Kentucky Supreme Court Addresses of Scope of Corporate Director’s Statutory Fiduciary Duties

Kentucky Supreme Court Addresses the Scope of Corporate Directors Fiduciary Duties and Limitations on Culpability

 

 

      Earlier today the Kentucky Supreme Court issued its long-awaited decision in the case now styled Baptist Physicians Lexington, Inc. v. The New Lexington Clinic, P.S.C., which case had previously been styled The New Lexington Clinic, P.S.C. v. Cooper.  Therein, the Kentucky Supreme Court provided useful guidance with respect to when the statutory formula for a director’s fiduciary duties, as well as the limits upon culpability, set forth in KRS § 271B.8-300 are and are not applicable.  Baptist Physicians Lexington, Inc. v. The New Lexington Clinic, P.S.C., 2012-SC-000242-DG, 2013 WL 6700209 (Ky. Dec. 19, 2013).  This opinion, which is designated for publication, was a unanimous decision of the Supreme Court.  The author of the opinion was Justice Abramson.

      Drs. Cooper, McKinney and Winkley, each a shareholder in and director of The New Lexington Clinic, P.S.C. (the “NLC”), were recruited to join a competing healthcare provider.  After agreeing to join the new venture, however, they did not immediately tender their resignations, but remained for a significant period of time directors able to access the financial information of NLC, and it is asserted, provide that information to their new employer.  Also, after having agreed to leave NLC, but before giving notice of doing so, some or all of the physicians solicited other employees of NLC to ultimately depart with them.  After those departures, NLC brought suit against the physicians alleging breach of fiduciary duties, but without making any reference to KRS § 271B.8-300.  Rather, they relied upon common law fiduciary duties owed a corporation, duties previously accepted to be part of Kentucky law under the Aero Drapery and Steelvest decisions.  The trial court granted summary judgment, primarily (at least for these purposes) on the basis that the complaint failed to cite and therefore state a claim under KRS § 271B.8-300.  That decision was affirmed by the Court of Appeals.

      The Supreme Court granted discretionary review and heard oral arguments on March 14 of this year.  As I here summarized on March 19, on behalf of the Defendants, it was argued that:

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

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

      In contrast, the Plaintiffs argued that:

·                     Under the modern Rules of Civil Procedure, it is not necessary to cite the statutory basis of the claim;

·                     Even if KRS § 271B.8-300 is the exclusive statement of a director’s fiduciary duty 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.

      Essentially, the Supreme Court has here agreed with the arguments of The New Lexington Clinic stating:

Contrary to the lower courts’ conclusions, KRS 271B.8-300 does not abrogate common law fiduciary duty claims against directors in Kentucky but essentially codifies a standard of conduct and a standard of liability for directors that is derived from business judgment rule principles.  As it explicitly states, the statute applies to “any action taken as a director” and “any failure to take any action as a director.”  Preparing for and participating in a competing venture does not constitute the internal corporate governance conduct addressed in KRS 271B.8-300 and consequently the statute does not apply.  Slip op. at 2.

       With respect to the standards applicable to a corporate director in the discharge of their obligations on behalf of the corporation, the Court held, inter alia, that the statutory formula is the exclusive standard, writing:

[KRS 271B.8-300] codifies both the standard of conduct applicable to a director and the circumstances in which the director can be held liable for monetary damages or subjected injunctive relief.  Significantly, subsection (5) limits a corporate director’s liability but it does so only in the context of “any action taken as a director or any failure to take any action as a director.”  In short, when acting in his or her directorial capacity, a director must comply with the statutory standard of conduct.  If he fails to do so, injunctive relief is available and if the conduct at issue is willful, misconduct or reflects wanton or reckless disregard for the corporation and its shareholders, then monetary damages may also be recovered.

Looking at the other side of the coin, the Court wrote:

But just as clearly, [271B.8-300(5)] does not purport to address circumstances where a director is acting, not in his capacity as a director, but in his own individual interest with respect to a matter beyond the conduct of the corporation’s business, even if that extra-corporate matter may have some impact on the corporation.  If a director is acting on his own accord in anticipation of competing with the corporation which he still serves, that conduct implicates the director’s common law fiduciary duties, not KRS 271B.8-300.

            I do have one small quibble with this decision based upon a small apparent conflict with the Supreme Court’s decision in Ballard v. 1400 Willow (Nov. 21, 2013).  Specifically, the decision rendered in Baptist Physicians Lexington provides:

Kentucky Courts have long recognized that corporate directors owe fiduciary duties to the corporation and its shareholders, duties emanating from common law.  Slip op. at 7, 2013 WL 6700209, *4.

