Thursday, November 29, 2012
Tuesday, November 20, 2012
Standing in Dispute Among Members of LLC
On November 16, the Kentucky Court of Appeals issued a decision addressing whether the member of an LLC has standing, in his own name, to bring an action asserting various claims including that the other member(s) has violated fiduciary duties. It also addresses a claim for wrongful termination of employment of a member by an LLC. Chou v. Chilton, 2012 WL 5626184 (Ky. App. Nov. 16, 2012).
As I was involved in this dispute I will not say more beyond recommending it to you.
Delaware Supreme Court Sidesteps Question of Default Fiduciary Duties in LLCs While Squarely Head-Butting Chancellor Strine
It had been hoped that the decision of the Delaware Supreme Court in Gatz Properties v. Auriga would resolve the question as to what are, if any, the default fiduciary duties imposed by the Delaware LLC Act. In the end, the Delaware Supreme Court has managed to avoid this question, finding that the contractual standards set forth in the limited liability company agreement of the LLC at issue provided a standard; consequently, the issue of a default duty in the absence of agreed contractual standard was not before the Court. At the same time, the Supreme Court, in a per curiam decision, chastised Chancellor Strine for his decision’s expansive explication of the question of what would be those default duties. Gatz Properties, LLC v. Auriga Capital Corp., ___ A.2d ___, 2012 WL 5425227, 2012 Del. LEXIS 577 (Del. Nov. 7, 2012), affirming 40 A.3d 389 (Del. Ch. 2012).
The Facts of the Dispute
Peconic Bay LLC was organized to hold a leasehold interest in certain property, to develop the property into a golf course, and to sublease the property to a golf course operator. The Gatz family and their affiliates held over 85% of the Class A and over 52% of the Class B membership interests in Peconic Bay.
By 2004 the golf course was failing and Gatz believed that the lease operator planned to exercise its early termination rights under the sublease. Instead of attempting to identify a new lessee to operate the golf course, Gatz hatched a plan intending that he could purchase Peconic Bay at a distressed price. Among other things, Gatz discouraged a potential third-party purchaser, provided misleading information to minority members about potential buyers, including understating their interest in the property, and conducted a “sham” auction. Gatz, the only bidder at the auction, purchased Peconic Bay. The minority members of Peconic Bay, LLC (“Peconic Bay”), sued Gatz Properties, LLC (“Gatz Properties”), the manager of Peconic Bay, and William Gatz (“Gatz”), who owned and controlled Gatz Properties, arguing that Gatz Properties breached its fiduciary duties. The Court of Chancery ruled in favor of the plaintiffs on both contractual and statutory grounds, from which ruling the defendants appealed.
Where the Supreme Court and the Chancery Court Agreed
The Delaware Supreme Court affirmed the finding that Gatz/Gatz Properties (collectively “Gatz”) violated the contracted-for fiduciary duty by refusing to negotiate with a third-party bidder and causing the company to be sold to himself at an unfair price in the flawed action. The relevant contractual provision of the LLC Agreement provided:
Neither the Manager nor any other Member shall be entitled to cause the Company to enter into any amendment of any of the Initial Affiliate Agreements which would increase the amounts paid by the Company pursuant thereto, or enter into any additional agreements with affiliates on terms and conditions which are less favorable to the Company than the terms and conditions of similar agreements which could then be entered into with arms-length third parties, without the consent of a majority of the non-affiliated Members (such majority to be deemed to be the holders of 66-2/3% of all Interests which are not held by affiliates of the person or entity that would be a party to the proposed agreement).
The Supreme Court wrote, “[v]iewed functionally, the quoted language is the contractual equivalent of the entire fairness equitable standard of conduct and judicial review.” It further determined that Gatz had acted in bad faith, in consequence of which Gatz was not entitled to the benefit of an exculpation and indemnification provision, of the LLC Agreement, it containing a carve-out for acts of gross negligence, willful misconduct or willful misrepresentation.
Where the Supreme Court and the Chancery Court Disagreed
Having disposed of the matter on the basis of the contract at issue and its definition of what were the manager’s fiduciary obligations, the Delaware Supreme Court held that the Court of Chancery acted improperly in addressing whether and what default fiduciary duties apply when the LLC agreement is silent on the issue. The Supreme Court characterized the Court of Chancery’s determination that default fiduciary duties exist “as dictum without any precedential value.”
The Court of Chancery had held that the “Delaware Limited Liability Company Act imposes ‘default’ fiduciary duties upon LLC managers and controllers unless the parties to the LLC Agreement contract that such duties do not apply.” The Supreme Court found that the issue had not been properly raised below, and that in any event it need not have been reached given the explicit duties detailed in the LLC Agreement. Moreover, according to the Delaware Supreme Court, “the merits of the issue whether the LLC statute does — or does not — impose default fiduciary duties is one about which reasonable minds could differ” and one that has not previously been decided by the Delaware Supreme Court. The Supreme Court expressed its view that one could reasonably conclude the LLC statute is “consciously ambiguous” in that regard, and suggested that the “‘organs of the Bar’ . . may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.”
