Delaware Chancery Court Addresses Effect of Good Faith and Fair Dealing, the Burdens Imposed on a Directed Fiduciary

Delaware Chancery Court Addresses Effect of Good Faith 

  and Fair Dealing, the Burdens Imposed on a Directed Fiduciary

 

     A recent letter decision by Vice Chancellor Noble provides helpful guidance as to the implied contractual covenant of good faith and fair dealing and the burden imposed upon a fiduciary who is bound to vote in a particular way.  Ross Holding and Management Co. v. Advance Realty Group, LLC, 2013 WL 764688 (Del. Ch. Feb. 28, 2013; revised March 7, 2013).

      The plaintiffs had been officers of Advance Realty prior to their termination and its subsequent recapitalization.  Their first objection (for purposes of this decision) was that Advance Realty had not redeemed their units in accordance with a Unit Holders Agreement.  Vice Chancellor Nobel noted, however, that the Agreement provided that Advance Realty “may” redeem the units.  Differentiating that permission “may” from a mandatory “shall,” at least at that point Advance Realty “had no express duty to repurchase” the units.

      He then turned to the implied covenant of good faith and fair dealing.  Advance Realty was based in new Jersey, and its law on the implied covenant controlled.  After noting the disconnect between an expectation that the units would be repurchased against an argument that said they may be redeemed, and in the absence of indications there was an agreement that the units would be redeemed, the Court would not under the implied covenant convert a permissive “may” into a mandatory “shall.”  On that basis Advance Realty was granted summary judgment on that claim.

      The Court next considered a claim against Rayevich, a member of Advance Realty’s managing board.  Under Delaware law it is presumed that Rayevich “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of” Advance Realty, citing Gantler v. Stephens, 965 A.2d 695, 705-06 (Del. 2009).  The plaintiffs alleged that Rayevich breached his fiduciary duties by “(1) failing ‘to evaluate the terms of the Conversion Agreement to determine whether it was in the best interests of the company and its unit holders’; (2) by failing to ‘voice opposition to the agreement in light of the conflicts of interest involved in his fellow board members’; and (3) by failing to take ‘any steps to prevent the self-dealing of the insider defendants.’”

      Rayevich was granted summary judgment on the basis that the Plaintiff’s pleadings did not assert facts sufficient to overcome the presumption of appropriate discharge of fiduciary obligations.  Before doing so, however, the Court considered the effect of structural limitations on Rayevich.  Under the controlling documents, he was required to vote as directed by Peter Cocoziello, Advance Realty’s founder, President and CEO.

      Rejecting the notion that his lack of discretion in voting is equivalent to a “get out of jail free card” (my characterization, not the Court’s), the Court wrote:

Rayevich cannot avoid liability simply by pointing out that he had no discretion—as restricted by the ARG Operating Agreement—to vote as a board member. He is correct that Cocoziello controlled his vote, but fiduciary duties extend beyond voting. They may involve, for example, studying the proposed action, determining the appropriateness of the proposed action, setting forth a dissenting view to fellow board members, and, in the proper circumstances, informing unit holders about the potential adverse affects of a proposed action.

      The decision also addressed aiding and abetting breach of fiduciary duty, conspiracy to breach fiduciary duty, and the disclosure of incorrect information.

      Clearly directed fiduciaries have obligations, and they cannot adopt the pose of a potted plant.  Rather, except as to the vote itself, they need to do what is expected of any other fiduciary.

No Homestead Exemption in House Owned by SMLLC

No Homestead Exemption in House Owned by SMLLC

 

      A recent decision of the Sixth Circuit Bankruptcy Appellate Panel has held that there is no homestead exemption for a residence owned not by the debtor but rather the debtor’s single-member LLC.  In re Breece, 2013 WL 197399 (6^th Cir. BAP (Ohio) Jan. 18, 2013).

       Monea Breece appealed the ruling of the bankruptcy court that she could not claim a homestead exemption in real property owned by an LLC of which Breece was the sole member; Breece resided in that property.  She claimed a homestead exemption in the property, identifying it as her property (the LLC was not identified) on her Schedule A.  After briefing and a hearing the bankruptcy court held there to be no homestead exemption in the property.

      Under the Ohio LLC Act, an interest in an LLC is personal property that does not confer on the member an interest in the LLC’s property.  Ohio Rev. Code Ann. § 1705.17; id. § 1705.34; In re Liber, 2012 Bankr.LEXIS 2244, *10 (Bankr. N.D. Ohio May 18, 2012).  After a comprehensive review of and response to arguments for allowing the exemption, these rules were applied to uphold the bankruptcy court in rejecting the claimed homestead exemption.  Further, the exemption was rejected on the basis that it may be claimed only as to property that is in the bankruptcy estate.  In this case the realty was not in the estate.  Rather, it was Breece’s interest in the LLC that was in the estate.  Ergo, there was another basis for the denial of the exemption.

The man Who Tells You He Understands Series Will Lie To you About Other Things As Well

My latest thoughts on series are set forth in The Man Who Tells You he Understands Series Will Lie To You About Other Things As Well, which appears at 16 Journal of Passthrough Entities 53 (March/April 2013).

Here is a LINK to the article on SSRN.

Is This Really Delaware’s Response to Auriga Capital Corp. v. Gatz Properties, LLC?

Is This Really Delaware’s Response to Auriga Capital Corp. v. Gatz Properties, LLC?

      The Delaware LLC, like the Delaware General Business Corporation Law, is silent as to both what are the applicable fiduciary duties and who is bound thereby.  Under Delaware’s common law, there has never been a question that directors are bound by fiduciary’s duties, although there have been ebbs and flows with respect to exactly what are those duties.  A variety of decisions have been rendered by the Chancery Court, they generally finding that those in control of an LLC owe fiduciary duties roughly equivalent to those owed by corporate directors.  The question had not, before Auriga Capital, been addressed by the Delaware Supreme Court.