In support thereof, there was cited the decision rendered in Urban J. Alexander Co. v. Trinkle, 224 S.W.2d 923, 926 (1949).  My concern is that the statement that corporate directors owe fiduciary duties to the “shareholders” may create an undesirable conflict with the decision rendered in Ballard v. 1400 Willow wherein the Kentucky Supreme Court interpreted the provision of the Nonprofit Corporation Act that is identical to KRS § 271B.8-300(1) to the effect that the director’s fiduciary duties are owed to the corporate entity and not to the individual shareholders.  Ballard v. 1400 Willow, slip op. at 20, 21.  That said, accepting that the statement in Baptist Physicians Lexington as to who is the beneficiary of the board’s fiduciary duty is dicta, while it is Ballard v. 1400 Willow a core component of the case as holding, the apparent conflict may be avoided.  That being the case, there is preserved the distinction between the two decisions, namely Ballard v. 1400 Willow addressing to whom the director’s fiduciary duties are owed while Baptist Physicians Lexington addresses when the statutory definition of the fiduciary duties owed and the application of the limitations on culpability for breach thereof are applicable.

Delaware Chancery Court Addresses Status as a Member of LLC, “Corporate” Opportunity Doctrine and Breach of Fiduciary Duty

Delaware Chancery Court Addresses Status as a Member of LLC,

“Corporate” Opportunity Doctrine and Breach of Fiduciary Duty

 

      A Delaware Chancery Court decision from this summer addresses an all too common situation, namely the break down in an equally-owned LLC with each of the opposing sides then seeking to protect what they think to be their rights.  Grove v. Brown, 2013 WL 4040495 (Del. Ch. Aug. 8, 2013).

      Marlene and Larry Grove entered into an operating agreement with Melba and Hubert Brown for Heartfelt Home Health, LLC, a Delaware limited liability company.  The operating agreement provided that each would be a 25% member and that each was obligated to make a $10,000 contribution to the LLC.  While the business was initially successful, at the end of the first year, in the course of working on the tax returns, a dispute arose because neither Larry Grove nor Melba Brown had yet satisfied the full $10,000 capital contribution.  Ultimately, Melba would contribute the full $10,000 while Larry would contribute an additional $3,657, asserting that the balance was satisfied by furniture and equipment he contributed to the LLC.  The Browns contested that valuation.  As this dispute was simmering, Marlene Grove, even as she continued her employment with the LLC, formed a new Maryland LLC for the purpose of engaging in that jurisdiction in a similar line of business as that of Heartfelt.  The place of business of this new LLC was less than ten miles from that of Heartfelt, the original LLC.  Ultimately the Groves would form as well another Delaware LLC, it engaging in a similar line of work in Delaware as that undertake by Heartfelt.

      Ultimately, the Groves decided to sever their relationship from the Browns, requesting a buyout in the amount of $941,000.  In addition, they stated an intention, presumably in the alternative, to move for the dissolution and liquidation of Heartfelt.  In response, the Browns first suggested an independent appraisal of the company, which offer was rejected.  Thereafter, the Browns sought to merge the Heartfelt Home Health LLC into another company, freezing out the Groves, this action taken on the purported basis that they held a 63% interest in the company based upon the capital contributions actually made.  Under Delaware law, the merger of an LLC may be approved by the members holding more than 50% of the current interest in the profits of the LLC.  See Del. Code Ann. tit. 6, § 18-209(b).

      The first question analyzed by the Chancery Court was whether or not the Groves and the Browns were equal owners of the company or, as asserted by the Browns, they had a majority position based upon the capital contributions made.  The Court directed that “the ownership of Heartfelt is governed by the Operating Agreement, which identifies Hubert Brown, Melba Brown, Larry Grove and Marlene Grove as the sole members of the LLC.”  2013 WL 4041495, *5.  The Court went on to note that the Operating Agreement provided that each of the four members had a capital interest of $10,000, and that “the Operating Agreement further provides that the profits and losses shall be divided among the members ‘in proportion to each Member [sic] relative capital interest in the company’.”  Id.  From there, the Court found that:

Nothing in the Operating Agreement indicates that the allocation of relative ownership interests was contingent on the Member’s actions post-signing.  Though the Operating Agreement imposes an obligation on the Members to provide capital to Heartfelt, the Operating Agreement does not provided that one member’s failure to do so divests that Member of his or her share of the company.  2013 WL 4041495, *5.   

