Friday, October 25, 2013

Court of Appeals New Opinion in Ziegler v. Knock is a Confused Mix of Partnership and LLC Law, Fiduciary and Contract Law

      In October, 2012,  the Court of Appeals issued its opinion in Ziegler v. Knock, affirming the trial court’s determination that there had been a breach of duty in accepting a secret commission but dismissing the action based upon a choice of venue provision in the subject agreements.  Ziegler v. Knock, No. 2008-CA-002160-MR, 2012 WL 5273999 (Ky. App. Oct. 26, 2012).  By its determination of improper venue the Court’s decision as to breach of fiduciary duty was rendered dicta.  That decision was reviewed here in Decision of Trial Court Reversed, Inter Alia, For Lack of Jurisdiction (posted Nov. 19, 2012).
      Presumably on a motion for reconsideration, the Court of Appeals issued a new decision in this case.  See Ziegler v Knock, No. 2008-CA-002160-MR (Jan. 18, 2013).  Like the prior holding it is designated “Not to be Published.”  On October 16, 2013, the Kentucky Supreme Court denied discretionary review.  The petition for discretionary review was restricted to the proper venue question.  That being the case I held off on a substantive review of the decision.  Ultimately it has serious issues.
      In this decision, on the basis that the question of venue had not been raised in a timely manner, the Court of Appeals determined that Ziegler had waived that defense.  Ergo, the Court of Appeal’s affirmance of the trial court’s ruling stands, and the matter would not be re-litigated in Ohio.
      Which brings us back to the primary point, namely Ziegler’s breach of duty.  The contract between Ziegler and Knock contained a warranty that Ziegler was not to receive a direct or indirect commission on the acquisition of the property to be acquired by TZG III, LLC, the acquisition vehicle formed by Zigler and Knock.  In fact, Ziegler received a $72,000 commission on the sale.
      While the ultimate determination that Ziegler’s conduct was improper is without question correct (at this point I’m not considering the effect of the release signed by Knock and Ziegler), the analysis applied by the Court of Appeals mixes concepts that are and should be distinct from one another.  Ergo, it might be a case of right answer, wrong reason.

      First is the issue of structure and the beneficiaries of fiduciary duties.  David and Richard Knock were the members of Knock Investments, LLC.  Ziegler Group, LLC appears to have been wholly-owned by Michael Ziegler.  Knock Investments, LLC and Ziegler Group, LLC in turn formed and were the members in TZG III, LLC; that LLC was the actual purchaser of the strip mall.  The agreement to form TZG III, LLC was labeled a “Membership Interest Purchase Agreement,” and it was in that document Ziegler represented he was not receiving a commission.
      One point of contention was whether the Knocks could individually be plaintiffs, or whether only Knock Investments, LLC had standing.  The Knocks were not individually parties to the Membership Interest Purchase Agreement.  Still the trial court allowed them to proceed individually, a decision not set aside by the Court of Appeals in either of its decisions.
      The problem with this conclusion is that it is manifestly erroneous.  The rights and claims of an LLC are not the property of its members.  See, e.g., KRS § 275.010(2) (LLC is a legal entity distinct from its member); id. § 275.250 (interest in an LLC is personal property); id. § 275.240(1) (property of LLC is that of the LLC and not of the members); Chou v. Chilton, Nos. 2009-CA-002198-MR, 2009-CA-002284-MR, 2012 WL 6526184 (Ky. App. Nov. 16, 2012) (individual member of LLC could not in his own name bring claim for breach of fiduciary duties owed to the LLC); R.C. Tway Co. v. High Tech Performance Trailers, LLC, 2013 WL 842577 (W.D. Ky. Mar. 6, 2013) (claim for misappropriation of company assets belongs to the LLC); Bobbitt v. Russellville Mobile Park, LLC, No. 2007-CA-00684-DG (Ky. App. Sept. 12, 2008, modified Oct. 17, 2008) (member of LLC, seeking to represent the LLC in court proceeding, engaged in unauthorized practice of law; member was not an attorney and the interests of the LLC were not those of the member). 

      Knock Investments, LLC, being a party to the Membership Interest Purchase Agreement, had standing to object to its breach.  The Knocks, not being parties to that agreement and absent other facts (e.g., intended third-party beneficiaries) not set forth in the opinion, had no standing.
      Turning to the substance of the dispute, Ziegler represented that he was not earning a commission on the sale of the property.  In fact he did receive a commission, and the court properly held him to account for his breach of that covenant.  The problem is in the muddled manner in which it did so.
      In explaining Ziegler’s liability for accepting the commission the Court wrote:
… because Knock Investments, LLC is a closely held entity owned by the Knocks individually, and because the Knocks were asserting claims of fraud and misrepresentation in their individual capacities rather than through the corporate entity, they had standing to assert their individual interests as members of the limited liability corporation. Ziegler and TZG have cited no statutory law or case law in support of their assertion that this conclusion was erroneous. The trial court's rulings are presumptively correct, and the burden rests with the appellants to demonstrate error. Boggs v. Burton, 547 S.W.2d 786 (Ky. App. 1977).