      Chancellor Leo Strine in Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 389 (Del. Ch. 2012), held that there exists default fiduciary duties in LLCs.  That proposition was in opposition to the view previously published by Chief Justice Steele in Freedom of Contract in Default Contractual Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L. J. 221 (Summer 2009).  When Auriga Capital was appealed to the Delaware Supreme Court, its per curiam decision found that the subject operating agreement contained an applicable fiduciary standard and, on the basis thereof, upheld the result of Chancellor Strine’s decision.  The Court went on to chastise Chancellor Steele for reviewing what it felt to be the hypothetical question of what would be the standards absent a contractual agreement.

      Draft legislation to amend the Delaware LLC Act has recently been circulated.  Anticipated with bated breath has been a statutory response to the dispute between the Chancery and the Supreme Court regarding the existence (or not) of default fiduciary duties in an LLC absent a provision in the operating agreement. 

      Now, under amendments proposed to the Delaware LLC Act, § 18-1104 would be amended (new text underlined) to provide as follows:

In any case not provided for in this chapter, the rules of law and equity, including the rules and laws of equity relating to fiduciary duties and the law merchant, shall govern.

      And that’s all we get.  We are not told: 

·                    who is it that will owe fiduciary duties;

·                    who will not owe fiduciary duties;

·                    why is it that fiduciary duties will arise;

·                    when those fiduciary duties will arise;

·                    what will be the standard of culpability for breach of the duty of care;

·                    is a “fair to the venture” defense available with respect to self-interested transactions;

·                    are the fiduciary duties owed to the LLC, to all of the members, or both; and

·                    any number of other points that are going to have to be resolved by litigation.

      With this amendment, Delaware provides a resounding “yes” to the question of whether, absent a contractual provision, there exist fiduciary duties in LLCs.  Ergo, Strine wins and Steele loses.  That outcome, however, has never really been in doubt under the existing decisions of the Delaware Chancery Court; we have numerous decisions holding that the “traditional fiduciary duties” exist in LLCs.  See, e.g., Phillips v. Hove, 2011 WL 4404034, at *24 (Del. Ch. Sept. 22, 2011) (“Unless limited or eliminated in the entity’s operating agreement, the member-managers of a Delaware limited liability companies owe traditional fiduciary duties to the LLC and its member”); Kelly v. Blum, No. 5616-VCP, 2010 WL 629850, at *10 (Del. Ch. Feb. 24, 2010) (“[U]nless the LLC agreement in a manager-managed LLC explicitly expands, restricts, or eliminates traditional fiduciary duties, managers owe those duties to the LLC and its members and controlling members owe those duties to minority members.”); Bay Ctr. v. Emery Bay PKI, No. 3658-VCS, 2009 WL 1124451, at *8 (Del. Ch. Apr. 20, 2009) (holding that “in the absence of a contrary provision in the LLC agreement, the manager of an LLC owes the traditional fiduciary duties of loyalty and care to the members of the LLC”); In re Atlas Energy Res. LLC, No. 4589-VCN, 2010 WL 4273122, at *6 (Del. Ch. Oct. 28, 2010) (“[I]n the absence of explicit provision in a limited liability company agreement to the contrary, the traditional fiduciary duties owed by corporate directors and controlling shareholders apply in the limited liability company context.”).  {This string cite has been adopted from Mohsen Manesh, Damning Dictum: The Default Duty Debate in Delaware, available on SSRN}. 

      Having done nothing more than confirm the current accepted view, the Delaware legislature proposes to give those utilizing Delaware LLCs no further guidance.  In consequence, the burden upon drafters of operating agreements remains to fully explicate the fiduciary duties and all issues related thereto.  Failing to do so, recourse to the courts for interpretation will remain necessary.

Delaware Legislature to Consider Amendments to its Charging Order Statutes

      There has been proposed for submission to the Delaware legislature amendments to the charging order provisions of the partnership, limited partnership and LLC Acts.

      With respect to all of the statutes (Del. Code tit. 6 § 15-504(d); id. § 17-703(d); and id. § 18-703(d)), there would be added that:

attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor.

       It would appear the purpose of this proposal is to enhance Delaware’s “asset protection score” by precluding judgment creditors from foreclosing on the charging order lien and thereby realizing value more quickly than they might in waiting on distributions.

      In the case of the charging order provision of the LLC Act there is as well to be added:

… whether the limited liability company has 1 member or more than 1 member.

      I believe these amendments in general, and especially as set forth in the LLC Act, are bad policy.  There is nothing special about the charging order lien that should preclude its foreclosure in the manner other liens may be foreclosed upon.  Upon foreclosure the purchaser becomes only an assignee of the interest, having no right to participate in the business and affairs of the partnership/limited partnership/LLC.  As such, the interest of the other partners and members are protected from interference by third-parties and in delectus personam is preserved.

      Further, these limitations are especially pernicious in the case of a single-member LLC.  Persons and entities may put assets into SMLLCs and when a judgment is rendered, simply allow the LLCs to accumulate income and defer making any distributions that would go to the judgment-creditor.  Yes, doing so may create phantom income problems to the sole member, but maybe not.  Assume Disreputable is the sole member of an LLC.  The only asset of the LLC is unencumbered real property with a FMV of $1,000,000.  Disreputable is the judgment-debtor of Reputable consequent to Disreputable’s intentional tort against Reputable.  The LLC is not generating any income, so there are no distributions for Reputable, as the judgment-creditor, to capture pursuant to a charging order.  If, however, Reputable could foreclose on the charging order the value of the property could be realized and Reputable could collect on his judgment.  The amendments proposed to the Delaware LLC Act would preclude Reputable from doing so and allow Disreputable to avoid his obligation to satisfy the judgment.

      Just because they do it in Delaware, it does not follow that it is a good idea.

Ohio Court of Appeals Disposes of Challenge to Charging Order

Ohio Court of Appeals Disposes of Challenge to Charging Order

      The Ohio Court of Appeals had no hesitancy in upholding the dismissal of challenges to a charging order issued with respect to a professional practice.  FirstMerit Bank, N.A. v. Xyran, Ltd., 2013 WL 1183340 (Ohio App. 8 Dist. March 21, 2013).

