An LLC and Its Solitary Member Are Not Legally Interchangeable

An LLC and Its Solitary Member Are Not Legally Interchangeable

      A recent decision of the Kentucky Supreme Court provides important guidance with respect to a number of issues, including the absolute legal distinction between an LLC and its members, even a sole member, and an unwillingness by the Court to permit members to at a whim ignore the legal reality of the LLC through insider reverse piercing.  Turner v. Andrew, ___ S.W.3d ___, 2013 WL 6134372 (Ky. Nov. 21, 2013).

       Andrew operated a trucking business under the name “Billy Andrew, Jr. Trucking, LLC” even as the individual trucks were in his own name.  One of those trucks was damaged in a collision with a truck belonging to M&W Milling Co., Inc.  Andrew then brought suit against M&W for both the damage to the truck as well as the lost profits suffered as a consequence of the truck being out of service.  Notably, the LLC through which the trucking business was operated was not a party to the action.  Thereafter, Andrew seems to have ignored the case, missing numerous discovery deadlines and even, apparently, ignoring a court order compelling him to produce documents.  Ultimately, the trial court entered an order in limine excluding from evidence any claim for property damages in excess of the amount estimated by M&W’s expert and as well granted M&W judgment on the pleadings with respect to the claim for lost business profits, that on the grounds that any lost profits were suffered by the LLC, a stranger to the action.

      The Court of Appeals reversed that determination, “concluding that Andrew could properly pursue the lost business claim in his own name because he is the sole owner of the LLC.”  2013 WL 6134372, *2.  The Kentucky Supreme Court would ultimately and resoundingly reject that suggestion.

       The Supreme Court began by reciting the law that a limited liability company is a legal entity distinct from its members, citing therefore KRS § 275.010(2).  Noting that:

The Court of Appeals reasoned that because Andrew was the sole owner of the business he was necessarily the real party in interest, a status that allowed him to properly advance the lost profits claim in his own name rather than in the name of the LLC.  2013 WL 6134372, *3.

the Supreme Court stated that this position was long ago rejected in Miller v. Paducah Airport Corp., 551 S.W.2d 241 (Ky. 1977).  From there the Supreme Court wrote:

The LLC and its solitary member, Andrew, are not legally interchangeable.  Moreover, an LLC is not a legal coat than one slips on to protect the owner from liability but then discards or ignores altogether when it is time to pursue a damage claim.

       The Court went on to then discuss the notion of piercing the veil, noting that traditional piercing is not here available, and likewise this does not constitute a “outsider reverse” piercing instance.  Rather, this is in effect an “insider reverse” pierce, i.e., Andrew sought to claim for himself the personal benefit of a company asset.  The Court as well noted that there exists a question as to whether Kentucky will recognize insider reverse piercing, but not making a ruling one way of the other.  What is clear is that in this case an insider reverse pierce was not allowed. 

       Separately, the trial court’s dismissal of the action for discovery abuse was reversed on the grounds that the court had not made findings of fact and conclusions of law with respect thereto.   For that reason, the case was remanded for consideration of those issues.

       My quibble with this decision is that it failed to cite the statute that most directly addresses the point in contention.  The Court properly cited KRS § 275.010(2) for the rule that the LLC is a legal entity distinct from its members, a statute that does support the Court’s reasoning.  Still, it could (and should) have as well cited KRS § 275.240(1), it providing that the assets of the LLC are not the assets of its members.  In that it was the LLC that had lost the profits, and not the member thereof, this statute clearly supports the determination that the claim for lost profits belonged to the LLC and not it's member.

Kentucky Supreme Court Identifies the Beneficiary of a Board’s Fiduciary Obligations

Kentucky Supreme Court Identifies the Beneficiary of a Board’s Fiduciary Obligations

      Last Thursday, the Kentucky Supreme Court issued its long-awaited decision in Ballard v. 1400 Willow Council of Co-Owners, Inc., a dispute that in part revolves around fiduciary duties among the members of the board of directors, the board of directors as a collegial body and the members of a nonprofit corporation.  In that the statute defining the fiduciary obligations of the directors of a nonprofit corporation (KRS § 273.315) uses the same formula as that utilized in the Kentucky Business Corporation Act (KRS § 271B.8-300(1)), this decision has application across both forms of business organization.  Ballard v. 1440 Willow Council of Co-Owners, Inc., 2010-SC-000533-DC (Ky. Nov. 21, 2013). 

