and Sullivan were legally separated as early as January 2006, and in November 2004, Ridley filed for divorce.  Also in 2004, Ridley left Hilliard-Lyons.  At the time of that departure, Ridley and Hilliard-Lyons entered into an agreement providing, inter alia, he would, with respect to his actions before his departure, continue to be indemnified as if he were still an employee.  Curiously, even though they had been long separated and were in the midst of a divorce, Sullivan’s accounts were transferred from Hilliard-Lyons to Ridley’s new employer, Atlas Brown, although at some point not identified in the opinion they were transferred back to Hilliard-Lyons.

            During the separation and while Ridley was still an employee of Hilliard-Lyons, Sullivan filed an action with the NASD charging Ridley with a variety of charges including inappropriate investments and having withdrawn funds from her account for household expenses.  The NASD awarded Sullivan $100,000 “solely” from Hilliard-Lyons (this amount was paid) and $150,000 “solely” from Ridley (this amount was not paid).  

     Ridley sought to have the arbitration award against him vacated and as well sought a declaration that Hilliard-Lyons was required to provide indemnification.  The trial court determined that indemnification was not available, a decision affirmed by the Court of Appeals.  Ridley v. Sullivan, 2011 WL 1900156 (Ky. App.) (Not to be Published).

Bad Faith and Acting Outside the Course of Employment

            Being compelled to somewhat read between the lines, both the trial court and the Court of Appeals determined that the arbitration panel’s award against Ridley, that decision having been described as an obligation for which he is “solely liable,” indicated a determination that Ridley acted outside his scope of employment.  That having been both raised as an affirmative defense by Hilliard-Lyons, and this point having been within the competence of the arbitration panel and having been resolved against Ridley, the court was not going to allow the point to be re-litigated.  Having acted outside of his course of employment with Hilliard-Lyons, and indemnification being limited to activities done in the course of that employment, as a matter of contract law, indemnification was simply not available.  Although likely dicta, the court noted that the right to indemnification was, pursuant to the statutory limits of KRS § 271B.8-510, limited by the requirement that he have acted in good faith.  Mixing the deference to the arbitration panel’s findings of fact and the motion for summary judgment filed at trial court seeking to have that determination overruled, the Court of Appeals noted that:

The panel heard evidence that Ridley acted in bad faith and that his actions were not in Hilliard Lyon’s best interest, but instead were for improper personal gain.  Ridley failed to adequately refute such allegations.  Id. at *7 (footnote omitted).

            From there, the court cited the requirement that, in response to a motion for summary judgment, one cite affirmative evidenced demonstrating a genuine issue of fact. 

Timing the Claim for Indemnification

     Ridley, at the level of the trial court, to litigate the right to indemnification, asserting that until the arbitration panel found him liable the claim for indemnification was not ripe.  The trial court, again affirmed by the Court of Appeals, determined that the question should have been resolved in the underlying arbitration, it having been put in play by Hilliard-Lyons’ assertion that Ridley was acting outside his course of employment.

The Black Death

Interesting story from NPR on tracing the bacteria that caused the Black Death of 1348 (yes, I know it was reported in Sicily in 1347, but the pandemic is usually dated from 1348) and subsequently throughout Europe. NPR on the Black Death

The Barest Hint of Caremark Duties

The Barest Hint of Caremark Duties, But Asserted by a

Stranger to the Corporation

The decision of the Court of Appeals in Woodall v. Bdesh, Inc., 2011 WL 2935567 (Ky. App. 2011) (Not to be Published) is focused upon employment law, but it contains as well an interesting sidenote on corporate governance.  That sidenote, in turn, deserves a sidenote on who may enforce corporate governance obligations.

Woodall, an employee of Bdesh, Inc., brought suit against her employer and Gulsan Kabir, the president of and a shareholder in Bdesh, based upon the alleged inappropriate conduct of “Irfawn,” another employee of Bdesh.  Woodall asserted that Bdesh and Kabir retaliated against her after reporting Irfawn’s conduct.

As an aside, the decision notes that service had never been made on the corporation.  How and why that was the case is never explained.  In light of the numerous alternative mechanisms by which service may be made on a corporation or other entity, some of which require only transmission and not a showing of receipt (KRS § 14A.4-040(2)(c)) of the service, it is hard to see how it could ever be the case that a corporation would not be served.