      Xyran defaulted on a loan that was guaranteed by Bhupinder, a neurosurgeon.  As part of its efforts to collect, the bank applied for and was granted a charging order with respect to Bhupinder’s interest in a professional practice, The Center of Neurosurgery, LLC (“The Center”).  The charging order was challenged on the basis that it permitted FirstMerit to engage in the unauthorized practice of medicine and violated the provision of The Center’s operating agreement that permitted assignment of an interest in The Center only to licensed physicians.

      The Court reviewed the Ohio LLC Act.  Thereunder, a charging order may be issued against a “membership interest,” and a “membership interest” is defined as a member’s economic rights in the LLC; a membership interest embodies no right to participate in the LLC’s management.  From there the Court determined:

Because the charging order merely allows FirstMerit to garnish Bhupinder’s financial interest in The Center, it does not allow the unauthorized practice of medicine or violate the terms of the operating agreement.

      The Court of Appeals as well upheld the determination that no evidentiary hearing was needed before the charging order was entered.

Court Rejects Notion That LLC is a “Nominal Party” to the Suit Over Its Assets

Court Rejects Notion That LLC is a “Nominal Party” to the Suit Over Its Assets

      In a recent decision, Judge Simpson of the Western District of Kentucky resoundingly rejected the notion that an LLC is only a nominal party to a lawsuit between its members as to its assets.  R.C. Tway Co. v. High Tech Performance Trailers, LLC, Civ. Act. No. 3:12-CV-122, 2013 WL 842577 (W.D. Ky. Mar. 6, 2013).

      This action was filed in federal court pursuant to its diversity jurisdiction.  As such, it was necessary that none of the plaintiffs have the same citizenship as any of the defendants.  At the time the complaint was filed, defendant High Tech Performance Trailers, LLC (“High Tech”) had as its sole member Bruce Hanusosky, an Ohio citizen.  As such, High Tech was a citizen of Ohio.  It bears noting that, after the time the complaint was filed, High Tech converted from an Ohio LLC to an Ohio corporation.  Under the rule of Grupo Dataflux v. Atlas Global Group, L.P., 541 U.S. 567, 570-71 (2004), the citizenship test applicable to LLCs rather than that of corporations was applied to High Tech.

      On the plaintiffs’ side, R.C. Tway Co. is a Kentucky corporation with its principal place of business in Kentucky.  Ergo, it is a citizen of Kentucky.  Kentucky High Tech Performance Trailers, LLC (“Performance Trailers”) had as its members Tway and High Tech.  As such, Performance Trailers is a citizen of both Kentucky, attributed to it through Tway, and Ohio, attributed to it through High Tech.  At this point of the analysis, diversity jurisdiction is lacking in that Ohio citizenship is shared by both a plaintiff and a defendant.  In response thereto, the plaintiffs asked the court to disregard Performance Trailers’ citizenship on the basis that it is but a nominal party to the action.  This suggestion was ultimately rejected by Judge Simpson, and the action was dismissed without prejudice for lack of subject matter jurisdiction.

      As an aside, where the Court utilized “High Tech” and “Ky. High Tech,” which I found confusing, I here utilize “High Tech” for the Ohio LLC (a defendant) and “Performance Trailers” for the Kentucky LLC (a plaintiff).

      Performance Trailers was organized as a joint venture vehicle between Tway and High Tech for the manufacture of custom trailers.  Under Performance Trailers’ operating agreement, Tway had day-to-day operational control, including the right to accept deposit of company funds.  The complaint alleged that High Tech and Hanusosky received at least $330,000 of Performance Trailers’ funds but did not surrender them to the LLC care of Tway.  There were additional allegations of various breaches of the operating agreement, intellectual property infringement and breach of a non-compete provision in the operating agreement.

      By means of complaint filed in January, 2012, Tway notified High Tech of Performance Trailers’ dissolution; Articles of Dissolution were subsequently filed with the Kentucky Secretary of State.  In the sixteen-count complaint, there were several allegations in favor of Performance Trailers, including those for High Tech’s failure to perform obligations owed Performance Trailers under the operating agreement, breaches of fiduciary duties owed to Performance Trailers, claims for defamation of Performance Trailers consequent to a press release issued by High Tech and claims for theft of the company funds received and not remitted.

      Based upon these facts, the Court determined that:

Each of the claims identified above clearly alleges that High Tech or Hanusosky violated some duty it owed directly to [Performance Trailers], thus causing [Performance Trailers] injury.  As [Performance Trailers] is the allegedly injured party for each of those claims, it is the one that is entitled to enforce the rights granted by substantive law.  Accordingly, [Performance Trailers] is not a nominal party, but instead is a real party in interest as to those claims.  2013 WL 842577, *3.

      While not cited therein, this statement from Judge Simpson is consistent with the ruling of the Kentucky Court of Appeals in Chou v. Chilton, No. 2009-CA-002198-MR, 2009-CA-00-2284-MR, 2012 WL 6526184 (Ky. App. Nov. 16, 2012), wherein the court, analyzing the issues in the terms real party in interest, dismissed for lack of standing claims brought by a member of an LLC on his own behalf (the LLC itself was not a party to the action) seeking damages for breach of the operating agreement, fraud, misappropriation, breach of fiduciary and gain taken by the defendant members.  See also, e.g., Pinnacle Fitness and Recreation Management, LLC v. The Jerry and Vickie Moyes Family Trust, 844 F.Supp.2d 1078 (S.D. Ca. 2012) (dismissing claims brought by member for breach of fiduciary duties owed the LLC and for tortious interference with LLC’s prospective business advantage).

      Against this the plaintiffs argued that Performance Trailers “has no real interest in the outcome of this case” consequent to its dissolution and the plan to marshal its assets, satisfy its debts and distribute the remaining assets amongst the members.  Rejecting this analysis, the Court wrote:

However, the court disagrees that the filing of Articles of Dissolution and the request for a distribution of assets renders [Performance Trailers] a nominal or formal party to this action.  First, Kentucky law makes clear that even after the filing of Articles of Dissolution, a limited liability company remains an existing entity.  KRS § 275.300(2).  Indeed, after dissolution, a limited liability company is empowered to take actions necessary for winding up its affairs, including inter alia, collecting assets and suing or being sued.  KRS § 275.300(2)(a) and (4)(a).  As a limited liability company retains the power under state law to enforce its rights in court until the company has finished winding up, there is no basis for disregarding it entity status and holding it to be merely a nominal party to an action simply because it has been dissolved.

