An Unincorporated Syndicate is Not Governed by Corporate Law

An Unincorporated Syndicate is Not Governed by Corporate Law

            In a recent decision, the Federal District Court for the Eastern District of Kentucky confirmed that an unincorporated syndicate is not, as a default matter, governed by the rules set forth in the Kentucky Business Corporation Act. KNC Investments, LLC v. Lane’s End Stallions, Inc., 2011 WL 5507395 (E.D. Ky. 2011).  In this instance, in a suit arising out of the interpretation of a stallion syndicate agreement, the plaintiff argued that the provisions of the Kentucky Business Corporation Act governing the inspection of corporate books and records should be referenced with respect to the interpretation of the books and records inspection right that existed under a syndicate agreement.  The court dismissed this argument, noting that:

No justification exists to extend Kentucky law that by its own terms is strictly limited to corporations to non-corporate entities such as the LDK Syndicate.  Id. at *4.

Vampires and Business Organizations

Vampires and Business Organizations

        The November/December 2011 issue of The Journal of Passthrough Entities includes my article Vampires and the Law of Business Organizations: The Fruitless Search for Authenticity.  This piece compares the various constructs used for the vampire in various books and movies, analogizing that to the various laws governing business organizations.  What is a vampire in a particular book or movie is determined by the author.  In the same way, what are the rights, duties and responsibilities of individuals within a particular organization are determined by the controlling statute and the governing documents.  Ultimately, each must be assessed on its individual terms, and assumptions that one characteristic applies in other contexts are often erroneous.

The article can be accessed HERE

NY's Top Court Hears Argument on LLC Promoter Liability

NY's Top Court Hears Argument on LLC Promoter Liability

Valuation of a Member’s Interest in an LLC Upon Dissociation

Valuation of a Member’s Interest in an LLC Upon Dissociation

            Last Friday, the Court of Appeals, in Eddy Creek Marina Resort, LLC v. Tabor, No. 2009-CA-001608-MR, 2011 WL 5599533 (Ky. App. Nov. 18, 2011) (Not to be Published), addressed the mechanism by which the interest of a resigning LLC member should be valued. 

        Tabor was a 10% member in Eddy Creek Marina Resort, LLC.  The Court of Appeals implied, but never stated expressly, that the operating agreement afforded a member the right to withdraw from the company; in my review of the agreement I can locate no such provision.  The briefs make clear that Tabor, by some undetailed mechanism, was forced out of the company.  The Court of Appeals' opinion recites that operating agreement provided that “the dissociated member … shall be entitled to receive the fair value of the Member’s Company interest as of the date of dissociation based upon the Member’s right to share in the distributions of the Company.”  Id. at *1 (more on this point below).  The operating agreement did not, however, either define fair value or set forth the mechanism by which fair value of a dissociated member’s interest would be calculated. 

         At a bench trial, experts presented estimates of the “fair market value” of the company as ranging from $3 million to over $5 million.  Mortgages on the company assets existed in the amount of approximately $2.3 million, and Tabor testified that he was liable for a potion of that debt.  The trial court determined a company FMV of $4 million and then applied a 10% marketability discount and a 10% minority discount.  The $4 million FMV determination did not, however, incorporate the $2.3 million of debt.  Ultimately, the court concluded that Tabor’s 10% in the company was worth $324,000.  Eddy Creek appealed from the trial court’s failure to subtract the $2.3 million in debt from the $4 million FMV in determining the value of Tabor’s interest.

            The Court of Appeals held that not incorporating the LLC’s debt in the determination of company value was an error and remanded the case for further fact-finding and presumably the calculation of the adjusted amount to Tabor.

            IMHO, while the outcome of this decision is entirely correct, the basis for the ruling was, at minimum, suspicious.  The court relied upon KRS § 275.205, the default rule for the allocation “of profits and losses amongst the members of an LLC.”  The court failed to recognize that, under the principles of partnership taxation, the sharing of profits and losses is an issue of allocation (i.e., who bears tax liability for the activities of the LLC) while it is distributions by which the members receive the net profits.  An allocation, which will give rise to a tax liability to an individual member, may not be accompanied by a distribution.  Further, assuming satisfaction of the substantial economic effect test of the Internal Revenue Code, it is possible to have differing allocations of profits and losses amongst the members.  In this instance, relying upon a provision addressing tax allocations likely did no harm, it being assumed that special allocations were not in issue in this LLC, but that will oftentimes not be the case.  The court’s decision would have been stronger if they had relied upon general principles of business valuation under which the company’s debt would have to be determined in valuing the ownership interest of a member.  Many such authorities were cited to it in the briefs presented.

            There exists as well a pair of issues that, even if not issues in this case, will be relevant in the future.

            With respect to the company debt, even as the value of Tabor’s interest in the LLC is calculated net of the debt, is he, in connection with the redemption, being released thereon?  As noted by the court:

Tabor testified that he was a signatory to the mortgage and thus liable for his portion of the debt.  It would be a waste of time and resources to give Tabor the full amount he seeks for his minority interest and then later require payment of his portion of the debt.  In the interest of judicial economy, we will make no such requirement.  Id. at *2.

The value of his interest in the company will be reduced, presumably on a dollar-for-dollar basis, to account for the outstanding balance on the mortgage as of the date of the redemption.  What will be the outcome if Tabor is not released on the mortgage and the obligation goes into default?  If he ever has to satisfy the mortgage, he will, in effect, have paid that debt twice. 

           With respect to the 10% minority interest discount and the 10% marketability discount applied by the trial court, there is a question as to whether doing so was appropriate.  Minority and marketability discounts are typically applied in determining “fair market value.”  In contrast, these discounts are not applied in determining “fair value,” and the Court of Appeals stated that the Eddy Creek operating agreement called for a payment of “fair value.”  See also Shawnee Telecom v. Brown, 2011 WL 5248307 (Ky. 2011) (rejecting, in the context of a dissenter rights statute and its directive that a dissenting shareholder receive the “fair value” of their shares, the application of discounts at the owner level).  While Tabor's Brief to the Court of Appeals accepted the application of these discounts (see p. 2), in another case on similar facts such an acceptance might not be appropriate. This may, however, be a problem of the Court of Appeals simply substituting "fair value" for "fair market value"; both briefs speak in terms of "fair market value."