      Ballard was the owner of a condominium in the 1400 Willow building.  Consequent to certain problems with exterior masonry, agreed by all to be a common element, the window frames in her condo began to rot out.  There was a dispute as to whether or not the rotting was of such a degree that there was a risk of the glass falling; the condominium board believed there to be an eminent risk, while Ballard’s consultant thought there to not be a problem.  During the pendency of a complaint for declaratory relief, workers employed by the condominium association (a/k/a the “Council”) entered the condominium and replaced the windows at a total cost of $65,000.  The Council as well filed a lis pendens on the title to the condominium as security for the amount it had expended.  Slip op. at 3.  Thereafter Ballard amended her complaint to claim damages for breach of contract, breach of fiduciary duty, promissory estoppel and punitive damages.  Some two years later she would again amend her complaint to assert that the lis pendens filed by the Council as well as a similar document filed with the Jefferson County Clerk constituted slander of title.

      At a trial that took place in September, 2007, the jury determined that the windows did need to be replaced and that the need for replacement was caused by the masonry problem.  The jury also found that (a) the Council failed to exercise “good faith and loyalty” to the condo owners including Ballard, (b) that she should be made whole on $54,000 of condo fees paid, and (c) that the lis pendens was a knowing and malicious false statement as to the title of her condo for which $75,000 would compensate her.  The jury declined to award punitive damages.

      The jury’s decision was appealed to the Court of Appeals, which reversed and remanded for a new trial.  The Supreme Court then granted discretionary review.

       Before going to what I find interesting in this decision, namely the discussion of fiduciary duties and contract law, it should be noted that this decision has important points on real property law.  First, the Supreme Court held that the statute of limitations on a claim of slander of title would be five years (KRS § 413.120) and in so doing reversed a prior decision holding it to be one year.  See slip op. at 11.  Turning to the actuality (or not) of the slander of title claim, while the Court reviewed a good deal of foreign law holding that the filing of a lis pendens has an absolute privilege, it ultimately held that the filing of a lis pendens has only a qualified privilege.  Slip op. at 16.  From there, in reliance upon the jury’s determination that the lis pendens was “false and knowingly and maliciously made,” the Court held that the qualified privilege was not available to the Council.

      The broader issue addressed by the Court is the nature of fiduciary duties, specifically who owes them and to whom they are owed.  While Ballard’s theory of the case appears to have changed over time, she ultimately asserted not a derivative action on the corporation’s behalf charging the directors with a breach of duty owed the entity but rather “she sued the [Council] as an entity for breach of its contractual obligations and common law fiduciary duties to her, individually.”  Slip op. at 20.  That attempted parsing of her claim ultimately failed as she relied upon a non-existent fiduciary duty.

[W]e cannot say that the Council had a fiduciary duty to the individual owners.  Ballard has not cited any Kentucky authority which provides that a nonprofit corporation has a fiduciary duty.  Rather, we believe it is the officers and directors that have a fiduciary duty, and that duty is to the nonprofit corporation.  See KRS 273.215.

Slip op. at 20.

      The Court continued its analysis of the point, making express that the duty is to the entity and not the individual members:

[T]he directors in this case only owed a fiduciary duty to the corporation.  Specifically, KRS 273.215 provides that a director shall discharge his duties “(a) In good faith; (b) On an informed basis; and (c) In a manner he honestly believes to be in the best interests of the corporation.”  (Emphasis added).  As correctly noted by the Court of Appeals, this is a reasonable interpretation because the co-owners in this case could have competing agendas, which may not be in the best interests of the Council.  Thus, the board of directors had a fiduciary duty to the Council as a whole and not to the individual unit owners, such as Ballard.

Slip op. at 21.  On that basis the jury’s award of $54,000 for breach of fiduciary duty was for breach of a non-existent duty, the Court of Appeal’s reversal thereof was upheld.