… The trial court determined that if Ziegler had not breached his fiduciary and contractual duty to forgo a commission, the purchase price of Park Plaza could have been lowered. In the alternative, the court determined that at the very least, the Knocks were entitled to a percentile share of the commission which they could have reinvested in the project or disposed of in some other manner. The basis of the court's conclusion on this issue is that as partners with mutual fiduciary duties, the Knocks and Ziegler were vested with the right to reap the benefits of their joint venture commensurate with their percentile ownership interest. Since Ziegler secretly received a 2% commission, the court concluded that equity demanded that the Knocks also benefit from that commission commensurate with their percentile ownership interest in the venture. The court awarded to the Knocks a 74% interest in the commission based on their 74% interest in the project. Since the relationship of partners imposes upon each the obligation of good faith and fairness with respect to partnership affairs, Betts v. Smither, 310 Ky. 402, 220 S.W.2d 989 (Ky. App. 1949), and since Ziegler unduly benefitted from his acceptance of a commission in violation of his fiduciary duty and the Membership Interest Purchase Agreement, we find no error in the court’s determination that the Knocks are entitled to a pro rata share of the commission.

      The Court, in these few sentences, mixed a significant number of concepts.
      First, even between those who stand in a fiduciary relationship with one another, is a breach of a contractual obligation a breach of fiduciary duty?  Assume that the receipt of a secret commission is a breach of fiduciary duty.  As was here the case that limitation was reduced to a contractual obligation.  There is then a breach of the obligation.  Does there now arise a decision for breach of fiduciary duty, breach of contract, or both?  The Court seemed to assume both, but it is not obvious that is correct.  Fiduciary duties are gap-fillers.  Conceptually, where the express contract addresses the point, there is no gap to be addressed by fiduciary obligation? 
      Second, what was the source of the alleged fiduciary duty?  The covenant was that Ziegler, and not Ziegler Group, LLC, was not receiving a commission.  Was Ziegler a member in a member-managed LLC or a manager of a manager-managed LLC?  The opinion does not say.  On the basis that the Ziegler Group, LLC was wholly-owned by Ziegler, is he being held responsible for discharge of the LLC’s fiduciary obligations?  The opinion does not say.   Did the operating agreement identify Ziegler as a fiduciary?  The opinion does not say.  Has USACafes been adopted as Kentucky law?  Essentially we are told that Ziegler violated a fiduciary duty without being provided any direction as to the source of that duty.
       Third, where was the breach of fiduciary duty?  Even assuming Ziegler was a fiduciary and that he accepted the commission, it does not necessarily follow that there was a breach.  What fiduciary duty was violated?  Subject to “First” above I have no doubt there was a breach, but the Court needs to tell us what it was and why.
       Fourth, if this is a case about a breach of fiduciary duties rather than contractual duties, why did the court use a contract measure of damages, namely putting the Knocks back in the same position they would have been but for the breach?

       Fifth, and going back to the point above on standing, whey is the recovery to the individual Knocks rather than either the TZG III, LLC or to Knock Investments, LLC?  Chou v. Chilton and the statutory law make clear that injury to the LLC, in this instance TZG III, LLC (if there had been no commission to Ziegler then TZG III, LLC’s purchase price for the subject property would have been lower), is to be addressed for the account and benefit of the LLC.
       Sixth, from where came this reference to “partners”?  Members in an LLC are members and they owe the duties and enjoy the benefits of members as defined by the LLC Act.  Partners in a partnership are partners and they owe the duties and enjoy the benefits of partners as defined in the law of partnerships.  Partnership law, by its express terms, does not apply among the members in an LLC.  See KRS § 362.1-202(2).  Yes, in LLCs there exists an obligation of good faith and fair dealing, but that is a principle of contract law that is confirmed by the LLC Act.  See KRS § 275.002(7).  And as good faith and fair dealing is a principle of contract law (and not the law of fiduciary duty), it cannot be the basis for the fiduciary duty Ziegler violated.

      It is clear that Ziegler’s conduct was improper, but this decision does little to illuminate why or to provide guidance for the analysis of future disputes.
      Which brings us back to the question of the effect of the mutual release, an issue to which the existence of the fiduciary duty is crucial.  Assuming a third-party independent relationship, a mutual release will be binding upon each party, and each party, in entering into such an agreement, is bound and required to look out for its own interest.  Where, in contrast, one bound by a fiduciary relationship seeks a release from the beneficiary of that relationship, the release is effective if and only if the fiduciary has made full and complete disclosure to that beneficiary.  See, e.g., Restatement of (Third) of Agency § 8.05.   Ziegler sought to avoid liability in this dispute by refereeing a mutual release that had been entered into.  Knock sought to avoid the application of that release on the basis that Ziegler was a fiduciary.  While the court may, ultimately, have been normatively correct in setting aside the release on the basis that Ziegler owed a fiduciary duty, its analysis was so muddled that little can be taken away from it.  For example, if Ziegler owed a fiduciary relationship, had that situation so broken down by the time that the mutual release was entered into that Knock had no right to expect Ziegler to be acting in a fiduciary, as contrasted with an arms-length independent, role?  Such determinations matter.  They were, however, ignored in this decision.


No comments:

Post a Comment