            It bears noting that the facts of this case are markedly different from those in the Chapman decision.  Chapman v. Regional Radiology Associates, PLLC, 2011 Ky. App. LEXIS 251 (Ky. App. Mar. 25, 2011).  In this instance, as described byt he Court of Appeals, there was a written operating agreement providing, inter alia, that upon resignation a member would be entitled to a valuation of their interest in the company and redemption at that price.  Chapman, in contrast, involved an LLC that did not have a separate written operating agreement providing for a right of redemption. 

         As for the Court of Appeals' statement that “the dissociated member … shall be entitled to receive the fair value of the Member’s Company interest as of the date of dissociation based upon the Member’s right to share in the distributions of the Company.”, it is a verbatim recitation of part of KRS 275.215 as adopted in 1994, which language was repealed in 1998.  

            Practice Pointer – Terms like “fair value” do not have objectively defined meanings.  An operating agreement that calls for redemption at “fair value,” without further defining what is meant by “fair value” and defining the mechanism by which that amount will be determined, simply invites further (and typically expensive) litigation.

Wisconsin Court Misses the Point of Choice of Entity

Wisconsin Court Misses the Point of Choice of Entity

            In a recent decision interpreting and applying the Wisconsin LLC Act, the Court, sadly, missed the point of choice of entity, suggesting that the fiduciary obligations amongst all businesses or organizations not only are but should be the same.  Executive Center III LLC v. Meieran, 2011 WL 4704274 (E.D. Wisc. Oct. 4, 2011).

            Meieran bought a 12.5% interest in BRIC Executive, LLC (“BRIC”) for $250,000 pursuant to an agreement under which that 12.5% interest would be redeemed by a date certain with penalties and additional expenses incurred for any delayed redemption.  A year and one-half after that agreement was entered into, and when the repurchase obligation was already in default, the Plaintiff entered into an agreement with BRIC for the sale/leaseback of a BRIC-owned building.  BRIC received approximately $1.3 million from that transaction and entered into a 3-year lease for one unit in the building.  BRIC distributed the $1.3 million it received to pay off various debts, including its redemption obligation to Meieran.  The redemption price had by then swelled to $425,000 – Meieran accepted $400,000 in full satisfaction thereon.  At that point, BRIC had no other assets, and immediately defaulted on its lease obligation to the Plaintiff.  They brought suit against Meieran, alleging a number of counts including fraudulent conveyance of the $400,000 paid to the Defendants, breach of fiduciary duty owed to the Plaintiff and receiving an improper inequitable distribution from BRIC. 

      My concern is with the statements made as to fiduciary duties. 

      After engaging in an effort to distinguish Gottsacker v. Monnier, 697 N.W.2d 436 (Wis. 2005), the Court discussed whether or not common law fiduciary duties exist in addition to those imposed by statute.  Apparently working from the positions that fiduciary duties amongst business owners are normative and that the fiduciary duties that are owed are equivalent amongst business organizations, the Court wrote:

In fact, there is growing consensus that common law fiduciary duties should apply to the operations of LLCs….  Logic dictates the same. Fiduciary duties exist to protect people who are affected by the actions of those who control businesses.  Therefore, it would not make any sense if the expectation for a business to act fairly were to be different simply due to the business owners’ choice of form – an LLC in this case.  If that were so, every dishonest owner could simply elect to operate its business as an LLC and claim that no fiduciary duties applied to its actions. 

For these reasons, the Court finds that common law fiduciary duties apply to LLCs.  2011 WL 4704274, *8-9. 

       Initially, there is a significant question, not addressed by the Court, as to why fiduciary duties are even being contemplated in this situation.  The suit here is filed by the purchaser of a commercial building who is, no doubt justifiably, upset that the seller has, in the capacity of a tenant, breached their obligations.  This appears to be, and the Court does not indicate anything to the contrary, an arms-length transaction.  Buyer is not a member of BRIC.  Setting aside the question of what are the fiduciary duties, there is no indication of a relationship from which the Plaintiff could assert there to have arisen a fiduciary obligation that was violated.  The opinion recites that the payment to Meieran rendered BRIC insolvent.  If the basis of the claim is a fiduciary shift on insolvency to the benefit of the creditors, that would be nice to know.

       Returning to the mindset issue, the dual suggestions by the Court that (a) as a normative matter fiduciary duties exist in business organizations and (b) that fiduciary duties do not change between organizations, are both demonstratively incorrect and indeed misleading. 

       The first proposition, namely that fiduciary duties are normative, is disproven by the fact that many statues expressly permit either the restriction or the elimination of fiduciary duties and/or permit the elimination of culpability for the breach of a fiduciary obligation.  See, e.g., Del. Code Ann. tit. 6, § 18-1101(c) (permitting an operating agreement to eliminate all fiduciary duties); KRS § 275.170 (permitting the statutory default fiduciary duties of care and loyalty to be altered in a written operating agreement); and id. § 275.185 (permitting a written operating agreement to eliminate culpability for breach of fiduciary duties of care and loyalty).  Ergo, the premise that all business organizations must impose upon their constituents fiduciary obligations is manifestly incorrect.

          Perhaps even more troubling is the Court’s suggestion that fiduciary duties are a constant across business organizations.  This is simply not the case.  As the U.S. Supreme Court stated so eloquently in SEC v. Cheney Corp., 318 U.S. 80, 85-86 (1945):

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?

       Different expectations and limits are placed upon different fiduciaries.  Simple paid agents are held to a care standard of simple negligence.  See Restatement (Third) of Agency § 8.08 (2006).  In contrast, corporate directors are held to a wanton or reckless standard.  See, e.g., KRS § 271B.8-300(5)(b).  Members of a Wisconsin LLC are held to a “willfull misconduct” standard.  Wisc. Code § 183.0402(1)(d). 

       Turning to the obligation of loyalty, partners, trustees and members of a member-managed are precluded from benefitting from a self-dealing transaction with the trust/partnership/LLC or the use of its assets.  See Restatement (Second) of Trusts § 203 (1959); Wisc. Code § 183.0402(2); KRS § 275.170(2); UPA § 21(1).  In contrast, corporate directors are permitted to enter into conflict of interest transactions and to utilize corporate assets for personal benefit provided the terms of the transaction are “fair” to the corporation.  See, e.g., KRS § 271B.8-310(1)(c).  Some jurisdictions even go so far as to remove from that director the burden of proving fairness, requiring, rather, that the complaining shareholder prove lack of fairness. 