Some Other Background
The views of Chancellor Strine to the effect that there do exist default fiduciary duties in the Delaware LLC Act runs directly contrary to a position previously taken by Chief Justice Steele. Rather, in Freedom of Contract and Default Contractual Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L. J. 221 (Summer 2009), he posited that there are no default fiduciary duties in limited partnerships or LLCs organized Delaware law. Chancellor’s Strine’s opinion in Gatz is directly contrary to this view.
What This Decision Means in Kentucky
At the broadest level, this decision has no impact upon Kentucky law. The Delaware LLC Act is silent as to the fiduciary duties owed by a member or manager. It is consequent to that silence that there exists a dispute as to whether fiduciary duties exist in that form, and if they do exist, what are they. Kentucky’s LLC Act, in contrast, specifies default fiduciary duties that may then be modified in a written operating agreement. See KRS § 275.170. Where the written operating agreement does not provide otherwise, the statutory provisions apply. See KRS § 275.003(8). Hence, in Kentucky, there cannot be a questions of “what are the fiduciary duties when the operating agreement is silent”; the statute has already addressed that question.
On a slightly more subtle level, this decision highlights the danger of knee-jerk reference to Delaware law. While it is indeed true that on many manners Delaware serves as the best authority when Kentucky law does not address a point, that reference presupposes that the policies of Delaware and Kentucky bear some high degree of similarity. As to this specific point, in that Kentucky has defined what are the default fiduciary duties in an LLC, it is ultimately of no concern what Delaware may ultimately resolve to be the default fiduciary duties in LLCs organized in that jurisdiction. Where Kentucky law has spoken to a point, the reference to foreign law as to its interpretation and application needs to be restricted to those states that have made similar determinations. As such, an Arkansas decision as to the fiduciary duties in LLCs, the Arkansas LLC Act being, as to that point, nearly identical to that in Kentucky, would be far more availing than would be a reference to Delaware law.
The last impact of this decision in Kentucky, and this is a bifurcated point, is upon practitioners. Initially, with an appreciation that the Kentucky and Delaware Acts are so dissimilar from one another, there should come as well the realization that mastery of the Kentucky LLC Act does not qualify one to practice in Delaware LLCs. Initially, the significant differences between the Kentucky and Delaware Acts often precludes skill transfer between the two forms. Second, with Delaware’s reliance upon its own contract law as the background against which LLCs agreements are drafted, one must, in order to effectively draft and interpret Delaware LLC agreements, master not only the LLC Act but the full range of Delaware’s contract law.
The second arm of this bifurcated point is that practitioners who aspire to draft operating agreements in multiple jurisdictions, even if limited only to Kentucky and Delaware, need to have a careful appreciation of the background against which the operating agreement is written. In drafting an operating agreement for a Kentucky LLC that is silent as to fiduciary duties, you in effect write into the agreement the statutory default rules. Whether, on a normative matter, with respect to any particular venture those are the most appropriate rules is a different question, the answer to which could well land the drafter into hot water for failure to consider their implications. In contrast, one who drafts a limited liability company agreement for a Delaware LLC that is likewise silent as to fiduciary duties has introduced a significant ambiguity into the relationship, namely what fiduciary duties, if any, apply? The ex post resolution of that ambiguity likely will be, at minimum, expensive. Failure to appreciate the problem created is even worse.
Monday, November 19, 2012
Preliminary Acquisition Discussions Not “Material”;
Claim for Securities Fraud Dismissed
In a recent decision, the 6th Circuit Court Appeals dismissed, on the grounds of lack of materiality, claims for securities fraud in connection with a shareholder’s sale of shares back to the corporation and to its President/CEO. Filing v. Phipps, 2012 WL 5200375 (6th Cir. Oct. 23, 2012).
Filing, an employee of White Rubber Company, acquired a significant number of shares of the corporation’s stock. He was offered the opportunity to sell shares back to the corporation, an offer which he accepted. Ultimately, the corporation, as well as Phipps, purchased fewer than the total number of offered shares at a price determined by a third-party valuation. While the discussions with respect to that purchase were taking place, a third-party, Norcross, expressed an interest in acquiring White Rubber, ultimately entering into a confidentiality agreement with respect to those discussions. The 6th Circuit noted, however, that Norcross had executed similar confidentiality agreement, with “dozens” of other possible acquisition targets. Those discussions ultimately broke down when White Rubber refused to provide certain requested due diligence. Shortly after that breakdown, the closing took place on the sale by Filing of stock to White Rubber and to Phipps. Several months later, another set of ultimately aborted discussions regarding the acquisition by Norcross of White Rubber were initiated. Then, a year later, after Norcross was recapitalized by its own acquisition, it acquired White Rubber for $22 million. Although not express in the opinion, Filing sold his shares based on a company valuation of approximately $4.65 million. Filing then brought suit against, ultimately, Phipps, the corporation and certain other directors alleging violations of § 10(b) of the ‘34 Act and Rule 10b-5 thereunder. The trial court granted summary judgment in favor of the defendants, and appeal to the 6th Circuit followed.