Nor does the fact that the parties request that this court effect an orderly distribution of [Performance Trailers’] assets change the analysis.  Questions regarding diversity of citizenship are assessed based upon “the state of facts that existed at the time of filing – whether the challenge be brought shortly after filing, after the trial, or even for the first time on appeal,” Grupo Dataflux, 541 U.S. at 571.  In other words, that the party contemplate that at the end of this action, [Performance Trailers] will no longer be an existing entity is meaningless to the diversity analysis.  The question is whether, at the outset of the action, [Performance Trailers] was entitled to enforce the rights it was asserting against High Tech and Hanusosky.  The answer to that question is plainly yes.

       On that basis the suit was dismissed.

       An LLC is not, on behalf of its members, a nominee holder of title to various assets.  Rather, an LLC is a legal entity distinct from its members that for itself holds title to assets.  See, e.g., KRS § 275.010(2) (“A [LLC] is a legal entity distinct from its members.”); id. § 275.150(1) (limited liability of members from LLC’s debts and obligations); id. § 275.155 (member not a proper party to an action against the LLC); id. § 275.240(1) (property of LLC is not that of its members); and id. § 275.246(2) (title to LLC’s property vests in the LLC and not in the members).  As such, the LLC cannot be ignored, and its rights, distinct from those of the members or a member, must be both respected and preserved.

The Uncertain Status of Default Fiduciary Duties in Delaware LLCs

The Uncertain Status of Default Fiduciary Duties in Delaware LLCs

While Delaware is often lauded as the font of knowledge in all matters involving the law of business organizations, this attitude is often unjustified.  As addressed in Going to Delaware(?), forthcoming in the  Journal of Passthrough Entities, the laws of Delaware are not necessarily better, even as they are often different. 

One point of particular note is that the Delaware LLC Act is silent as to what are the fiduciary duties that exist in an LLC and is as well silent as to who owes those duties and to whom.  There is brewing a dispute in Delaware, not always polite, as to whether there are default fiduciary duties and what they are.

Chief Justice Myron T. Steele, 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), posited that there are no default fiduciary duties in limited partnership or LLCs organized under Delaware law.  Chancellor Leo Strine, in Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 389, 2012 WL 361677 (Del. Ch. 2012), held that there exist default fiduciary duties in Delaware LLCs.  When that decision was appealed to the Delaware Supreme Court, Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 839 (Del. 2012), it held (per curium) that the LLC manager had violated a contractually defined standard and went on to chastise Chancellor Steele for reviewing hypothetical of what are the standards absent a contractually agreed standard and declaring those portions of his opinion dicta.  Then, in Feeley v. NHAOCG, LLC, 2012 WL 5949209, *8-10 (Del. Ch. Nov. 28, 2012), Vice Chancellor Laster adopted the reasoning and path of analysis employed by Chancellor Strine in Auriga Capital, writing “Until the Delaware Supreme Court speaks, the long line of Court of Chancery precedents and the Chancellor’s dictum provide persuasive reasons to apply fiduciary duties by default to the manager of a Delaware LLC.” 

The word on the street is that the normally quite secretive official drafting committee is crafting a statutory patch to address the issue.

Arbitration Agreement that elected to be Governed by FAA Enforced

Arbitration Agreement that Provided it is Governed

by the Federal Arbitration Act Held Enforceable

 

      A recent decision of the Kentucky Supreme Court has returned to the oft-litigated question as to whether or not a particular arbitration agreement would be struck down as unenforceable under Kentucky’s requirement as to arbitration agreements or, rather, upheld as being subject to the Federal Arbitration Act.  In this instance, the agreement at issue, it providing that it is to be governed by the Federal Arbitration Act, was held to be enforceable.  MHC Kenworth-Knoxville/Nashville v. M & H Trucking, LLC, ___ S.W.3d ___, 2013 WL 646250 (Ky. Feb. 21, 2013). 

      M & H Trucking, LCC (“M & H”) purchased a truck from MHC Kenworth-Knoxville/Nashville (“Kenworth”).  Believing that the truck delivered did not meet the specifications of that ordered, and after negotiations failed to bring about a resolution, M & H brought suit against Kenworth.  In response, Kenworth sought to enforce the arbitration agreement set forth in the purchase agreement.  Under Ally Cat, LLC v. Chauvin, 274 S.W.3d 451 (Ky. 2009), an arbitration agreement governed by the Kentucky Arbitration Act will not be enforced unless it provides that the arbitration will take place in Kentucky.  No such stipulation existed in this agreement.  It did provide, however, that:

The parties acknowledge and agree that this Order evidences a transaction involving interstate commerce.  Accordingly, the United States Arbitration Act (Title 9 of the United States Code) shall govern the interpretation, enforcement and proceedings pursuant to the arbitration provisions of this Order.

      Notwithstanding this language, both the trial court and the Court of Appeals refused to uphold the arbitration agreement, citing Ally Cat.  As formulated by the Supreme Court:

This case presents a simple issue:  Can Kentucky’s courts enforce an arbitration agreement that fails to require the arbitration be held in this state but states that the Federal Arbitration Act governs its interpretation and enforcement?

      Disposing of the question on an almost summary basis, the Court stated definitively that where an arbitration agreement provides that it is governed by the Federal Arbitration Act, the Kentucky Arbitration Act and its limitation on enforcement of agreements to those that provide that the arbitration take place in Kentucky are inapplicable:

M & H Trucking’s brief, like the Court of Appeals below, failed to recognize our recent line of cases holding that “we need not consider Kentucky’s Uniform Arbitration Act” when “the agreement[ ]explicitly require[s] that the dispute be governed by the Federal Arbitration Act.”  Instead, when the agreement “includes a ‘choice of law’” provision selecting the Federal Arbitration Act as the law governing any dispute between the parties … the Federal Arbitration Act governs the arbitration clause.”  We have gone so far as to state expressly that “Ally Cat has no applicability to an arbitration agreement governed exclusively by the Federal Arbitration Act.”  (citations omitted, brackets in the original). 