         Clearly not every “fiduciary” is held to the same standard.  The failure to recognize this crucial aspect of business organization law generally and the entire point of the choice of entity calculus is the fundamental failure of Executive Center III LLC v. Meieran.

Martin v. Pack’s Inc.

Martin v. Pack’s Inc.:  The Court of Appeals

Adds Uncertainty and Risk to Dissolution

      Martin v. Pack’s Inc. involved a claim for construction services rendered by Pack’s prior to the administrative dissolution of Southeastern Construction, Inc.  After the administrative dissolution of Southeastern, Ed Martin, on the corporation’s behalf, entered into two agreements with Pack’s, Southeastern’s creditor, for resolution of that debt.  Southeastern failed to perform.  Pack’s then sought to enforce the debt against not only Southeastern but also Ed Martin and Jeff Collinsworth, Southeastern’s shareholders.  Granting summary judgment to Pack’s, the trial court held, and the Court of Appeals affirmed, that each of Martin and Collinsworth are personally liable on the debt.  Martin v. Pack’s Inc., 2011 WL 3207947 (Ky. App. 2011) (To Be Published). 

     IMHO, the grounds for that determination were erroneous.

The (Flawed) Understanding of the Effect of Dissolution on Shareholder Limited Liability

                One basis upon which the Court of Appeals affirmed holding Martin liable on the obligation to Pack’s was that the agreement for the resolution of the corporation’s debt was entered into after the corporation’s administrative dissolution, the court reasoning that after dissolution there was neither a corporation nor the consequent limited liability.  Id. at *5. “To reiterate, Martin cannot be shielded from personal liability by virtue of the statute, (sic) because his corporation was dissolved at the time of his actions.”  The Court said, in effect, that dissolution abrogates the rule of limited liability.

It appears there was not identified to the Court, and that its own research did not unearth, the 2007 amendment to the Business Corporation Act enacted in response to and legislatively overruling the Forleo decision (2006 WL 2788429 (Ky. App. 2006)).  That amendment expressly provides that a corporation’s dissolution does not “abate or suspend” the shareholder’s limited liability.  See Ky. Rev. Stat. Ann. § 271B.14-050(2)(i); see also Thomas E. Rutledge, The 2007 Amendments to the Kentucky Business Entity Statutes, 97 Ky. L.J. 229, 243 (2008-09). 

To the extent that the Court of Appeal’s affirmation of the trial court’s ruling was based upon the notion that, subsequent to dissolution, shareholders do not enjoy limited liability, that ruling was directly contrary to the controlling statute.

A (Flawed) Understanding of the Effect of Dissolution on Corporate Status

The second substantive failure of the decision is its assumption that upon dissolution a corporation ceases to exist.  Simply put, that is not the law.

        In a prior age it was the rule that upon dissolution a corporation simply ceased to exist – its property became vested in the shareholders, its debts were extinguished and suits by or against it were terminated.  See, e.g., 16A William Meade Fletcher, Fletcher Cyclopedia of the Law of Private Corporations § 8113; II Stewart Kyd, A Treatise on The Law of Corporations 516 (1794) (“The effect of the dissolution of a corporation is, that all its lands revert to the donor; its privileges and franchises are extinguished; and the members can neither recover debts which were due to the corporation, nor be charged with debts contracted by it, in their natural capacities.”)  Those rules have been long repealed.  See, e.g., Greene v. Stevenson, 175 S.W.2d 519, 523-24 (Ky. 1943).  Under the formula currently employed, a corporation, after dissolution, continues to exist as a corporation.  See, e.g., Ky. Rev. Stat. Ann. § 271B.14-050(1) (“A dissolved corporation shall continue its corporate existence….”).  A dissolved corporation is restricted to activities “appropriate to wind up and liquidate its business and affairs.”  Ky. Rev. Stat. Ann. § 271B.14-050(1). 

     At one time a corporation’s dissolution caused it to cease to exist.  Under the modern system as enacted by the General Assembly, a dissolved corporation continues to exist as a corporation.  See KRS § 271B.14-050(1); id. § 14A.7-020(3).  Ergo, any conclusion based upon the premise “a dissolved corporation no longer exists as a corporation” must fail as the premise is false.

The (Flawed) Understanding of the Winding Up Process

            Dissolution effects a limitation upon the proper activities of the dissolved organization, restricting it to those that are appropriate for its winding up and termination.  See, e.g., Ky. Rev. Stat. Ann. § 271B.14-050(1) (“A dissolved corporation … may not carry on any business except that appropriate to wind up and liquidate its business and affairs….”).  Whether any particular activity is appropriate for the winding up and termination of a particulate venture is a fact dependent issue.  For example, in the winding up and termination of a retail store, it is difficult to contemplate a situation in which the acquisition of additional inventory would be appropriate.  Conversely, in the winding up and termination of a landscaping business, the purchase of additional materials with which to complete a job that is under contract and partially completed likely would be appropriate.  The open and fact dependent nature of this assessment is implicit in the statute’s use of “including” in the description of activities that are appropriate after dissolution.  Id.

      The Martin court makes much of the fact that the agreement with Pack’s was created subsequent to the dissolution.  2011 WL 3207947 at *2-3.  Even accepting that characterization as true, it is not determinative of the outcome.  Rather, nothing in the law of dissolution precludes a dissolved corporation from entering into entirely new obligations.

      In the resolution of claims with creditors, whether they are known or unknown, there will often need to be a new agreement entered into pursuant to which the amount and manner of resolution are agreed upon.  While some of these agreements may constitute only a modification of existing agreements, a claim arising, for example, in quasi-contract will not.  Were the rule espoused in Martin v. Pack’s, Inc. to be correct, then the post-dissolution sale of assets sanctioned in Greene v. Stevenson would have exposed whoever signed the sale agreement to personal liability thereon.  Assume a creditor initiates an action against a dissolved corporation.  Is the corporation precluded from entering into an engagement with an attorney for the purpose of making a defense or even asserting a counter-claim?  That engagement letter with the attorney will be a new post-dissolution obligation.

      Curiously, neither the Court of Appeals nor the trial court explained how the post-dissolution agreement between Southeastern and Pack’s did not fall within KRS § 271B.14-050(i)(c) and its express authorization for a dissolved corporation to “mak[e] provision for discharging its obligations.” 