Ultimately most of the harassment claims were dismissed on summary judgment, a decision upheld by the Court of Appeals.  What interests me is an assertion that Kabir violated a Caremark obligation.

The Delaware Chancery Court’s Caremark decision, greatly simplified, recites that as a component of their fiduciary obligations, directors have a duty to adopt and maintain corporate compliance programs designed to detect wrongdoing and to bring malfeasance to the attention of management and the board.  In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).

Woodall sought to charge Kabir with violating his duties under KRS § 271B.8-420(1), asserting that this statute, requiring an officer to act “in good faith, on an informed basis and in a manner he honestly believes to be in the best interests of the corporation,” created an obligation “to inform himself of the actions of Bdesh’s employee and the corporation’s business.”  2011 WL 2935567 at *5.  Woodall relied as well on KRS § 271B.8-240(2), it defining the standard (“ordinary prudent person in a like position”) required of an officer in order to act on an informed basis.

While the Court of Appeals recognized that these statutes require an officer to act on an informed basis, it rejected the notion that there is thereby created a duty of ab initio investigation.  “However, these statutory provisions do not require a corporate officer, with no basis for doing so, to ask employees if they have sexually harassed anyone ….”  Id.

What I think to be the more interesting question is what would have been the result had the court held there to be a duty of affirmative investigation?  Assume even that the company suffered a pervasive history of sexual harassment and the company had in place a program to actively monitor and respond to those allegations.  In my view the outcome would have been the same, namely no claim.  An officer’s fiduciary duties flow to the corporation or to the corporation and the shareholders.  Under no formulation do the fiduciary obligations flow to employees and others with a contractual relationship to the corporation.  While the officer’s obligations may be enforced in a direct suit by the corporation or a derivative action brought by a shareholder, a mere employee cannot, in the name of the corporation, vindicate its rights.  Woodall simply had no capacity to look into the discharge (or not) of fiduciary obligations in Bdesh, Inc.

The Effect of Reinstatement on Agent Liability

The Effect of Reinstatement on Agent Liability as Analyzed Under the
Restatement (Third) of Agency

     Agent A, on behalf of Principal P, has both actual and apparent agency authority conferred at a time when P was fully competent to do so.  At some later time, P becomes incapacitated.  A has the capacity to learn of P’s incapacity, but has no actual knowledge thereof.  During P’s incapacity, in the ordinary course of what would otherwise be P’s line of business and having fully disclosed P’s identity as the principal, A enters into a contract with third-party (“TP”).  At some point thereafter, P regains competency and expressly ratifies A having, during the period of incapacity, entered into the agreement with TP on P’s behalf.  Thereafter, P defaults on the agreement with TP.

     Just to put matters in context, P is a business corporation, and A is its President.  The incapacity came about due to the administrative dissolution of the corporation for failure to have filed its annual report.  Upon discovery of the dissolution, the corporation was, within the time limit imposed by its state of incorporation, reinstated.

     Notwithstanding the fact that A was not aware of P’s incapacity, in entering into the contract with TP, A violated his Warranty of Authority and has potential direct liability on the obligation.  See Restatement (Third) of Agency § 6.04 (2006) (the “Restatement”) (“Unless the third party agrees otherwise, a person who makes a contract with a third party purportedly as an agent on behalf of a principal becomes a party to the contract if the purported agent knows or has reason to know that the purported principal does not exist or lacks capacity to be a party to a contract.”); id. § 6.10.  See also 3 Am.Jur.2d Agency § 295 (2008) (“Generally, one who contracts as an agent in the name of a non-existent or fictitious principal, or a principal without legal status or existence, is personally liable on a contract so made.”).  Still, by ratification after the incapacity was lifted, P agreed to be bound on the contract with TP.  See Restatement § 4.02.  The question is whether P’s ratification of A’s conduct during the period of incapacity cures as to TP the breach of the warranty of authority with the effect that TP is not able to look to A for performance upon P’s default.

     Applying the Restatement, the agent is not liable on the agreement.  This conclusion is dictated by Restatement section 4.02, it addressing the “Effect of Ratification.”  Presuming that the entity ratifies the actions undertaken during the period of incapacity (administrative dissolution), section 4.02(1) provides:

Subject to the exceptions stated in subsection (2), ratification retroactively creates the effects of actual authority.