This is an interesting decision for at least a pair of reasons.  Initially, it provides clear guidance as to how one can draft an arbitration agreement that will avoid the application of Kentucky’s atypical Ally Cat rule.  Second, the ability to apply the Federal Arbitration Act is not indicated as being dependent upon the existence of interstate commerce with respect to the subject transaction.  Ergo, it would appear that a purely intra-state transaction, by a choice of law provision such as that discussed in this case, could elect to be governed by the Federal Arbitration Act.

More Evidence that Kentucky Law Does Not Recognize Fiduciary Duties Among Shareholders

More Evidence that Kentucky Law Does Not Recognize

Fiduciary Duties Among Shareholders

     I have argued at length, and I think pretty well demonstrated, that the shareholders in a Kentucky corporation do not, qua shareholders, owe fiduciary obligations to one another.  This premise is the topic of a forthcoming article:  Shareholders Are Not Fiduciaries – A Positive and Normative Analysis of Kentucky Law, 51 Louisville Law Review ___ (2012-13).  The galley draft of this article is available on SSRN.  It is difficult to prove a negative, and that article could have easily been longer than it is (the journal said I could have 25 pages; I think I came in at 26).

       One point not addressed therein was a clear rejection of a statutory provision recognizing fiduciary duties among and between shareholders.

      The 1928 Model Business Corporation Act, at § 28(II), provided:

If, by the articles of incorporation, voting power is granted to the holders of shares of a certain class or classes and denied to the holders of shares of different classes, then the person or persons exercising such power shall stand in a fiduciary relation to the entire body of shareholders and shall be responsible to the corporation, for the benefit of all shareholders, for any violation of the obligations of such relationship.

      Under this provision, fiduciary duties would flow from those shareholders controlling the corporation to all of the shareholders and the corporation.

      Kentucky, in 1946, adopted the 1928 Model Business Corporation Act, codifying it at KRS ch. 271.  See 1946 Ky. Acts, ch. 141.  That adoption was near complete and without modification.  There was, however, at least one telling change between the Model Act and the Kentucky adoption thereof.  While Kentucky otherwise adopted § 28 thereof without alternation, subsection (II) of § 28 was not adopted.  Compare 1928 Model Business Corporation Act § 28 with KRS § 271.315 as enacted in 1946 Ky. Acts, ch. 141, § 1. 

      In 1946, Kentucky could have adopted a model act expressly creating fiduciary duties among shareholders.  Instead, the only provision of the Model Act providing for fiduciary duties among shareholders was excised from the Model Act before its adoption in Kentucky.

Bank Under No Obligation to Investigate Possible Revocation of Recorded Power of Attorney

Bank Under No Obligation to Investigate Possible

Revocation of Recorded Power of Attorney

      The Kentucky Court of Appeals, affirming the trial court, has ruled that a bank is not obligated to independently investigate the continuing viability of a recorded power of attorney.  Hull v. Citifinancial Services, Inc., No. 2011-WL-002163-MR (Ky. App. Feb. 8, 2013) (Not to be Published).

      David Hull gave a power of attorney, created under Pennsylvania law, to Yvonne Stanley.  The power of attorney was first recorded in Pennsylvania, allowing Yvonne to on David’s behalf sell a house there located.  The power of attorney was also recorded in Kentucky in connection with Yvonne’s purchase on David’s behalf of a farm in Morgan County.  Yvonne listed herself as a co-owner on that property, a point now challenged by David.

      On March 1, 2007, David orally advised Yvonne that the power of attorney was revoked.  However, it was not until September 24, 2008 that David recorded a revocation of the power of attorney in Pennsylvania, and it was only on April 16, 2009 that a revocation was recorded in Morgan County.

      Yvonne, in the meantime, borrowed $49,000 from Citifinancial, pledging the Morgan county farm as collateral; this she did on April 3, 2009, after the recording of the revocation in Pennsylvania but before the filing of the revocation in Kentucky.

      On the basis that Citifinancial should have investigated the Pennsylvania records before making the loan, an investigation that would have brought to light the revocation of Yvonne’s power of attorney, David brought suit against Citifinancial, asking that the mortgage collateralizing Yvonne’s borrowing be declared null and void.

      The Court of Appeals affirmed the trial court’s grant of summary judgment to Citifinancial.

      Relying primarily upon KRS § 382.370, which provides in part that no recorded power of attorney:

… shall be deemed to be revoked by any act of the party by whom it was executed, except from the time when there has been lodged for record in the office in which the power is recorded a written revocation, executed and proved or acknowledged in the manner prescribed for conveyances, or a memorandum of revocation made on the margin of the record thereof, which memorandum is signed by the party executing the same, and attested by the clerk.

the Court of Appeals held that the recorded power of attorney upon which Citifinancial relied was valid at the time Yvonne pledged the farm as collateral.  As for the revocation of the power of attorney in Pennsylvania, the Court found there to be no duty to investigate in that jurisdiction.

[A]s Citifinancial argues, Kentucky law requires that a document relating to title to real property be recorded in the clerk's office of the county where the property is located in order to constitute notice to subsequent purchasers. … David’s power of attorney was properly recorded in Kentucky in accordance with the pertinent statutes, and third parties, including Citifinancial, had a right to rely on it. Once such a power of attorney was validly recorded in Morgan County, to be valid, any revocation also had to be recorded in that county. To hold otherwise would undermine the purpose of the recording statutes.

      In response to a suggestion that the validity of the power of attorney should be reassessed applying Pennsylvania law, the Court found that Kentucky had the most significant relationship with the matter at hand, namely a mortgage on Kentucky property and the application of Kentucky law as to recording real property conveyances.  In addition, the application of that law would not matter as there was not shown to be an obligation under Pennsylvania law to investigate the continuing validity of a power of attorney.