      The suggestion that a corporation, after dissolution, cannot in its own name and on its behalf enter into agreements in settlement of its debts and obligations is without analytic support and is contrary to the statute. 

A (Flawed) Understanding of the Effort of Dissolution Upon Agency

       A corporation “is an artificial being, invisible, intangible, and existing only in contemplation of law.”,  Trustees of Dartmouth Coll. v. Woodward, 17 U.S. (4 Wheat.) 518, 636 (1819), able to act only through those natural persons who are its agents.  Restatement (Third) of Agency § 3.04, comment d.  As noted above, a corporation continues to exist after dissolution for the purpose of its winding up and liquidation.  During the dissolution process the corporation must act through agents.  Presuming appropriate identification of the principal and that the action is within the agent’s authority, the agent is not a party to and is not personally liable on the agreement at issue.  Restatement (Third) of Agency § 6.01.

        There is currently pending before the Supreme Court a petition for discretionary review.

History Note - Mary Tudor

       Today (Nov. 17) marks the anniversary of the death of Queen Mary Tudor.

      Mary has gone down in history with the label "Bloody Mary," attached to her by later English who were themselves of a Protestant viewpoint.  

      Life was in many respects not good to Mary.  The only surviving child of Henry VIII and Catherine of Aragon, she grew up within and firmly believed in her mother's strict Spanish Catholicicism.  As Henry withdrew England from obedience to the Pope as a mechanism for achieving the "divorce," obvious strains arose between Mary and her father.  That marriage being ultimately declared invalid, Mary found her position changed from Princess to a bastard unable to inherit the throne.  The birth of the presumably legitimate Princess Elizabeth further cut Mary off from her expected inheritance.  Enmity between Mary and Anne Boleyn made the situation even more difficult, Mary being required to serve Elizabeth even as a member of the Boleyn family, who likewise was against Mary, was in charge of the household.  While Boleyn's execution and the declaration of the invalidity of her marriage to Henry as well rendered Elizabeth illegitimate,  the birth of Edward (ultimately Edward VI) removed her even further from the throne.

     After the death of Edward VI Mary finally succeeded to the throne, but her reign was at best troubled.  Believing herself to be duty bound to undo the "reforms" of her father and their expansion under her brother, Mary reaffirmed the obedience of the English Church to Rome, recalled Cardinal Pole and made him Archbishop of Canterbury, and set about the return of the Catholic faith.  As demonstrated by the work of A.J. Scarisbrick and Eamon Duffy, this was for the most part a small task - the overlay and substitution of what we today consider to be "Protestant" aspects of faith were a thin facade.  Still, there were "true believers" who were executed, most notably Cramner, former Archbishop of Canterbury.

   Her marriage to Philip of Spain was a disaster, especially on a personal level.  

   While Tom Petty tells us "Its good to be king," at many levels Mary's refrain might have been "Its not good to be a king's daughter or to be queen."

Philanthropic Facilitation Act of 2011

Here is the text of the submitted legislation.
It has been referred to House Ways and Means.

HR 3420

Philanthropic Facilitation Act of 2011

Foundations on the Hill has posted a position paper on the Philanthropic Foundation Act of 2011.

http://www.foundationsonthehill.org/docs/PRI-Promotion-Act-0228.pdf.

Waiving Limited Liability

Waiving Limited Liability

       A recent case from a North Carolina Court of Appeals highlights how easy it may be to waive limited liability.  Consolidated Electrical Distributors, Inc. v. Wieltech Electric Co., LLC, No. COA 11-96 (N.C.) (Ct. App. Oct. 18, 2011).

      In September, 2006, Wieltech Electric Company was reorganized into an LLC; the opinion is silent as to its earlier form of organization.  In connection therewith, a letter was sent to Wieltech’s vendors and customers advising them as to the change and stating in part that the debts and obligations of the predecessor organization “shall be transferred wholly into the newly formed LLC and the two individual organizers.”  Slip op. at 2, emphasis added.  Jennifer Fortenberry and Benjamin Wieland had been identified as the organizers of the LLC.  When the claim of Consolidated Electrical Distributors, Inc. against the LLC was not satisfied, it initiated suit, including against Fortenberry and Wieland, the suit against the individuals being based upon the letter stating that the obligations were “transferred” to them.

      Fortenberry’s defense focused on the Statute of Frauds, asserting that the letter was insufficient to constitute an agreement to be responsible for the LLC’s debt.  Distinguishing the writing from that in a prior dispute to the effect that the individual would “try” to pay off an obligation, which was found to be insufficient under the Statute of Frauds to create a binding obligation, in this instance the letter stated that the accounts would be transferred to the LLC’s organizers including Fortenberry.  On that basis, the court found that the letter was sufficiently detailed to satisfy the Statute of Frauds and on that basis the trial court’s grant of summary judgment to the plaintiff was affirmed.

      Under the reasoning of this decision, it is obviously not going to require much in the way of formality for an individual to waive the limited liability they otherwise enjoy from the debts and obligations of an LLC.  Whether it reflects, however, the law that would be applied in Kentucky is open to question.  See Racing Investment Fund 2000, LLC v. Clay Ward Agency, Inc., 320 S.W.3d 654, 659 (Ky. 2010) (“To reiterate, assumption of personal liability by a member of an LLC is so antithetical to the purpose of a [LLC] that any such assumption must be stated in unequivocal terms leaving no doubt  that the member or members intended to forego a principal advantage of this form of business entity.”)

Good Faith, Fair Dealing, and the Stones v. The Beatles

The Delaware Court of Chancery Ranks the Beatles Versus the Rolling Stones (and Also Talks About the Obligation of Good Faith and Fair Dealing)

      Last Thursday (Nov. 10, 2011), the Delaware Court of Chancery (Chancellor Strine) issued the opinion in Winshall v. Viacom International, Inc., 2011 WL 5506084.  It is quite possible this opinion will be most remembered for the conclusion of Chancellor Strine that the Beatles were a better group than were the Rolling Stones.  See id. at footnote 44 and accompanying text.  Still, this decision is a furthering interesting stage in the definition of the parameters of the obligation of good faith and fair dealing.