Filing asserted that the failure to disclosed the discussions between White Rubber and Norcross violated §10(b) and Rule 10b-5, the latter of which precludes “the making of ‘any untrue statement of material fact’ or the omission of any material fact ‘necessary to make the statements made … not misleading.’” 2012 WL 5200375, *2. A fact is material if “a reasonable shareholder would (1) consider the fact important in making an investment and (2) view the fact as having significantly altered the total mix of information available.” Id., citing Basic Inc v. Levinson, 486 U.S. 224, 231-32 (1998). There having been no disclosure of the potential acquisition, the question turned entirely on whether those discussions had been material.
Ultimately, in light of the preliminary, on and off nature of the negotiations between White Rubber and Norcross, the 6th Circuit affirmed the determination that those discussions had not been material. The Court noted as well that it was not until Norcross was itself acquired that a transaction with White Rubber took place. Ergo, Filing’s claims for securities fraud were unavailing.
Decision of Trial Court Reversed, Inter Alia, For Lack of Jurisdiction
A recent decision of the Kentucky Court of Appeals discusses a variety of interesting topics including standing to assert a claim for breach of fiduciary duty, the effectiveness of a release given to a fiduciary with respect to undisclosed activities and whether a secret profit earned in connection with the purchase of property by an LLC constitutes a breach of fiduciary duty. Ultimately, however, this is all dicta in that the Court of Appeals determined that the trial court lacked jurisdiction to hear the dispute, it arising out of a contract containing an exclusive venue clause referring disputes to Cincinnati, Ohio. Ziegler v. Knock, No. 2008-CA-002160-MR, 2012 WL 5273999 (Ky. App. Oct. 26, 2012).
David Knock and Richard Knock, members of Knock Investments, LLC and Ziegler Group, owned by Michael Ziegler, joined together by means of a Membership Interest Purchase Agreement, to form Knock/Ziegler LLC for the purpose of acquiring a strip mall in Ohio. The Membership Interest Purchase Agreement contained a warranty from Ziegler that he was not being paid, directly or indirectly, a sales commission on the transaction. It came to pass that Ziegler, through a wholly owned LLC, did receive a sales commission on the property acquisition. The Knocks and Knock Investments filed suit in Boone Circuit Court alleging that the commission was improper, including as a breach of fiduciary duty. They would largely prevail at the Boone Circuit Court, receiving a judgment roughly equivalent to their percentage interest in the LLC multiplied by the amount of the secret commission. Cross-appeals were then filed with the Kentucky Court of Appeals.
In what is ultimately dicta, the Court of Appeals upheld the rulings of the Boone Circuit Court with respect to: (1) the capacity of the Knocks as individuals, as proper parties to the litigation (I believe I am in disagreement, on a normative matter, with that determination; more on it below); (2) that a release entered into between the parties was not enforceable; (3) that Ziegler did breach his fiduciary duty in taking the sales commission; and (4) a claim by Ziegler for reimbursement for tax work performed on behalf of the LLC.
Ultimately, however, none of it mattered. The Membership Interest Purchase Agreement at issue provided an exclusive venue provision calling for any litigation to take place in Cincinnati, Ohio. Finding that, inter alia, this provision stripped the Boone Circuit Court of jurisdiction to hear this dispute, its decision was reversed.
Choice of Venue Upheld an Appeal
It is curious that the Court of Appeals was able to determine that the choice of venue clause is valid and enforceable. In Midnight Terror Productions, LLC v. Winterland, Inc., 2012 WL 5457530 (Ky. App. Nov. 9, 2012) (reviewed here in November 14), in response to a challenge to the legitimacy of a venue clause, the Court of Appeals directed that that determination needed to be made by the trial court and on that basis remanded for a decision on the merits. While the court wrote that “Nothing in the record demonstrates that Prudential Resources Corporation (v. Plunkett, 583 S.W.2d 97 (Ky. App. 1979)) should operate to void the application of the choice of venue clause in the Membership Interest Purchase Agreement,” neither does it recite that the various factors set forth therein have been considered by either the trial court or the Court of Appeals.
This opinion gives far too few facts to come any binding conclusions as to the standing, but further understanding would be helpful. It appears that the Knocks held their entire interest in the LLC that was the acquirer of the property through an LLC. Normally, to the extent there was any breach of fiduciary duty, that duty would have been owed to the LLC that was itself a member of the purchaser LLC; the Knocks as individuals, would not have individual standing to object. The opinion does not specify, however, whether the Knocks individually or their LLC were the signatories to the Membership Interest Purchase Agreement.
Breach of Fiduciary Duty
It is unfortunate that the decision of the Boone Circuit Court’s as supported (in dicta) by this holding of the Court of Appeals must ultimately be ignored. Clearly, the earning of an undisclosed commission on the LLC’s acquisition of property, unless specifically disclosed and approved by the disinterested members (see KRS § 275.170), is a breach of fiduciary duty. See also Thomas E. Rutledge and Thomas Earl Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 (2010). At the same time it is not clear that recourse to fiduciary duty law was necessary. Ziegler warranted that he was not to receive a commission when in fact he was. Clearly he violated his warranty, a matter that can be resolved as a straight-forward breach of contract action.