Kentucky Supreme Court Hears Oral Arguments in New Lexington Clinic v. Cooper

Kentucky Supreme Court Hears Oral Arguments in New Lexington Clinic v. Cooper

      On March 14, the Kentucky Supreme Court heard oral arguments in New Lexington Clinic v. Cooper (now styled Baptist Physicians Lexington, Inc. v. New Lexington Clinic, P.S.C.).  This case, may lay down numerous important principles of law governing Kentucky business corporations.

      To briefly recap the facts to date, several director/employees of a medical practice entered into negotiations to create a new practice liaisoned with an existing healthcare network.  While still directors of the existing venture, the physicians solicited other doctors and professional staff to move to the new venture.  Also, at least one of the director/employee physicians shared with the new venture certain internal financial reports of the existing practice.  After the director/employees resigned and left, suit was filed charging them with breach of fiduciary duty.  The complaint did not reference KRS § 271B.8-300, which recites the fiduciary duties of a director of a Kentucky business corporation.

      Anne Chestnut, representing the defendants, argued (at least) a pair of themes:

·                     KRS § 271B.8-300 sets forth the only fiduciary duties of a director of a Kentucky business corporation and also specifies the threshold of culpability for assessing damages against a director; and

·                     there is no causal linkage between any violation that may have occurred and the damages now claimed by the plaintiff.

      The plaintiffs, represented by Tom Miller, argued that:

·                     under the modern rules of civil procedure, it is not necessary to cite the statutory basis of a claim;

·                     even if KRS § 271B.8-300 is the exclusive statement of a director’s fiduciary duties and the limits on a monetary claim for breach of those duties, the limits do not apply when the violation of duty does not take place in the course of discharging the duties of a director; and

·                     the summary judgment granted the defendants was premature.

      It was my impression that the Justices have spent a good deal of time studying this case.  That said, and applying Samuel Mayer’s rule that “I never make predictions, especially about the future,” I would be hard pressed to hazard a guess as to the Court’s ultimate ruling or the alignment of any individual justice.

      Issues such as the necessity of demonstrating causation of damages and the sufficiency of the discovery before summary judgment was granted are all points above my pay grade.  I can, however, speak to issues of fiduciary duty.

      I begin initially by agreeing with both Anne Chestnut on behalf of the defendants and Tom Miller on behalf of the plaintiffs.  As Anne argued, there really can be no question that KRS § 271B.8-300 was intended by the General Assembly to constitute the exclusive recitation of the duties of a director of a Kentucky business corporation, including the standard of culpability and the imposition of the burden of proof.  See KRS § 271B.8-300(1) (standard of conduct); id. § 271B.8-300(5)(b) (standard of culpability for monetary damages from breach of duties); and id. § 271B.8-300(6) (allocation of burden).  These statutory provisions entirely identify the burdens of a corporate director in the discharge of his or her obligations as such and the requirements for a challenge thereto, supplanting any prior common law to the contrary.

      At the same time, Tom is correct that these limitations as to culpability and burden of proof are not applicable with respect to all charges against an individual merely because he or she happens to be a director.  He referenced at length Judge Coffman’s ruling in Gundaker/Jordan American Holdings, Inc. v. Clark, 2008 U.S. Dist. LEXIS 80907 (E.D. Ky. 2008),  and argued that as the organization of a competing business is never part of the discharge of a director’s obligations, conduct of this nature falls outside the protections of the statute.  See also KRS § 271B.8-300(1) (“A director shall discharge his duties as a director ...”).  To provide an example that was begun by Tom in the course of his argument, but not completed in order to respond to a question from the Court, a director who embezzles money from the corporation is not, while executing the embezzlement, acting in the discharge of his or her obligations as a director.  As such, when the corporation brings an action against the director for what is indisputably theft, conduct manifestly “not in the best interest in the corporation” (KRS § 271B.8-300(1)(c)), the director cannot raise as a defense the obligation of the corporation to demonstrate that his or her conduct was wanton or willful.  KRS § 271B.8-300(5)(b).

      Cases like this are, however, somewhat closer than a case of embezzlement would be.  It could be said that an aspect of a director’s obligations of good faith and to act in the best interest of the corporation necessitate an obligation to protect the confidentiality of company financial information; from there it could be argued that the inappropriate dissemination of that information is a breach of the statutory duty of loyalty for which the protections of KRS §§ 271B.8-300(5), (6) apply.  Against this argument is the fact that seeking to utilize company financial information to benefit a different venture is not an action in the discharge of a director’s duties, so the statute should not control.  My feeling is the latter position is correct. 

      Under this analytic structure, Steelvest and Aero Drapery can be reconciled and exist alongside the statutory standard when a director is acting outside his or her capacity as a director, such as leaving one venture to accept employment with another.  At the same time, the statutory limitations of KRS § 271B.8-300 will alone be applicable (i.e., excluding any prior law) when the board is exercising its oversight function with respect to a corporation; for example, approving a merger or sale of substantially all corporate assets, or approving the terms by which the corporation will enter into a conflict of interest transaction with an entity controlled by a director.  See also Ridley v. Sullivan, No. 2009-CA-000712-MR (Ky. App. May 20, 2011) (Not to be Published) (corporate officer would be denied indemnification otherwise provided to officers by KRS 271B.8-510 where his actions involved intentional misconduct for improper personal benefit and were not within the scope of his employment as a corporate officer).

       With respect to the question of damages, I must disagree with both Mr. Miller and Ms. Chestnut.  The plaintiffs are arguing that they should be allowed to proceed with discovery in order to calculate damages and demonstrate them to a finder of fact.  Conversely, the defendants argue, in the absence of a demonstration of causation between the alleged breach and any damages that might be sought, that there is no need to proceed further (it is not clear to me whether or not Ms. Chestnut’s position is based upon KRS § 271B.8-300(6) and its allocation of the burden of proof).  As indicated above, I do not believe that KRS §§ 271B.8-300(5), (6) are relevant to this case in that the actions at issue were not taken in the discharge of director obligations.  Ergo, the burdens imposed by these statutes for the plaintiff to clearly demonstrate that the director’s conduct was wanton or willful and to prove causation are inapplicable to the dispute.