      The Plaintiffs had sold Harmonix Music Systems, Inc. to Viacom by means of a merger agreement including a contingent right to receive certain payments based upon Harmonix’s financial performance in the two years following the merger.  Harmonix was itself a developer of video games.  A year after the closure on the merger and during the earn-out period, Harmonix released the “Rock Band” game.  In light of the success of Rock Band, Electronic Arts (“EA”) sought to renegotiate its distribution agreement with Harmonix for the purpose of acquiring greater distribution rights to both Rock Band and any sequels that might be issued.  As renegotiated, in return for the right to distribute certain Rock Band sequels and as well the right to expand its distribution channels to include hand-held devices, distribution fees being paid by Harmonix were reduced for future years, all after the expiration of the earn-out for Harmonix’s original shareholders.  Had the reduced distribution fees applied during the earn-out period, the payments to the former Harmonix shareholders under the earn-out would have been increased.  Those shareholders sued Viacom alleging that the amendment distribution agreement was “purposefully renegotiated to reduce the earn-out payments, thereby breaching the covenant of good faith and fair dealing.”  In effect, Harmonix’s former shareholders asserted that the obligation of good faith and fair dealing should be applied to capture for them the benefit of any renegotiated distribution agreement.  This assertion was squarely rejected by Chancellor Strine, he writing:

Even assuming that Viacom and Harmonix intentionally forewent possible opportunity to increase Harmonix’s profits during the earn-out period and structured the amended contract with EA so that Viacom and Harmonix could enjoy all the benefits for themselves, Viacom and Harmonix took no steps to reduce any reasonable contractual expectation of the Selling Shareholders.  It would be inequitable for this Court to imply a duty on Viacom and Harmonix’s part to share with the Selling Shareholders the benefits of a renegotiated contract addressing EA’s right to distribute Harmonix products after the expiration of the earn-out period.  The implied covenant of good faith and fair dealing is not a license for a court to make stuff up, which is what [the Plaintiffs] seeks to have me do.

     The Court reiterated the rule that the implied obligation of good faith and fair dealing is not a mechanism by which, after the fact, parties to an agreement may secure for themselves benefits that they failed to negotiate.  Focusing upon the situation as it existed at the time the merger agreement was entered into, that preceding the resounding success of the Rock Band game and the consequent shift in bargaining position to Viacom with respect to the renegotiation of the distribution agreement:

I find that Winshall has failed to allege facts that support a reasonable inference that the Selling Stockholders did not get the benefit of their bargain under the Merger Agreement.  On these facts, even viewed in the light most favorable to Winshall, the Selling Shareholders could not conceivably have a reasonable expectation that Viacom and Harmonix had a duty to renegotiate the [original distribution agreement] to increase the amount of earn-out payments the Selling Stockholders would receive.

     Contrasting these facts with the situation in which the acquirer manipulates the finances of the acquired company in order to reduce the amount of the earn-out, the Chancery Court was not willing to impose a reciprocal obligation that the benefits of any future events must be allocated in such a manner as to increase the earn-out amount.

“The Cornerstone of Statutory Interpretation”

“The Cornerstone of Statutory Interpretation”

The recent ruling of the Kentucky Court of Appeals in Beverage Warehouse, Inc. v. Commonwealth of Kentucky, No. 2009-CA-002020-MR (Oct. 28, 2011) (To Be Published) is for the most part a tripartite analysis as to whether particular determinations made in connection with the issuance of a liquor license constitute “orders” and how and when those particular orders may and may not be appealed.  No doubt all of this is quite helpful to those who regularly practice in retail liquor license regulation and the disputes that arise in connection therewith.  In contrast, what I found interesting was the Court’s discussion of the rules of statutory construction.  Citing Aldridge v. Commonwealth, 232 S.W. 619, 621 (Ky. 1921) and it quoting Bosley v. Mattingly, 14B Mon. 89 (Ky. 1853), the

Beverage Warehouse Court

recited what it identified as “the cornerstone of statutory interpretation”:

It may be proper in giving a construction to a statute to look to the effects and consequences when its provisions are ambiguous, or the legislative intention is doubtful.  But, when the law is clear and explicit, and its provisions are susceptible of but one interpretation, its consequences, if evil, can only be avoided by a change of the law itself, to be effected by legislative, and not judicial action.

The court should construe statutes in accordance with the legislative intent, since it is always to be presumed the Legislature designed the statute to take effect, and not be a nullity.

History Note - Edward III

       Today is the anniversary of the birth in 1312 of Edward III.  Crowned at the age of 14, he would go on to be the father of the "Black Prince" and to defeat the French at the Battle of Crecy.

      For those of you who saw the movie "Braveheart," as is often the case, the script writers were setting you up to fail a history exam.  It is strongly suggested that Edward II's wife Isabella was pregnant by William Wallace, making him the father of Edward III.  Now there is no question that Isabella of France was a fascinating woman, one who could hold her own in diplomacy with any man of the age.  That said, Wallace was executed in August, 1305; Edward III was born in 1312.  Even Isabella could not pull off a pregnancy of at least 7 years and 3 months.

       It was during the reign of Edward III that the excellent historic novel "World Without End" (sequel to "The Pillars of the Earth") was set.

Arbitration “To Take Place in the Commonwealth of Kentucky”

Arbitration “To Take Place in the Commonwealth of Kentucky”

        The Kentucky Court of Appeals has addressed the requirements for an enforceable arbitration agreement where the arbitration is to take place under the Kentucky (as contrasted with the Federal) Arbitration Act.  Padgett v. Steinbrecher, No. 2010-CA-000647-MR (Ky. App. Nov. 4, 2011) (To Be Published).  It bears noting that the holding in this case was substantially based upon a prior ruling of the Kentucky Supreme Court, namely Ally Cat, LLC v. Schuvin, 274 S.W.3d 451 (2009).

        This dispute arose in the context of an LLC whose operating agreement provided, inter alia, that all disputes arising out of or in connection with the LLC or the operating agreement would be resolved by binding arbitration.  One member, Steinbrecher, filed suit against the managing member, Padgett, alleging claims including breach of fiduciary duty.  In response, the defendant filed a motion with the court seeking (somewhat inartfully) dismissal of the suit and referral to arbitration.  The Court of Appeals reports that the parties did not dispute either the validity of the arbitration clause or that, were it enforceable, that it would cover the plaintiff’s claims. 

        Reading between the lines, there were no interstate activities, so the enforcement of the arbitration clause arose exclusively under the Kentucky Arbitration Act, it being an enactment of the Uniform Arbitration Act.  KRS ch. 417. 