Saturday, November 17, 2012
So Begins Gloriana
On this day in 1558 Mary Tudor, who would later have foisted upon her the moniker "Bloody," died, leaving the English throne to her half-sister Elizabeth. Where Mary's reign of just over 5 years was one of tumult at the highest political levels, for at least a significant and perhaps a majority of the population it was a return to the preferred old ways, a view put forth expertly by Professor Scarisbrick in his The Reformation and the English People. Elizabeth's reign would by contrast be seen as one of peace and growth, later dubbed the Gloriana. Elizabeth would rule until 1603.
Friday, November 16, 2012
When You Use the Corporation as Your Personal Piggybank,
Don’t Be Surprised When Your Creditors Do So As Well
It axiomatic, all else being equal, the assets of a corporation are not the property of corporation’s shareholders. A concept identified under a number of labels including “asset partitioning,” while the shareholder may own 100% of the corporation, that ownership does not translate into an ownership interest in the corporation assets. Sometimes, however, all else is not equal, and shareholders treat the corporation assets as their own. As reviewed in a recent decision by the Kentucky Court of Appeals, when a shareholder acts in that manner, they should not be surprised when their creditors are permitted to do so as well. Caswell v. Richardson, 2012 WL 5457402 (Ky. App. Nov. 9, 2012).
Richardson held a judgment against Caswell and sought to enforce it by a garnishment action served against C. Caswell, Inc., a corporation wholly owned by Caswell. The corporation made no response to that garnishment order, and Richardson filed a motion to hold both Caswell and the corporation in contempt. Following a hearing on the contempt motion (the decision does not recite whether or not either Caswell or the corporation appears thereat), the corporation was found to be in possession of Caswell’s property, that it had failed to file a timely affidavit, and that civil sanctions in the amount of $25,000 were appropriate. The corporation was afforded the opportunity to purge the contempt by answering the garnishment order.
The corporation did finally respond through an affidavit from Caswell denying that the corporation held any of his property. That affidavit denied that the corporation had any net assets, whereupon Richardson was granted the opportunity to subpoena the corporation’s bank records.
The inspection of the bank records demonstrated that corporation assets were being dispersed for Caswell’s personal expenses:
In her motion, Richardson alleged that Caswell had been untruthful in his affidavit. She contended that the corporation’s bank statements showed that the business had made substantial withdrawals to pay Caswell’s expenses of a purely personal nature soon after its receipt of the garnishment order in May.
The trial court held an evidentiary hearing whereupon it found that:
Caswell regularly deposited money in the corporate bank account and freely accessed any and all funds held by the corporation. The court determined that Christopher Caswell’s affidavit filed in answer to the order of garnishment was intended merely to thwart Richardson’s efforts to collect on the judgment.
In light of his actions, Caswell was fined $14,853.18 payable to Richardson, was sentenced to 24 days of jail, was ordered to pay Richardson’s attorney’s fees; there was as well assessed against the corporation a contempt penalty in the amount of $1,482.00. On appeal, Caswell argued that the trial court was in error in concluding that the corporation held assets belonging to him. Based upon his own testimony to the effect that he used the corporation as his personal piggybank, the Court of Appeals rejected that assertion:
In support of his argument, Caswell relies on the affidavit and testimony of Belinda Pinotti, accountant for Caswell and his corporation. Pinotti indicated to the court that as of the day on which the garnishment was served, there was no money to which Caswell was entitled. In light of this testimony, Caswell objects to the court’s conclusion that the corporation was, in fact, holding money that belonged to him.
At the hearing, Caswell indicated to the court that he had routinely paid personal expenses from the corporate bank account and that he “knew it was my business’s money, but ... if I did not have the money in my personal account, yes, I used it at my leisure.” From an abundance of testimony in a similar vein, the trial court concluded that the corporation was a mere instrumentality and that all the funds held in the corporate account on the day the garnishment was served “was for all intents and purposes being held for Mr. Caswell to do with as he pleased.” Opinion and Order at 5. The trial court did not err by concluding from the evidence presented that the corporation held money belonging to Caswell.
In response to the defense that in fact he had not lied on his affidavit, again the Court of Appeals was able to reject his argument based upon his own testimony:
While Caswell indicated in his affidavit that the funds in the corporate bank account were all tagged for disbursement to contractors and suppliers, he admitted that he wrote checks from the corporate account in May 2009 to pay off the loan on his Mercedes-Benz and to pay his home mortgage and that he otherwise generally used the corporate account as his own. Although he denied that he had lied or willfully refused to obey the court's garnishment order, the trial court concluded from his testimony that Caswell's affidavit was patently false and that he had intended by this falsehood to avoid the order of garnishment by perpetrating this deception. The record contains ample proof to refute any claim of an abuse of discretion.
The Court of Appeals was able to summarily dispose of assertion that the trial court was prejudiced against Caswell and that somehow Richardson was acting in bad faith in seeking to enforce the judgment.