      Absent KRS §§ 271B.8-300(5), (6), under the traditional law of fiduciary duties as exemplified in trust law, in the event of a fiduciary’s breach of its obligations to the beneficiary (in this instance the corporation), the fiduciary must pay over to the trust all of the benefits derived from the transaction tainted by the breach of duty, with the fiduciary bearing the burden to show that not all of the proceeds thereof should be surrendered.  Such an in terrorem imposition of liability serves an important policing function with respect to fiduciaries and appropriately relieves the beneficiary of an obligation to demonstrate damages.

The Worst Decision of Marcus Aurelius Comes Home to Roost

The Worst Decision of Marcus Aurelius Comes Home to Roost

      Today marks the anniversary of the death in 180 of the great Roman Emperor Marcus Aurelius.  It is as well the date upon which his worst decision was inflicted upon the world.

      There is no question that Marcus was a great emperor.  In fact he is the only emperor to have written a book, namely the Meditations, that to this day remains in print (while Caesar's Gaelic Wars remain a staple of classes in both Latin and military history, Caesar was never emperor).  And he was a member of a string of excellent emperors.  After the tragedy that was Nero and the tumult of the Flavians (Vespasian, Titus and Domition), the Nervan-Antonian dynasty had consistently been effective leaders.  This had been largely achieved by the sitting emperor adopting his heir.  This path avoided the deficiency's of restricting passage of control to only natural heirs, necessarily limiting the pool of possible successors.  For example, Hadrian was only a cousin to his predecessor Trajan. While Hadrian would in turn adopt Antoninus Pius, it does not appear they were related to one another.  It is reported that a condition imposed by Hadrian on Antoninius adoption was that he in turn adopt Marcus.

      Marcus broke with this approach, appointing his natural son Commodus as his heir (Commodus was appointed co-emperor some three years before Marcus' death). He was a disaster.  A man of apparently no character, he is described by Aelius Lampridius as "even from his earliest years he was base and dishonorable. and cruel and lewd, defiled of mouth, moreover, and debauched."   A megalomanic, he took to fighting in the gladiatorial games.  Of course he always won; who is going to try to kill the emperor in front of thousands of witnesses.  Of course it did not hurt that he secretly directed that his opponents be given dulled weapons.  Meantime he ignored the operation of the Empire, leaving decisions to his chamberlain and other officials.  He did, however, both order a devaluing of the currency and imposed excessive taxes.  Gibbons dated the decline of the Roman Empire from Commodus.

      Finally he was assassinated.  There was, however, no natural heir to the position of Emperor, and his death would be followed by the "Year of Five Emperors."  

      Had Marcus Aurelius followed the path of the other Nervan-Antonian emperors and adopted as his heir a proven leader, the path of the Roman Empire would well have been substantially different.  But he did not.

      In closing, contra the movie "Gladiator," Marcus was not killed by Commodus.  Rather, he died of natural causes (it has been suggested that an unidentified plague was involved), possibly in what is now Vienna.

     

Diversity Jurisdiction and "Fair Reading" of Complaint

“Fair Reading of the Complaint” Analysis Applied to

Determine Whether or Not Diversity Jurisdiction Exists

 

      In a recent decision, the U.S. District Court (E.D. Ky., Judge Caldwell) analyzed a complaint to determine whether or not the jurisdictional minimum of $75,000 in damages was being sought.  The parties being diverse, it was still necessary for diversity jurisdiction to exist that the jurisdictional minimum of damages exceeding $75,000 be sought.  Shupe v. Asplundh Corporation, 2013 WL 647504 (E.D. Ky. Feb. 21, 2013). 

      Shupe brought suit against Asplundh on claims including violation of her civil rights and sexual and age discrimination.  In accordance with the Kentucky Rules of Civil Procedure, she simply asserted that the amount of her damages exceeded the jurisdictional minimum of the Kentucky Circuit Court.  The parties being diverse based upon their citizenship, Asplundh asserted in its petition for removal that the amount in controversy exceeded $75,000.  Shupe, in response, filed a motion to remand and for attorney’s fees, alleging that “This court lacks jurisdiction because the amount in controversy does not exceed $75,000.”  In furtherance of that assertion, she submitted to the court her pre-litigation demand letter in which she offered to settle her claims for $60,000.

      Parsing the complaint, Judge Caldwell determined that the claim for “back pay alone would total more than $68,000 if trial occurs by September 2013.”  There were in addition claims for front pay, humiliation and embarrassment and attorney’s fees, “so these may be considered when determining the amount in controversy.”  In consequence:

Based on these combined damages – back pay, front pay, humiliation and embarrassment, and attorney’s fees – the Court is satisfied that the amount in controversy more likely than not meets the statutory requirement for federal jurisdiction.

Setting aside Shupe’s pre-litigation demand letter, the court found that they are “not especially strong evidence of the amount in controversy,” being rather negotiation documents.

      The court having denied her motion for remand, it as well denied her motion for attorney’s fees in connection therewith.

Beware the Ideas of March

Et tu, Brute?

       The above was not said by Julius Caesar.

       Today, the Ides of March, marks the anniversary of the assassination of Julius Caesar in 44 B.C. Caesar was famously assassinated at a meeting of the Roman Senate after having (almost certainly apocryphally) been warned to “Beware the Ides of March.” He was presented with a written warning of the conspiracy against him as he was taken to the Senate meeting, but seems to have never read the warning. Although stabbed twenty-three times by the various conspirators, only one wound was fatal.