        In light of the federal and state policies in favor of arbitration, we would normally expect that this dispute would have been resolved by the staying of the case and the referral of the matter to arbitration.  That was, however, not the resolution because of an insufficiency in the arbitration clause in that operating agreement.

      Under KRS § 417.200, a Kentucky court has jurisdiction to enforce an arbitration agreement where the agreement provides “for arbitration in [Kentucky].”  While the agreement at issue in this case provided that the rules of the AAA as enforced in Kentucky would control, inter alia addressing the choice of law, the document was silent as to the choice of forum.  The Court rejected the argument that the agreement as to choice of law implied an agreement as to forum.  There having been, in the end, no contractual agreement that the arbitration would take place in Kentucky, the agreement fell outside the scope of those that may, pursuant to statute, be enforced by a court.  On that basis, the trial court’s denial of the motion to compel arbitration was affirmed.

      The moral of the story – if you are drafting an arbitration agreement that is to be, if ever applied, enforced in accordance with the Kentucky Arbitration Act, it is absolutely essential that the agreement contain the magic words “with the arbitration to take place in the Commonwealth of Kentucky.”  Fail to include these magic words or some similar provision as to the arbitration actually taking place in Kentucky and it may come to pass that disputes will be resolved in court and not in arbitration.

      No word yet as to any appeal is being sought. 

An LLC Must be Represented by a Lawyer

An LLC Must be Represented by a Lawyer

       An LLC cannot appear pro se; rather, it must be represented by counsel.  The Kentucky Court of Appeals has held that where one of the members, on the LLC’s behalf, filed an action, he was engaged in the unauthorized practice of law. Bobbett v. Russellville Mobile Park, LLC, No. 2007-CA-000684-DG (Sept. 12, 2008; modified October 17, 2008).

      Stating the rule to be that “a lay-person may not represent a separate legal entity such as a corporation,” (citing Eagle Assoc., 926 F.2d at 1380 and Shapiro Barnstein & Co. v. Cont’l Record Co., 386 F.2d 426, 427 (2^nd Cir. 2967)) the Lattanzio LLC v. Comta, 481 F.3d 137 (2^nd Cir. 2007) Court explained how this rule has been applied in a number of contexts including the single-member LLC: 

[The lay individual] chose to accept the advantages of incorporation and must now bear the burdens of that incorporation; thus, he must have an attorney present the corporation’s legal claims.  Similarly, a sole member of a limited liability company must bear the burdens that accompany the benefits of the corporate form and may appear in federal court only through a licensed attorney. (citation omitted). 

Further decisions on this point include:  Collier v. Cobalt LLC, 2002 WL 726640 (E.D. La. 2002); U.S. v. Hagerman, 545 F.3d 579, 581-82 (7^th Cir. 2008); In re Shattuck, 411 B.R. 378, (CA-10 B.A.P. 2009) (pleadings filed by the non-lawyer receiver of an LLC were stricken); Kipp v. Royal & Son Alliance Pers. Ins. Co., 209 F. Supp.2d 962 (D.C. Wisc. 2002) (complaint filed on behalf of LLC by non-attorney dismissed); Valentine L.L.C. v. Flexible Business Solutions, L.L.C., 2000 WL 960901 (Conn. Super. June 22, 2000) (holding that an LLC cannot appear pro se, seeing no reason to distinguish an LLC from a corporation or partnership, neither of which may appear pro se); Banco Popular North America v. Austin Bagel Company, L.L.C., No. 99 CIV. 11252 SAS, 2000 WL 669644 (S.D.N.Y. May 23, 2000) (default judgment entered against LLC which attempted to appear pro se); International Association of Sheet Metal Workers Local 16 v. A.J. Mechanical, No. CIV. 99-451-FR, 199 WL 447459 (D. Or. June 16, 1999) (pleading of LLC which attempted to appear pro se struck); Poore v. Fox Hollow Enterprises, No. C.A. 93A-09-005, 1994 WL 150872 (Del. Super Ct. March 29, 1994) (holding that a Delaware LLC, like a Delaware corporation, may not appear pro se); In re IcInds Notes Acquisition, LLC, 259 B.R. 289 (Bankr. N.D. Ohio 2001) (holding that LLC may not file bankruptcy petition without being represented by counsel); Board of Education v. Franklin County Board of Revision, NOS 01AP-878, 01AP-879, 2002 WL 416953 (Ohio App. March 19, 2002) (distinguishing LLC from partnership, an aggregate of individuals, and characterizing LLC as separate legal entity like a corporation for purposes of requirement that it be represented by attorney in property tax valuation dispute, holding statute permitting LLC member to file a complaint on behalf of LLC unconstitutional insofar as it permits persons who are not attorneys or owners of property to file a complaint before a board of revision on behalf of the owner); Martinez v. Roscoe, 33 P.3d 887 (N.M. App. 2001) (holding that provisions of New Mexico LLC Act allowing authorized members to bring suit on behalf of the LLC do not permit members or managers who are not licensed attorneys to bring pro se claims on behalf of the LLC, but merely provide a mechanism for determining who may make the decision for the LLC to bring a lawsuit).

A Claim for Attorney’s Fees Must be Expressly Pled

A Claim for Attorney’s Fees Must be Expressly Pled

     The recent case of O’Rourke v. Lexington Real Estate Company LLC provides a bit of interesting guidance with respect to claims for attorney’s fees.  No. 2010-CI-0001208-MR (Ky. App. Oct. 7, 2011) (To Be Published). 

     O’Rourke was a residential tenant of Lexington Real Estate Company LLC.  After O’Rourke vacated the property, the landlord sought in excess of $5,600 in both repair costs and late fees.  Having been awarded those amounts, they were also awarded $5,000 in attorney fees.  The lease in question did not contain a attorney fee provision.  Rather, the attorney’s fees were, inter alia, awarded pursuant to the Court’s general equity powers (or so it would appear, the Court of Appeals did not identify the basis of the trial court’s award).

     It was that additional $5,000 assessment that O’Rourke appealed to the Court of Appeals.

     Initially, the Court found that, in that the legislature had by statute precluded a contractual attorney fee provision in a residential lease, and further determining that O’Rourke’s conduct was not “willful” such that an exception allowing attorney’s fees to be recovered, the attorney’s fees were rejected.  Acknowledging that, in certain situations, the Court may utilizing its equity authority require one party to pay attorney’s fees, citing Batson v. Clark, 980 S.W.2d 566 (Ky. App. 1998), the Court held that, in the face of the express statute precluding an attorney’s fee clause in the lease, the Court’s equitable authority could not enable what was by statute forbidden.