Limited liability, the rule that the shareholders are not, by reasons of that status, liable for the debts and obligations of the corporation, is oft (incorrectly) cited as the sine qua non of the corporation. Just as important as that rule is its flip side, namely that the corporation is a legal entity distinct from the shareholders and that the corporation’s assets are not available to satisfy the shareholders’ debts and obligations. These rules, however, assume that the corporate form is being appropriately utilized. The rule of shareholder limited liability from the debts and obligations of the corporation may be, in appropriate circumstances, set aside under doctrines including piercing the veil. As demonstrated by this case, efforts to rely upon the asset segregation aspects of the corporation can similarly be set aside when the corporate form is abused.
Wednesday, November 14, 2012
Remand to the Trial Court to Assess Venue Clause
In a recent decision, the Kentucky Court of Appeals directed that, in response to a challenge to the legitimacy of a choice of venue clause, the matter be remanded to the trial court for specific findings. Midnight Terror Productions, LLC v. Winterland, Inc., 2012 WL 5457530 (Ky. App. Nov. 9, 2012).
Midnight Terror Productions, LLC, a Kentucky LLC, entered into a contract (the “JV Agreement”) with Winterland, a corporation based in Indiana. The JV Agreement between Midnight Terror and Winterland contained a provision in the nature of a non-compete precluding Winterland from being involved in any similar lighting event within 50 miles of that planned between Midnight Terror and Winterland. That contract, which contained a choice of law clause requiring that any dispute be resolved in Grant County, Indiana, in turn obligated Winterland to enter into a separate agreement (the “License Agreement”) with the Louisville/Jefferson County Metro Parks Department (“Metro Parks”). That License Agreement provided, in the event of any dispute, for venue in a federal or state court within the Western District of Kentucky; Midnight Terror was not a party to the License Agreement.
Seeking damages based upon Winterland’s alleged failure to complete delivery of the lighting displays by the JV Agreement’s contractual deadline as well as its participation in another lighting event alleged to violate the non-compete provision, Midnight Terror filed a breach of contract action in Jefferson Circuit Court. In reliance upon the exclusive venue clause directing that all disputes would be heard in Grant County, Indiana, Winterland filed a motion to dismiss. The trial court granted that motion, writing:
The terms of paragraph 16 of the agreement [the venue clause] are not unconscionable as defined in Conseco Finance Servicing Corp. v. Wilder, 47 S.W.3d 335, 341 (Ky. App. 2001) and (sic) therefore fully enforceable. A fundamental rule of contract law holds that, absent fraud in the inducement, a written agreement duly executed by the party to be held, who had an opportunity to read it, will be enforced according to its terms. Conseco at 341.
Midnight Terror appealed on the basis that (i) the forum selection clause in the License Agreement between Winterland and Metro Parks should control over that in the Midnight Terror/Winterland JV Agreement and that (ii) the forum selection clause directing that disputes be resolved in Grant County, Indiana is unfair or unreasonable. While Midnight Terror was unsuccessful on the first of these arguments, as to the second they at least lived to fight another day.
As to the assertion that the Western District of Kentucky forum selection clause of the License Agreement between Winterland and the Metro Parks should control, the court noted that the License Agreement was separate and independent from the Winterland/Midnight Terror JV Agreement, and that the License Agreement made no reference to the other document.
There is no indication that the provisions of the License Agreement were intended to govern the contract dispute that has arisen between Midnight Terror and Winterland. The subject matter of the License Agreement is distinct and separate from the substance of the dispute at issue. Consequently, we hold that the forum-selection provision included in the License Agreement is neither superior to the provision in the [JV] Agreement nor is it relevant to these proceedings.
Turning to the question of the validity forum selection clause, the court began by noting the general rule that “Forum selection clauses are presumed to be valid and enforceable in Kentucky unless the party opposing enforcement can demonstrate that circumstances render the clause unfair or unreasonable,” citing Prezocki v. Bullock Garages, Inc., 938 S.W.2d 888 (Ky. 1997). In making that assessment, the trial court is to weigh a number of factors including:
· the inconvenience to the parties of holding the trial in the specified forum;
· the inconvenience to witnesses of holding the trial in the specified forum;
· the inconvenience of accessing other proof by holding the trial in the specified forum;
· the disparity in bargaining power that existed between the parties at the time the contract was executed; and
· whether the state in which the incident occurred has at least a minimal interest in the action.
Midnight Terror cited a variety of justifications for the Court of Appeals setting aside the venue clause, including its small size, the residence of the witnesses in or near Louisville and its lack of ties to Grant County, Indiana. It cited as well, consequent to its small size, its inability to “resist oppressive clauses included in Winterland’s contracts.” Last, it asserted that Kentucky had the greatest interest in the action since the contract was to be performed there, and it was in Kentucky that the alleged breach took place. Winterland, in contrast, asked the Court of Appeals to uphold the trial court’s determination that the forum selection clause is enforceable.