      Justice Noble, joined by Justice Scott, dissented as to the reversal of the finding of a breach of fiduciary duty.  Essentially, Justice Noble argued that the jury’s determination that the Council filed to “exercise good faith and loyalty” (slip op. at 27) equated to a breach of fiduciary duty.  The problem with this assessment was identified (but apparently not recognized) by Justice Noble when she noted the source of Ballard’s rights as a condo owner as to her particular unit, namely the “contractual rights and expectations” set forth in her deed and the Master Deed.  The failure was in not recognizing that contractual obligations are not fiduciary obligations, and that the obligation of “good faith and fair dealing” is contractual in nature.  See slip op. at 31 (“thus violating the general fiduciary duty – that ‘of good faith and fair dealing’ – contained in all contracts.”).

      Fortunately the majority opinion addressed this point, recognizing that “we cannot say that the jury’s find of a breach of fiduciary duty is equivalent to a finding of failing to act in good faith” (slip op. at 22), thereby properly separating the status-based gap filler that is the law of fiduciary duties from the contractual interpretation principle that is good faith and fair dealing.

Pillars of the Earth & the Sinking of the White Ship

Pillars of the Earth & the Sinking of the White Ship

            Pillars of the Earth is in my view an excellent book both for its description of events “from the ground level” of the period of English history known as the Anarchy as well as its treatment of medieval as people just like those of the modern era who are just trying as best they can to make it through each day.

 

            The fulcrum of the macro-political events described in the book is the Anarchy, the contest between Matilda, daughter of King Henry I (and former spouse of the Holy Roman Emperor, hence her title “Empress,), and Stephen of Blois, Henry’s nephew (just to keep things confusing Stephen’s wife was named Matilda).  The expected heir to Henry I was his son William.  William, however, drowned on this day in 1120 in the sinking of the White Ship, thereby affording Follett the pivot around which to write Pillars of the Earth.

North Carolina Supreme Court Addresses Nature of Piercing the Veil

North Carolina Supreme Court Addresses Nature of Piercing the Veil

      A recent decision from the Supreme Court of North Carolina is notable in every jurisdiction for the clear guidance it has provided with respect to piercing the veil.  Green v. Freeman, No. 424A12 (N.C. Nov. 8, 2013).

      Most of this decision is spent addressing whether or not there existed a valid evidentiary basis for holding a particular individual liable for an alleged breach of fiduciary duty.  Ultimately, the Court found that evidence to be lacking.  In the course thereof, the Court also set aside an earlier determination to pierce the veil in order to hold that individual liable for the alleged breach.  In this case, the Court noted that, even where the elements of piercing itself, mainly domination and control, are established, the task is only half done.  “There must also be an underlying legal claim to which liability may attach.”  As such:

The doctrine of piercing the corporate veil is not a theory of liability.  Rather, it provides an avenue to pursue legal claims against corporate officers or directors who would otherwise be shielded by the corporate form.

      This is important guidance that apparently must be oft repeated.  Piercing the veil is not a legal theory of liability, but rather a remedy.  If and only if the plaintiff has a claim against the legal organization that is not satisfied from corporate assets does piercing become an issue.  Like negligence in the air resulting in no injury to anyone giving rise to a claim, domination and control of a corporation is of itself not actionable unless and until, on some other basis, a plaintiff is both injured and unable to recover.

When Does a Transaction Involve “Commerce” Implicating the Federal Arbitration Act

Kentucky Court of Appeals Addresses When a Transaction Involves

“Commerce” Implicating the Federal Arbitration Act

      In a recent decision, the Kentucky Court of Appeals addressed the question of when a particular transaction involves “commerce” such that the Federal Arbitration Act, rather than the Kentucky Arbitration Act, is controlling.  This question can be crucial in that the Kentucky Arbitration Act is far more restrictive than the Federal Arbitration Act, enforcing arbitration agreements only if they provide that the arbitration will take place within the Commonwealth of Kentucky.  If the agreement is governed by the federal law there is no such limitation.  Nissan v. Hurt, 2013 WL 5592372 (Ky. App.  Oct. 11, 2013) (Not To Be Published)

      The Hurts contracted to purchase a vehicle from Nissan.  Thereafter, they sought to void the contract on the basis that Nissan had falsified the credit application associated therewith.  In turn, Nissan moved that the trial court compel arbitration pursuant to an arbitration clause contained in the agreement between Hurt and Nissan.  The trial court denied that motion on the basis that the arbitration clause at issue did not require arbitration in Kentucky as required by Ally Cat, LLC v. Chauvin, 724 S.W.3d 451, 455 (Ky. 2009).  Essentially, it was held that “the transaction did not involve interstate commerce so as to bring it within the purview of the Federal Arbitration Act.”  Nissan appealed that determination. 