      In that the Operating Agreement said that each of the four was an equal 25% member of the company, the Browns were 50% owners of Heartfelt, not 63% owners based upon a greater capital contribution to the company.  As such, “the purported merger transaction, in which Heartfelt merged into a company wholly owned by the Browns was a legal nullity” in that the Browns “never owned more that 50% of Heartfelt.”  2013 WL 4041495, *7.  

      Although obviously in dicta, with respect to the suggestion that  the supposed threat from the Groves to dissolve Heartfelt justified the Brown’s action in effecting the merger, the Court noted that “tit for tat is not a justification for breach for fiduciary duty under Delaware law,” and that there was no threat of dissolution in that the Groves, as 50% members, had no authority to unilaterally dissolve the company. 

      The Court then turned its attention to the breach of fiduciary duty and the usurpation of business opportunities, by Marlene and Larry Grove in setting up the LLCs that were engaged in the same line of business as Heartfelt.  Finding that both Marlene and Larry owed fiduciary duties to the LLC and the other members {note that the Delaware LLC Act, unlike the Kentucky LLC Act, does not define either what are the fiduciary duties owed by the members or to whom they are owed; rather, those duties have been developed primarily through case law and only in 2013 enacted, in at best skeletal form, into the Delaware LLC Act.  This is in contrast to the Kentucky LLC Act, which at KRS § 275.170 defines who owes fiduciary duties, to whom the duties are owed and what those duties are}, the Court reviewed Delaware law on business opportunity and determined that the companies set up by Marlene and Larry Grove in competition with Heartfelt constituted a breach of fiduciary duty.  With respect to that issue, the Court found much of the testimony to be not credible and focused on the fact that there was no “express grant of permission” from the LLC for Marlene Grove to open those other companies.  Highlighting as well the legal separation between an LLC and its members, the Court wrote:

It is unclear to what extent Marlene’s testimony, even if I accepted it as true, supports a finding that Heartfelt waived a corporate opportunity.  Marlene did not testify she presented the opportunity to expand to nearby markets to Heartfelt; she avers that she invited the Browns in their individual capacity to join her in creating new, competing entities.  Presenting an opportunity to the Browns is not the same as presenting an opportunity to Heartfelt….  In any event, as mentioned above, the Groves had the burden of proving that they had the right to pursue the opportunities which would otherwise belong to Heartfelt.  I find that they failed to meet that burden.  2013 WL 40414945, *10.

      Finding that all of the parties had engaged in some inappropriate conduct, the Court ordered that all of them account to the Heartfelt LLC for any profits they have derived that should have been earned by and paid to it, and invited the parties to come to an agreement with respect to dissolution of the company.

No Claim for Promissory Estoppel in Withdrawing Offer of At-Will Employment

No Claim for Promissory Estoppel in Withdrawing Offer of At-Will Employment

      A recent decision by Judge Hood saw him apply Kentucky’s law of employment-at-will to reject a claim for promissory estoppel while at the same time rejecting a claim for violation of the Americans With Disabilities Act (“ADA”).  McDonald v. Webasto Roof Systems, Inc., 2013 WL 5676223 (E.D. Ky. Oct. 18, 2013). 

      McDonald, then an employee of Washington Penn, applied for a position at Webasto.  At the end of the interview he was offered the position, and he advised that he needed to give two weeks’ notice.  A week after giving that notice McDonald was called by Webasto and told that a criminal background check, a drug test and a medical exam would be required.  He agreed to each.  A medical exam reported a herniated disc in McDonald’s back, but did not indicate he was unsuited for the job.  Webasto then sent McDonald to another medical facility for further investigation of his back.  Based upon that second examination and a report from a physician thereat that he could not recommend McDonald for the job, it appears (it is certainly implied but never expressly stated in the opinion) that Webasto withdrew the offer of employment.

      McDonald brought suit for violation of the ADA, asserting that Webasto withdrew the offer of employment because it regarded him as having a disability.  He also sued for breach of the employment contract and for promissory estoppel.  All these claims would be dismissed on summary judgment. 

      With respect to the claim under ADA, while acknowledging that McDonald could make out a prima facie case of unlawful discrimination, it found that McDonald would still lose.  Notwithstanding the fact that the medical assessment was open to objective questioning:

Defendant Webasto has come forward with a legitimate, non-discriminatory reason for not hiring him:  it concluded that he was not qualified based on the results of the examination of the Kentucky Back Center as reported by Dr. Lester and which stated McDonald could not perform the work required in the position for which he had been hired.  2013 WL 5676223, *4.