Ultimately, neither party won. Rather, the matter was remanded to the trial court for evaluation of the evidence vis-à-vis the factors informing whether or not a particular forum selection clause would be enforceable.
In a dissent, Judge Thompson would have upheld the forum selection clause as a matter of substantive law, and additionally denied relief for failure by Midnight Terror to exercise its rights under Rule 52.02 for specific findings of fact.
It was incumbent upon the appellant [Midnight Terror] to request that the trial court make the required findings of fact as required by CR 52.02 and 52.04. Under our Rules, the trial court does not have the burden of rendering findings of fact without a proper motion made by a party, and the trial court does not have the burden of practicing the case for either party.
Kentucky Has Some Strange Laws – The State Pledge of Allegiance
Did you know that Kentucky has its own pledge of allegiance to the state flag? It does. KRS § 2.035 provides:
The following shall be the official pledge of allegiance to the flag of the Commonwealth of Kentucky: “I pledge allegiance to the Kentucky flag and to the Sovereign State for which it stands, one Commonwealth, blessed with diversity, natural wealth, beauty and grace from on High.”
Tuesday, November 13, 2012
6th Circuit Court of Appeals Confirms that Kentucky Business
Corporation Act Does Not Govern Unincorporated Syndicates
In a November 8 decision, the 6th Circuit Court of Appeals, on an almost summary basis, dismissed the suggestion that the Kentucky Business Corporation Act and specifically the provisions thereof affording shareholders the right to inspect corporate records should apply to an unincorporated syndicate. KNC Investments, LLC v. Lane’s End Stallions, Inc., 2012 WL 5440032 (6th Cir. 2012).
KNC Investments, a member of an unincorporated syndicate managed by Lane’s End Stallions and managing the Thoroughbred Lemon Drop Kid, sought, under both the syndicate agreement and the Kentucky Business Corporation Act, financial information with respect to the syndicate as well as the names and contact information of the other syndicate owners. Those efforts were rejected in a decision here reviewed on November 30, 2011 (“An Unincorporated Syndicate is Not Governed by Corporate Law.”).
The dispute was then appealed to the 6th Circuit. The primary focus of this decision was an effort by Lane’s End to have the appeal set aside on the basis that the syndicate agreement had been expressly amended to preclude KNC’s claimed right to inspect the records. The Court of Appeals directed that that dispute needed to be taken up with the trial judge and not with it. At the same time, however, the court was able to reject the notion that the document inspection rights afforded under the Kentucky Business Corporation Act in some manner apply to an unincorporated syndicate:
We need no additional facts, however, to reject KNC’s claim that the Kentucky Business Corporations Act gives it the right to inspect and copy the syndicate’s records. Kentucky law treats owners of horse-ownership syndicates as tenants in common. See, e.g., Weisbord/Etkin/Goldberg v. Gainesway Mgmt. Corp., No. 2007-CA-000280-MR, 2008 WL 820950, at *1 (Ky. Ct. App. Mar. 28, 2008). And by its terms, the Business Corporations Act applies only to corporations, not to unincorporated syndicates. See Ky. Rev. Stat. §§ 271B.1-400(4) & (10) (distinguishing a “corporation,” which includes only incorporated for-profit corporations, from an “entity,” which includes unincorporated associations and persons sharing common economic interests); id. § 271B.16-020 (giving shareholders only of a “corporation” the right to inspect and copy corporate records). We thus need no additional facts to conclude that the district court correctly rejected KNC’s claims under the Business Corporations Act.
Otherwise the case was remanded back to the district court.
Tuesday, November 6, 2012
Piercing the Veil – The Kentucky Court of Appeals
Discusses Choice of Law and Applies Inter-Tel
A November 2, 2012 decision of the Kentucky Court of Appeals has provided helpful guidance with respect to (i) the question of the applicable law as to piercing the veil of a limited liability entity and (ii) the application of the Kentucky Supreme Court’s Inter-Tel decision on piercing the veil. Howell Contractors, Inc. v. Berling, ___ S.W.3d ___, 2012 WL 5371838 (Ky. App. Nov. 2, 2012).
Howell Contractors, Inc. contracted with Westview Development, LLC, an Ohio limited liability company, to perform certain services in connection with a subdivision development. Howell ultimately billed Westview for $1,103,569.63, of which Westview paid $923,902.06, leaving an outstanding balance of $179,666.67. When the arrearage was not satisfied, Howell filed suit against Westview, Charles Berling (Westview’s sole member), and Charles Berling Land Corporation, and Berling Homes, Inc., it being implied in the opinion that they were either partially or wholly owned by Berling.
As part of competing motions for summary judgment, Charles Berling, Berling Land and Berling Homes moved for dismissal on the basis of absence of liability, they not being parties to the contract with Howell. In addition, “They further argued the doctrines of veil-piercing, instrumentality and alter-ego do not apply to LLCs ….” Summary judgment was granted to Charles Berling and the Berling entities, while summary judgment against Westview was denied. Ultimately, an agreed judgment was entered in the amount of $179,666.97 against Westview.