     The Court of Appeals cited an additional basis on which the attorney’s fee claim must fail, namely the sufficiency of the original complaint.  While Lexington Real Estate included a claim for attorney’s fees in the ad damnum clause, “it failed to state any claim for attorney’s fees in the body of the complaint.”  Slip op. at 5.  Ergo, where there is a claim for attorney’s fees, it would appear necessary that it be set forth as an independent count within the complaint, and not be simply recited in the list of damages sought.

Rednour Properties, LLC v. Spangler Roof Services, LLC - A Rant in Three Parts (Part III)

Rednour Properties, LLC v. Spangler Roof Services, LLC –

A Rant in Three Parts (Part III)

What Next?

A Motion for Discretionary Review has been filed with the Kentucky Supreme Court. In the judicial sphere, there seem to be four possible outcomes to the Rednour dispute, namely:

• The Supreme Court does not grant discretionary review, leaving Rednour an unreviewed and published decision;

• The Supreme Court does not grant discretionary review, but does direct the Court of Appeal’s decision not be published;

• The Supreme Court grants discretionary review and overturns the troubling aspects of the Rednour decision; or

• The Supreme Court grants discretionary review and affirms the troubling aspects of the Rednour decision.

All of these options carry a significant aspect of uncertainty. Assuming the Kentucky Supreme Court does grant discretionary review (and we likely will not have a decision on that for many months), there will be a significant delay thereafter in the release of the final decision. Assuming it to be the fastest possible course, even a denial of review but a de-publishing of the Court of Appeals’ ruling would not entirely resolve our issues as Rednour, being the only decision on this point in Kentucky, may continue to be cited as authority.

A Legislative Response?

Unlike states such as Texas that have sought to reduce the rule of piercing the veil to statute, Kentucky has relied exclusively on common law save and except for a provision in the LLC Act providing that the failure to maintain the required records is not a basis for setting aside the otherwise applicable rule of limited liability. While it should remain under consideration, attempting a legislative fix would involve a number of issues including the decision as to whether to only respond to the problems raised by the Rednour decision or, alternatively, to adopt an entirely statutory formula for piercing (a middle point may as well be possible) and the need to amend multiple statutes so that a consistent rule can be adopted. There is as well the risk that certain members of the bar would object to either or both of the reversal of Rednour and/or any effort to reduce to statute the piercing rules.

What to do Now?

Assuming we have a year until these issues can be resolved, we must decide what we are going to do in the meantime. With respect to newly organized entities, are we still going to organize single member LLCs and single shareholder corporations in Kentucky, and what are going to do with respect to those SMLLCs and single shareholder corporations that are already our clients?

New Organizations

If someone walks into our office today and requests a SMLLC or single shareholder corporation, are you going to still organize them in Kentucky (presumably with appropriate disclosure as to the risk) or are you automatically going to organize them in another state?

Existing SMLLCs and Single-Shareholder Corporations

Similar to the question above, but in this instance restricted presumably to those clients with whom we have an ongoing relationship, a decision needs to be made whether you will advise them of these developments in the law and lay out their options, namely remain organized in Kentucky or reorganize in another jurisdiction.

The Internal Affairs Doctrine

Of course, domiciling these ventures in Delaware or another jurisdiction assumes, when the question of piercing a foreign corporation or LLC arises, that the court will apply the proper law, that being the law of the jurisdiction of organization. In the case of a corporation this rule is recited in the Restatement (2nd) of Conflicts § 307 and in Kentucky law at KRS § 271B.15-050(3). It is embodied well in our LLC Act. KRS § 275.405(2). See also United States v. Daugherty, 599 F. Supp. 671, 673 (E.D.Tenn. 1984) (applying Kentucky law to determine whether corporate veil should be pierced because corporation was incorporated in Kentucky); Soviet Pan Am Travel Effort v. Travel Committee, Inc., 756 F. Supp. 126, 131 (S.D.N.Y.1991) (“Because a corporation is a creature of state law whose primary purpose is to insulate shareholders from legal liability, the state of incorporation has the greater interest in determining when and if that insulation is to be stripped away.”).

Why Are We Even Needing to Consider These Issues?

I appreciate that some believe it inappropriate to challenge the Bench by suggesting that a ruling was not well reasoned and insightful. I am not one of those persons, and those who are of that viewpoint should not read the balance of this column.

The public and the practicing bar have every right to expect that the decisions of all of our courts, but especially those at the appellate level, are complete and well grounded. Decisions like Rednour that entirely depart from the statutory law, the case law and the extensive scholarly commentary, impose a significant burden upon Kentucky’s business community and our too fragile economy. Untold hours are now going to be spent redomesticating existing business to other jurisdictions in an effort to avoid the application of this decision. For the same reason, newly organized businesses are more likely to be organized outside of Kentucky, and they will now bear the cost of foreign qualification and of additional tax filing. These costs are a tax on business that have directly come about by at best weak and even non-existent analysis. Kentucky cannot and should not have to bear these costs.

Rednour Properties, LLC v. Spangler Roof Services, LLC – A Rant in Three Parts (Parts II)

Rednour Properties, LLC v. Spangler Roof Services, LLC –

A Rant in Three Parts (Part II)

Substantive Failures

On the facts of this case, piercing could well have been proper.  What is more important, however, is the fact that the opinions rendered do not of themselves justify piercing.  Rather, to suggest that the Rednour decision is unsupported by either the facts recited or the law applied would be generous.  Without intending to address every issue:

·                    Selecting a form that provides limited liability is not only entirely permissible but intended – did the General Assembly adopt numerous statutes for organizational forms that provide limited liability expecting they would never be utilized?;

·                    Electing to be organized as a corporation (or other form that affords limited liability) for the purpose of achieving limited liability is entirely permitted.  Anderson v. Abbott, 321 U.S. 349, 361 (1944);

·                    Corporate law has long recognized the permissibility of a single-shareholder corporation.  As the Court of Appeals recently observed in Thomas v. Brooks, 2007 WL 1378510 (Ky. App. May 11, 2007), “it is perfectly legal for a corporation to be owned by a single shareholder”;

·                    Were the 1998 Amendments to the LLC Act affirmatively providing for a single-member LLC intended by the General Assembly to be a trap for the unwary?;