       Caesar’s death unleashed upon the tottering Roman Republic the Second Civil War of Caesar’s heir Octavian (later to be Caesar Augustus) and his compatriot Marc Antony (Lepidus, the third member of the Second Triumvirate, was a place holder) against the assassins and their various supporters. Assassins Brutus (Marcus Junius Brutus the Younger) and Cassius (Gaius Cassius Longinus) would each commit suicide after losing a phase of the Battle of Philippi (notwithstanding the presentation in the HBO series "Rome," they actually died on different days), and Cicero (who was not himself part of the conspiracy) would be assassinated as part of the proscriptions after the victory of the Second Triumvirate. Still later Octavian and Antony would turn on one another, Antony’s forces being routed at Actium.

But back to Caesar’s dying words. “Et tu Brute” is not recorded by any classical historian – it is a quote from Shakespeare. Plutarch, who was born exactly 100 years after the assassination, reports that Caesar said nothing after the attack began in earnest. Suetonius wrote that others reported his last words to be “καὶ σύ, τέκνον” (Greek still being the lingua franca of the Romans), transliterated as “Kai su, teknon” or “You also child,” addressed to Brutus. There were rumors, later reported by Plutarch (Suetonius is silent on the topic) that Caesar was in fact Brutus’ father – it was known that Brutus’ mother Servilia was Caesar’s mistress.  Still that would appear to be something of a stretch; Caesar was 16 at the time of Brutus' conception; Servilla was at that time 28. 

For anyone watching the "Spartacus" series, while the sources do not exclude Caesar's participation in the war against Spartacus (i.e., the "Third Servile War"), they provide no details of that participation.  Ergo, the details of Caesar's actions as recounted are pure fiction. 

County Clerks Have No Standing to Complain about MERS

Sixth Circuit Court of Appeals Confirms That

Kentucky’s County Clerks Not Injured by the MERS System

        In a recent decision, the Sixth Circuit Court of Appeals confirmed the holding of the trial court to the effect that the various county clerks in Kentucky were not injured by the existence of the Mortgage Electronic Registration Systems, Inc. program pursuant to which real estate mortgage assignments could be effected electronically and without a county filing.  Christian County Clerk v. Mortgage Electronic Registration Systems, Inc., 2013 WL 565198 (6^th Cir. Feb. 15, 2013).

      Under Kentucky law and specifically KRS § 382.360(3), mortgage assignments are required to be recorded with the county clerk’s office.  The county clerk collects a fee in connection with that filing.  Under the MERS system, a mortgage is recorded in its name as the assignee of the ultimate beneficial owner.  Transfers of that beneficial ownership are accomplished in the MERS computer system without any recording with the county clerk.  Various county clerks brought suit against MERS asserting that the transfers on its system, without a corresponding county-level filing (with the appropriate fee), was improper, asserting that MERS was established “to enable its members to avoid recording mortgage assignments and paying the associated recording fees to the county clerks,” for which the clerks sought “damages to recover unpaid recording fees and an injunction ordering Defendants to cease their practice of not recording mortgage assignments.” 

      The Sixth Circuit affirmed the determination of the Circuit Court that the count clerks lacked standing to prosecute the suit.  Rather, it was found that the clerks had no private right of action to sue for any alleged violation of the recording requirements imposed by Kentucky law.  Expressly avoiding the question as to “whether Defendants are obligated to record assignments when notes are transferred per the MERS system” (2013 WL 465198, *4), it was determined that the clerks did not fall within the class of persons intended to be protected by the recording requirement, those being:

(1)        Existing lienholders and lenders who record their security interests in the land to give notice of their secured status;

(2)        Prospective lienholders and purchasers; and

(3)        Property owners and borrowers whose loans have been satisfied.  2013 WL 565198, *5 (citations omitted).

In that the clerks were not persons intended to be protected by the statute, they were not entitled to bring an action to enforce the statute or to seek damages for its alleged violation.

      The Sixth Circuit also affirmed the dismissal of the claim for unjust enrichment, noting that unjust enrichment arises in contract as a mechanism for precluding one from enjoying benefits received without providing compensation.  In that the clerks had afforded no benefit to the participants in the MERS system, there can be no claim for unjust enrichment.  2013 WL 565198, *7-8.

Principal Bound by Arbitration Agreement Only if Agent Had Authority

Principal Bound by Arbitration Agreement Only if Agent Had Authority

      In yet another consideration of whether an agreement to arbitrate included in health care facility admission documents would be enforced against the person admitted (or ultimately their estate), the Court of Appeals has again held that it is necessary that the person executing the admission documents on behalf of the patient have agency authority to do so.  Absent authority to bind the principal to the arbitration agreement, the agent’s action are for naught, and no valid agreement to arbitrate exists.  Kindred Hospitals L.P. v. Clark, No. 2011-CA-001663-MR (Ky. App. Feb. 15, 2013) (Not to be Published).

      Julie Clark held a medical surrogate power-of-attorney to make healthcare decisions with respect to Dorothy Harold (the opinion does not otherwise specify the nature of their relationship).  On at least four occasions, Clark, on Harold’s behalf, completed admissions paperwork to Kindred facilities, each of which contained an alternative dispute resolution provision.  After her last admission to a Kindred skilled nursing home, Harold died.  Subsequently thereto, Clark, as Harold’s executor, filed an action against Kindred for gross negligence and recklessness; in response Kindred moved to dismiss on the basis of the agreement to arbitrate.  The trial court denied Kindred’s motion, and it appealed to the Court of Appeals.  The Court of Appeals ultimately upheld the trial court’s decision.

       Essentially, Clark lacked agency authority to, on Harold’s behalf, bind her to the agreement to arbitrate.  In Ping v. Beverly Enterprises, 376 S.W.3d 581 (Ky. 2012), the Kentucky Supreme Court determined that the daughter of the deceased, who acted under a general durable power-of-attorney, did not have authority to waive her mother’s right to a jury trial or to bind her to arbitration.  In this case, the medical surrogate power-of-attorney held by Clark afforded even less authority on Harold’s behalf than had been the case in Ping.  Clark had only authority to make healthcare decisions on Harold’s behalf, and that authority did not extend to waiving her right to redress in the courts.  Further, estoppel would not work to bind Harold’s estate in that there was no evidence that Harold made an affirmative representation to Kindred or any reliance by Kindred upon her conduct.