Choice of Law as to Piercing
Initially, the Court noted that the proper law to apply in determining whether the defendants other than Westview could be held liable to Howell is that of Ohio (and not that of Kentucky). Referencing the Restatement (2nd) of Conflicts of Laws § 307 (1971), the Court wrote that “By analogy to corporate law, the rights, duties, and obligations of an LLC and its members are governed by Ohio law”, the court going on to then cite a number of cases from various jurisdictions standing generally for the proposition that piercing analysis involves the application of the law of the jurisdiction of organization (rather than the law of the situs of the dispute) should be applied. The application of Restatement (2nd) of Conflicts § 307 to LLCs is a topic I explored in To Boldly Go Where You Have Not Been Told You May Go, 58 Baylor L. Rev. 205 (2006).
The court went on to reject the notion that Ohio law does not address piercing of LLCs, citing Ossco Props, Ltd. v. United Commercial Prop Group, LLC, 968 N.E.2d 535 (Ohio App. 2011) for the test to be there applied. Applying that law, the Kentucky Court of Appeals determined that the plaintiffs had not made out a case to justify piercing, writing that:
In the case at bar, while Howell has demonstrated Berling’s control over Westview and his other entities, but the conduct complained of does not rise to the level of fraud, illegality or unlawfulness. A careful review of the record discloses that Westview has merely failed to pay an entity debt. The facts are that Westview purchased a tract of land for approximately $287,000. Westview, presumably through Berling, secured a loan in the amount of $1,000,000 from Bank of Kentucky to develop the property. Berling further loaned over $485,000 to Westview, personally and through other entities, some controlled by Berling and others not controlled. The property in question is still owned by Westview. While this development has not quite panned out as planned, and Howell's preference is to be paid a little more promptly, it has a judgment which can undoubtedly be domesticated in Ohio. And, presumably, Howell exercised diligence in maintaining its security in the property by resort to Ohio’s mechanic’s lien statute. Ohio Rev. Code Ann. §§ 1311.01-1311.22.No Piercing Even if Kentucky Law Applied
Having disposed of the case under the properly applicable Ohio law, the court went on to consider whether the result would be any different were Kentucky law applied, ultimately determining it would not. While obviously dicta, the Court of Appeals summarized the expanded test set forth in Inter-Tel Technologies, Inc. v. Linn Station Properties, LLC, 360 S.W.3d 152 (Ky. 2012), observing:
Again, Howell has established its present inability to collect a debt owed. It has not established fraud or unjust enrichment of the type demonstrated in Inter-Tel., i.e., the “squirrel[ing of] assets into a liability-free corporation while heaping liabilities upon an asset-free corporation [.]” Id. The record does not disclose that Berling siphoned money or assets out of Westview. To the contrary, Berling put money into Westview, primarily his own, in the form of unsecured loans. As noted, Westview has assets in the form of a real estate development, and Howell, as a judgment creditor of Westview, will presumably be able to collect its judgment, with interest, as and when Westview’s property in Ohio is sold.
Piercing Kentucky LLCs
The Court of Appeals, in a footnote, observed that “No reported Kentucky decision discusses the piercing of an LLC entity.” While the aspects of this decisions applying the Inter-Tel analysis to these facts is obviously dicta, the Court of Appeals has at minimum undercut the validity of its statement. Rather, it might have been more accurate for it to state that “Prior to this decision, no reported Kentucky decision discussing the piercing of an LLC.” Regardless, this statement obviously ignored (perhaps further evidencing its consignment to the dustbin of history?) the decision rendered in Rednour Properties, LLC v. Spangler Roofing Services, LLC, 2011 WL 2535330 (Ky. App. 2011). Still, it bears noting that in an unpublished trial court ruling written by now Justice Abramson of the Kentucky Supreme Court, it was stated that:
While it is true that the foregoing represents the law with respect to the liability of corporate officers and shareholders, equity and fairness require that those same theories of liability [piercing and personal responsibility for personally committed torts] should extend to managers and members of limited liability companies as well.
Fabing v. E Concepts, LLC, Jef. Cir. Ct. (Div. 3) No. 01-CI-06835, Order Granting Plaintiff’s Motion for Partial Summary Judgment entered June 9, 2003 (emphasis in original).
Obviously, much more remains to be done with respect to clarifying how the Inter-Tel analysis will be applied to LLCs.
Friday, November 2, 2012
Does the Rednour Decision Have Any Continuing Viability?
I have on several occasions been asked whether the Rednour decision continues, after Inter-Tel, to have any continuing viability. Cutting to the chase, I believe the Rednour decision should be now a dead letter with no continuing effect on Kentucky law.
Rednour is a decision of the Kentucky Court of Appeals in which a divided panel upheld a trial court’s determination to pierce the veil of an LLC. The decision is, at best, weak. Without engaging in any analysis, and particularly failing to identify what fraud or injustice had taken place vis-à-vis the plaintiff, the veil of the LLC was set aside on factors including that the LLC had a single member, that the single member was the registered agent, and that the LLC had been set up for liability protection and for tax planning purposes. A detailed exposition of the decision and its failings has been published in a three-part review available here: LINK 1, LINK 2 and LINK 3.