It is important to consider as well section 4.01(1) of the Restatement, defining “ratification,” it providing:

Ratification is the affirmance of a prior act done by another, whereby the act is given effect as if done by an agent acting with actual authority.

See also Restatement § 4.03 (“A person may ratify an act if the actor acted or purported to act as an agent on the person’s behalf.”).  Official comment (b) to section 4.02 of the Restatement provides in part:

Ratification has an immediate effect on legal relations between the principal and agent, the principal of the third party and the agent and the third party.  Ratification recasts those legal relations as they would have been had the agent acted with actual authority.  Legal consequences thus “relate back” to the time the agent acted.

     Ergo, even if during the period of administrative dissolution the entity could not authorize an agent to undertake an act not relating to its winding up and liquidation (see, e.g., KRS § 14A.7-020(4)), upon reinstatement the ratification of that actor’s actions causes them to have been vested with actual authority.  See Restatement, Ch. 4, Introductory Note; id. § 4.01, comment b (“That is, when a person ratifies another’s act, the legal consequence is that the person’s legal relations are affected as they would have been had the actor been an agent acting with actual authority at the time of the act.”).  Having actual authority to act on the principal’s behalf, and assuming due identification of the principal, the agent is not personally obligated on the agreement. See Restatement § 6.01.



Judicial Dissolution and Arbitration

Judicial Dissolution and Arbitration

            The operating agreement of XYZ, LLC provides that “any dispute, controversy or claim arising out of or in connection with, or relating to this Agreement” shall be submitted to arbitration.  A member brings an action for judicial dissolution on the statutory basis that it is not reasonably practicable to operate the LLC in accordance with the operating agreement.  Should that action be referred to the arbitrator?  That question was considered last year by the Georgia Court of Appeals.  Simmons Family Properties, LLLP v. Shelton, 705 S.E.2d 258 (2010).

            The Court determined that the judicial dissolution would be tried by the Court and not be referred to arbitration.  Essentially, the Court reasoned that judicial dissolution is a creature of statute, existing independent of the operating agreement.  Not arising out of the operating agreement, which directed that disputes “arising out of” it be arbitrated, the matter was retained by the Court.  Id. at 260.

            I am not aware of a Kentucky court considering this issue.

A Favorite Operating Agreement Provision

A Favorite Operating Agreement Provision

     My practice often involves reviewing operating agreements, and from time to time I stumble upon provisions that fall into the category of “certainly that can’t say what they mean to have said.”  One of my favorites, written by a St. Louis firm, provided:

The Company may engage in any activity lawfully permitted a limited liability company organized under the Act.  The Company may engage in any other activity with the approval of a majority of the Members.

      If, under the first sentence of this provision, the LLC may do anything that it is legally permitted to do, what is the range of activities that are intended to be addressed by that second sentence?

     At least one moral of the story – just because it gets past “spell check” does not mean it necessarily make sense.

Mary Tudor

     Today is the anniversary of the 1514 marriage of Mary Tudor to King Louis XII of France.

     This “Mary Tudor” is not the queen saddled for posterity with the moniker “Bloody Mary,” but rather her aunt.  This Mary Tudor was one of the two daughters (the other was Margaret) of King Henry VII and was therefore as well the sister of King Henry VIII.  The Queen Bloody Mary was a daughter of Henry VIII.

     The marriage was not to be of long duration; Louis would die on January 1.

     For those of you who watched “The Tudors” and are thinking to yourselves “Oh yeah, I remember that,” well, not so much.  The series significantly departed from the history on this and many other points.  In the series only one sister of Henry is identified, there named Margaret.  The actual Margaret married King James IV of Scotland.  The sister portrayed in the series is shown marrying (and later suffocating) a King of Portugal.  Suffice it to say that it never happened.  

     Still, it was true that the actual Mary Tudor did, after the death of Louis XII, marry Charles Brandon, likely the closest friend of Henry VIII.  The marriage took place against the explicit instructions of Henry VIII.   Given Henry’s propensity for shortening those around him by a head, although his descent into true brutality would not being until the 1530’s, this was a rash act.  Henry did extract his punishment in the way of a large financial penalty.