·                    In that the role of the registered agent is defined as being to accept legal process and notices tendered to the entity and to retain information as to the entity’s communications contact (KRS § 14A.4-050), there is no basis for the argument that the sole owner being the registered agent justifies piercing the entity;

·                    There exist models, each employing various elements, for piercing the veil of a business corporation, a path of analysis exemplified in Kentucky in White v. Winchester Land Development, 584 S.W.2d 56 (Ky. App. 1979).  That model applies to a corporation.  An LLC is not a corporation.  See, e.g., Cook v. Patient EDU, LLC, 2011 WL 3276679 (Mass. Super. 2011).  A court that is considering piercing an LLC must first articulate a model for when piercing an LLC is appropriate.  That an independently justified analytic framework is needed for LLCs, as contrasted with corporations, has been recognized by the Court of Appeals.  See Welty v. Sexton, No. 2000-CA-002847-MR (Ky. App. 2002), slip op. at 6-7;

·                    In the context of an analytic model, an explanation of the facts of the case that do and do not justify piercing needs to be set forth – that was not done in Rednour;

·                    It is and has been the law of Kentucky that piercing may not take place absent “a showing of fraud or injustice separate and apart from the corporation’s failure to pay its debt.”  Scarbrough v. Perez, 870 F.2d 1079, 1084 (6^th Cir. 1989).  See also, e.g., Sudamax Industria e Comercio de Cigarros, LTDA v. Buttes & Ashes, Inc., 516 F. Supp.2d 841, 849 (W.D. Ky. 2007) – that was not done in Rednour; and

·                    A failure to identify the capacity, as a principal or as an agent, on a document goes at best to the question of whether “corporate” formalities have been maintained, but more importantly goes to the question of the disclosed or undisclosed principal.  Agency law has its own protocols for when an agent may be held liable on an obligation, and those protocols should not be mixed with those for piercing.

Rednour Properties, LLC v. Spangler Roof Services, LLC – A Rant in Three Parts (Part I)

Rednour Properties, LLC v. Spangler Roof Services, LLC –

A Rant in Three Parts (Part I)

      A recent decision of the Kentucky Court of Appeals has thrown into doubt whether a single-member LLC (SMLLC) is effective in providing limited liability to its sole member, a decision equally applicable to single shareholder corporations.

       Rednour Properties, LLC v. Spangler Roof Services, LLC, No. 2009-CA-001159-MR, 2011 WL 2535330 (Ky. App. June 10, 2011, modified July 8, 2011) (“To Be Published”) involved a dispute over payment for roofing and related refurbishment work on an apartment complex.  Ritchie Rednour was the sole member and registered agent at Rednour Properties, LLC and Rednour Blake, LLC, both Kentucky LLCs.  On June 6, 2007 Rednour Blake, LLC purchased an apartment complex.  Rednour Properties, LLC managed the apartment complex.  On July 12, 2007 Rednour, signing as the “general/owner,” entered into a contract between Rednour Properties, LLC and Spangler Roof Services, LLC (“Spangler”) whereunder Spangler agreed to perform certain repairs to the apartment complex.  Thereafter, three change orders dated August 12, 2007, August 20, 2007 and January 2, 2008 were agreed upon.  On September 20, 2007, Rednour Blake, LLC transferred title to the apartment complex to

250 Oxford Drive

, LLC, a Kentucky LLC.  A judgment for $48,531.83 plus $15,000 in attorney fees was entered.  Although the opinion does not address whether the judgment against Rednour Properties, LLC was or was not collectable, the Court of Appeals affirmed the trial court’s refusal to dismiss Rednour, an individual and the sole member of Rednour Properties, LLC, from the action and holding him personally liable on the judgments.

       In affirming the trial court’s determination that the separate existence of Rednour Properties, LLC would be ignored and that Rednour, an individual, would be held liable on the LLC’s debts, the Court of Appeals recited the following facts:

·                    That one of the LLCs at issue transferred the apartment complex to its own wholly-owned subsidiary;

·                    Trial court testimony (the nature of this testimony is not recited in the trial court’s opinion, order and judgment of May 20, 2009) “showing a lack of distinction between the various LLCs which Rednour owned, and Ritchie Rednour, the individual”;

·                    The identification in the contract for repair work of one LLC as the owner of the property when in fact it was owned by the other LLC (the contract was prepared by Spangler); and

·                    All three of the LLCs were owned by Rednour and he signed the contract with Spangler “without specifying that he was acting in a corporate capacity.”

The Court of Appeals noted Rednour’s argument that Spangler had not established “any evidence of fraud or injustice,” but said nothing more beyond that.

In its holding, the Court of Appeals wrote:

[W]e hold that there is substantial evidence to support the Circuit Court’s decision to pierce the corporate veil in this action.  While the record establishes the corporate existence of the entities at issue (Rednour Blake and Rednour Properties, which both list Rednour as the registered agent), it is obvious that these entities were “dummy” corporations [throughout, the Court of Appeals refers to LLCs as “corporations”] designed to protect Rednour from personal liability.  Rednour is the sole member and agent of these companies as well as several others, at least one of which is a subsidiary of another LLC, and Rednour admits to having set up the LLCs for tax purposes.  Under these circumstances, we aren’t able to discern any difference between Rednour and his various LLCs.  Accordingly, we must hold that the Circuit Court did not commit any error when it held Ritchie Rednour individually liable for the corporate debts and declined to dismiss him as a defendant.

      Needless to say, if this decision stands, it is a body blow to single-member LLCs as well as single-shareholder corporations in Kentucky; it may be extended as well to multiple owner entities.  Without here reciting the myriad analytic failures of this decision, it must be recognized that:

·                    Every choice of entity decision is going to have a tax component, and if having engaged in tax planning is a reason for setting aside a limited liability entity, then every limited liability entity should be pierced because its election was at least in part for tax purposes; and

·                    It is unclear whether the court is referring to Rednour being the registered agent or rather the apparent agent (see KRS § 275.135(1)) of the LLCs, but it appears more likely that the reference is to the position of registered agent.  If that is the case, the sole owner may never be the registered agent of a business organization without thereby supporting an argument that the veil should be pierced; and

·                    The fact that one elected a limited liability entity with the intention of reducing one’s personal liability (and is there any other reason for doing so?) will be a basis for setting aside that limited liability shield.