Inter-Tel Technologies v. Linn Station Properties
In February of this year, the Kentucky Supreme Court issued its unanimous decision (written by Justice Abramson) in Inter-Tel Technologies v. Linn Station Properties, 360 S.W.3d 152 (Ky. 2012), thereby adopting a new test in Kentucky for piercing the veil, and in so doing superseded White v. Winchester Land Development, 584 S.W.2d 56 (Ky. App. 1979). Under the new test, a series of eleven factors are examined as the first step in determining whether the veil of a corporation should be pierced, namely:
(a) Does the parent own all or most of stock of the subsidiary?
(b) Do the parent and subsidiary corporations have common directors or officers?
(c) Does the parent corporation finance the subsidiary?
(d) Did the parent corporation subscribe to all of the capital stock of the subsidiary or otherwise cause its incorporation?
(e) Does the subsidiary have grossly inadequate capital?
(f) Does the parent pay the salaries and other expenses or losses of the subsidiary?
(g) Does the subsidiary do no business except with the parent or does the subsidiary have no assets except those conveyed to it by the parent?
(h) Is the subsidiary described by the parent (in papers or statements) as a department or division of the parent or is the business or financial responsibility of the subsidiary referred to as the parent corporation’s own?
(i) Does the parent use the property of the subsidiary as its own?
(j) Do the directors or executives fail to act independently in the interest of the subsidiary, and do they instead take orders from the parent, and act in the parent’s interest?
(k) Are the formal legal requirements of the subsidiary not observed? 360 S.W.3d at 163-64.
Assuming some subset of those factors have been sufficiently satisfied (the Supreme Court’s decision does not identify either a minimum number of the factors that must be satisfied or contain a weighting between them, although it did indicate that grossly inadequate capital, egregious failures to see to required formalities and disregard of the subsidiary’s separateness and domination of day-to-day decisions were most crucial; 360 S.W.3d at 164), the second step of the analysis can be undertaken, namely whether there has been a fraud or injustice perpetuated upon the plaintiff. 360 S.W.3d at 163-65. Only if such a fraud or injustice is shown is piercing then permitted.
Responses to Rednour
The plaintiff applied to the Kentucky Supreme Court for discretionary review of the Rednour decision. The Supreme Court denied discretionary review but did order that the decision of the Court of Appeal’s not be published; why the Supreme Court did not remand the case for reconsideration in light of Inter-Tel is simply beyond me, but that is a discussion for another day. In addition, the 2012 General Assembly enacted amendments to both the business corporation and LLC acts, each amendment providing, inter alia, that the fact that a corporation has a single shareholder or that an LLC has a single member is not of itself justification for setting aside the otherwise applicable rule of limited liability. See 2012 Ky. Acts, ch. 81, § 88 (creating KRS § 271B.6-220(3)); id. § 105 (amending KRS § 275.150(1)).
As matters stand today as to the Rednour decision:
· The Kentucky Supreme Court has ordered the opinion not to be published;
· The General Assembly has expressly precluded (The Rednour decision was expressly identified to the Kentucky General Assembly in the course of the explanation of the need for the statutory amendments.) treating single shareholder/single member status, of itself, as a justification for piercing;
· The factors set forth in Inter-Tel justifying piercing do not include planning for liability protection;
· The factors set forth in Inter-Tel justifying piercing do not include tax planning; and
· The notion that piercing is justified because the sole member is as well the registered agent is so preposterous that it never should have been uttered but, again, the Inter-Tel decision did not identify that as a factor that justifies piercing.
Note, however, that there is unfortunate dicta in Inter-Tel that may be read to support tax planning as a justification for piercing. The Supreme Court noted (although it did not otherwise expand upon the holding by the trial court) that piercing was available on the basis that ITS was the instrumentality or alter-ego of its parents “operated by them to achieve tax benefits and avoid various liabilities.” See, e.g., Slip op. at 3; id. at 9 (“[Members of company management] explained ITS was continued as a separate entity after its acquisition by Technologies so that Inter-Tel could gain a tax advantage by offsetting income from other subsidiaries against ITS’ net operating loss.”) While manifestly dicta, this language unfortunately perpetuates the view that the utilization of a distinct entity for the segregation of liabilities or for achieving desired consequences under the tax code is somehow suspect and justifies piercing. Hopefully, the point is no more than the utilization of a subsidiary to generate tax advantages for the parent even as creditors go unpaid is inequitable but not of itself sufficient to justify piercing.
None the less, it is my assessment that the Rednour should be treated as an aberration having no further precedential value.
Montana Supreme Court Interprets Judicial Dissolution Statute and Upholds Order Dissolving LLC
Here is another as always excellent analysis from Doug Batey.
It should be noted, however, that the standard for dissolution under the Montana LLC Act is quite different from the standard employed in the Kentucky LLC Act.
Here is another as always excellent analysis from Doug Batey.
It should be noted, however, that the standard for dissolution under the Montana LLC Act is quite different from the standard employed in the Kentucky LLC Act.