      An agreement to arbitrate will be enforced under the Federal Arbitration Act when the contract at issue “evidenc[es] a transaction involving commerce.”  9 U.S.C. § 2.  In turn, “commerce” is defined as “commerce among several States.”  9 U.S.C. § 1.  The Court of Appeals also referenced certain ruling of the United States Supreme Court indicating that the “involving commerce” component of the Federal Arbitration Act is “functionally equivalent” to the “affecting commerce” term used with respect to the powers afforded Congress under the Commerce Clause.

      Applying these principles, the Court of Appeals found that the transaction between Hurt and Nissan involved interstate commerce.  While it was “a transaction between a Kentucky resident and a Kentucky business concerning a vehicle located in Kentucky,” it also involved interstate commerce in that the vehicle had been transported between various states and the credit application had been submitted to an out-of-state processing facility.  Further, that credit application specified that it would place the transaction with GMAC in either New Mexico or Michigan or a GMAC affiliate in Arizona. 

       It will be interesting to see what are ultimately determined to be the outer limits of “involving commerce” and thereby preserving the application of the Kentucky Arbitration Act.  For example, if this transaction had not involved an out-of-state lender, would the mere fact that the vehicle had moved across state lines be sufficient?

The Supreme Court and the Contraceptive Mandate

The Supreme Court and the Contraceptive Mandate

     As matters stand, the Hobby Lobby and Gilardi courts have held that either the corporation or the shareholders thereof have standing to object to the contraceptive mandate aspects of the PPACA while the Autocam, Eden Foods and Conestoga Woods courts have all found that both the shareholders and the corporation lacked standing to assert the mandate violates the Free Exercise clause and the RFRA.

 

       Following is a copy of a posting from today's SCOTUS Blog discussing the mandate cases, the question of which cases the Supreme Court will take and when it might rule:

Birth-control mandate: Which case to review? Posted: 04 Nov 2013 05:20 PM PST With lawyers in different cases arguing that theirs is the best one for the Supreme Court to use in deciding the legality of the birth-control mandate in the new federal health care law, the Court on Monday indicated that it will examine all four pending cases together later this month. The Court’s electronic docket said the four will be considered on November 26. If any are granted then or soon afterward, the Court probably would hear and decide them in the current Term. The federal government has one of the three petitions, and ordinarily it can expect to get its pleas heard. But the government’s case has been challenged by other lawyers as too narrow in scope, and that has led government lawyers in reply to promise to make theirs broader if it is the one chosen. The Affordable Care Act’s contraceptive mandate requires employers with fifty or more employees to provide health care coverage that includes birth-control methods and devices, pregnancy screening, and other reproductive health services. At this point, three of the pending cases involve only challenges to that by profit-making business firms with owners who are religiously devout, and the fourth is a challenge by a religiously affiliated university. At least one of the cases has a strong likelihood of being heard by the Justices, because the federal appeals courts have reached conflicting rulings on the mandate, and two of those courts have indicated that the mandate cannot survive the legal challenges by the business itself, or by its owners as individuals. To illustrate the conflicts: The Tenth Circuit Court, in the case that the Justice Department has appealed in the case of a retail crafts store chain, ruled that the mandate’s required coverage of birth-control drugs is likely to be struck down as it applied to the corporation itself; it did not rule on whether the owners themselves could pursue a similar religion-based challenge. The petition in that case is Sebelius v. Hobby Lobby (docket 13-354). (The D.C. Circuit Court, in a decision last week that has not yet been taken to the Supreme Court, ruled that the corporation was not protected from the mandate, but that the owners were as individuals.) The Third Circuit Court, in a case appealed to the Court by a Pennsylvania cabinet-making company and its owners, disagreed directly with the Tenth Circuit, and ruled that a corporation has no religious rights of its own, and it also refused to allow the individual owners to object on their own. The petition in that case is Conestoga Wood Specialties Corp. v. Sebelius (docket 13-356). The Sixth Circuit Court, in a case involving two related Michigan companies that make precision instruments for use in auto manufacturing and in medical practice, ruled that a corporation cannot exercise religion and thus cannot make a challenge for itself, and it also barred the religious owners from pursuing their own complaint, finding that the mandate only applies to the company. The petition in that case is Autocam Corp. v. Sebelius (docket 13-482). The fourth case in the group now at the Court is Liberty University v. Lew (docket 13-306). That case involves challenges not only to the birth-control mandate, but also to the individual insurance mandate and the employer insurance mandate. The Fourth Circuit Court did not rule on the complaint about the birth-control provision, saying that the company was late in raising that issue; however, it rejected the other challenges. (In 2012, the Supreme Court upheld the tax penalty that is used to enforce the individual mandate, but did not rule on the employer mandate.) The Justice Department rushed to the Court its responses to the Conestoga, Autocam, and Liberty University petitions to assist the Court in taking them up together, and it urged the Court either to deny review, or to hold the other cases until after it ruled on the government’s Hobby Lobby petition. Lawyers in the other cases, however, have argued that the Hobby Lobby case only involves the question of a business firm’s right to pursue a challenge to the mandate, and does not address whether the individual owners could do so for themselves. Thus, the attorneys contend, that is not the best case for review. The Justice Department, however, has countered that some members of the Tenth Circuit Court did address that separate question when their court ruled, that Hobby Lobby’s lawyers will be raising the issue in their defense of the Tenth Circuit ruling, and that, if the government petition is selected, it will confront that issue in the written briefs it would file in that case. The government’s case asks the Court to rule only on whether the birth-control mandate violates a federal law, the Religious Freedom Restoration Act. However, the Conestoga petition also urged the Court to rule on whether it violates the First Amendment’s protection of the “free exercise” of religion, as well as violating RFRA. The Justice Department argued that the constitutional issue has been ruled upon only by the Third Circuit in the Conestoga case, and the issue has thus not produced a conflict among the appeals courts. The Court, the Department contended, should not step in to decide that issue.

Proposed Charging Order Rejected for Including Right to Participate in LLC’s Management

Proposed Charging Order Rejected for Including

Right to Participate in LLC’s Management

 

       A recent decision from the Court of Civil Appeals of Oklahoma has affirmed the rule that while a charging order may properly reach a member’s economic (interim and liquidating distribution) rights in an LLC, it does not extend to giving the judgment-creditor a voice in the LLC’s management for control over the judgment-debtor’s voting rights therein.  Southlake Equipment Company, Inc. v. Henson Gravel & Sand, LLC, __ P.3d __, 2013 WL 5657702 (Okla. Civ. App. Div. 4 Sept. 6, 2013).

      An agreed judgment in the amount of $40,840.19 plus attorneys’ fees and costs was entered against Henson Gravel & Sand, LLC and Melvin D. Henson, Jr., that judgment in favor of Southlake Equipment Company, Inc.  That Texas judgment was then domesticated in Oklahoma and Southlake filed an application for a “writ of special execution” pursuant to which Henson’s 24% interest in Econtuchka Erosion Control, LLC (“EEC”) would be assigned to Southlake.  The trial court granted that request, and Henson appealed.

      The Court of Appeals reviewed Oklahoma’s charging order statute as set forth in its LLC Act, noting that it is limited in application to a member’s economic rights in an LLC and does not extend to the voting rights.  It bears noting that while this statute contains the usual recitation that the holder of the charging order has only the rights of an assignee of the membership interest, the Oklahoma statute goes on to provide:

A charging order entered by a court pursuant to this section shall in no event be convertible into a membership interest through foreclosure or other action.

      The Court ultimately determined that, while the charging order could be properly issued with respect to Henson’s right to the economic fruits of EEC, it could not extend to the right to participate in management.  Rather:

In the present case, the trial court charged Debtor to transfer his entire membership interest, both economic and voting, to Southlake in partial satisfaction of the judgment.  This charge clearly conflicts with the plain meaning of § 2034 and was therefore in error.  The trial court may only charge Debtor to assign the share of the profits and surplus that flow from his membership interest in his Units in EEC until the judgment has been satisfied.