      The court rejected McDonald’s suggestion that this was proforma in that he was sent to the Kentucky Back Center in an effort to disqualify him from the position.  Rather:

McDonald does not dispute that Webasto could rightfully require and even condition his employment on the results of the medical examination.  Nor does McDonald suggest that the physical requirements contained in Webasto’s position description, against which his ability to perform job-related functions was measured, for anything other than job-related and consistent with business necessity.  He has provided the Court with no citation to relevant statute, regulation or case law to support his argument that an employer cannot seek a second opinion or that his pre-employment inquiry is per se limited once an initial evaluation is received.

      With respect to the charge of breach of contract, Judge Hood noted that Kentucky follows the rule of employment-at-will, stating that to be the rule unless there is a “clearly manifested intent” to the contrary.  There being no showing of a contract of employment other than on terms of at-will, the Court found there could be no action for breach of any such contract. 

      The Court went on to note that an at-will employee cannot assert promissory estoppel as the basis for damages.  2013 WL 5676226, *6.

Counsel for Partnership Disqualified Based Upon “Substantially Related” Work on Behalf of a Partner

Counsel for Partnership Disqualified Based Upon

“Substantially Related” Work on Behalf of a Partner

 

      As described by the Sixth Circuit, this case is about the meaning of “substantially related” in the context of the rule disqualifying counsel from being adverse to a former client as to a “substantially related” matter.  Bowers v. The Ophthalmology Group, __ F.3d __, 2013 WL 5763173 (6^th Cir. Oct. 25, 2013).

      Bowers was a partner in The Ophthalmology Group, LLP; she was expelled from the partnership in 2010.  She filed suit over that expulsion under Title VII and Kentucky law.  She moved to disqualify the partnership’s attorney on the basis that another attorney in the same firm (M&L) had previously represented Bowers on a substantially related matter.  Specifically, she referenced assistance from the firm on an ultimately uncompleted effort to open an ophthalmology practice in Louisville and counsel provided the partnership several years prior on the expulsion of another partner.

      The trial court dismissed the Title VII claim as Bowers was a partner and not covered thereby, determined to not exercise supplemental jurisdiction over the state law claims, and dismissed as moot the motion to disqualify counsel.  This appeal followed.

      The Sixth Circuit held (i) the motion to disqualify counsel should have been addressed before considering the merits of Bower’s claims and (ii) the counsel should have been disqualified.  As to the first point it wrote “A district court must rule on a motion for disqualification of counsel prior to ruling on a dispositive motion because the success of a disqualification motion has the potential to change the proceedings entirely.”  2013 WL 5763173, *6.

      As to the substance of the disqualification, the burden is not upon the objecting former client to divulge the previously disclosed confidential information, and the court is to look to the type of information “as would normally have been obtained in the prior representation.”  2013 WL 5763173, *4, quoting Ky. S. Ct. R. 3.130 (1.9 comment 3).  For similar formula the court also cited the Hazard & Hodes treatise and the Restatement (3^rd) of the Law Governing Lawyers.  Addressing only the representation as to opening another practice in Louisville, the Court created hypothetical disclosures that Bower’s might have made and then explained how they might be detrimental to her in this case, acknowledging them to be “scenarios.”  2013 WL 5763173, *5.  Still, these hypothetical scenarios were enough to disqualify M&L.

      Judge Griffin filed a dissent to the majority’s determination that a conflict existed and that M&L should have been disqualified.  Beginning from the rule that motions to disqualify are viewed with disfavor, she would have found there to be no conflict as there was no “substantial relationship” to the earlier matters.  As to the earlier partner expulsion, the discussions were between all of the partners and M&L as its counsel.  On that basis she found there to be no possibility of confidential communications between Bowers and M&L.  2013 WL 5763137, *7.  As for opening a Louisville practice, those plans were disclosed to the partnership’s other partners and never materialized.  Judge Griffin was unable to see those earlier efforts as being substantially related to defending the partnership against Bower’s discrimination claims, characterizing the majority opinion as “rife with speculative scenarios.”

Nevada Supreme Court Addresses Member Status Upon Failure to Make Contribution to LLC

Nevada Supreme Court Addresses Member Status

Upon Failure to Make Contribution to LLC

      Recently the Nevada Supreme court addressed the question of whether a member of an LLC who failed to make an initial capital contribution was or was not a member.  Kaufman v. HLK, LLC, 2013 WL 5230797 (Nov. Sept. 12, 2013).

      Kaufman and Hawley formed HLK, LLC.  Kaufman’s initial capital contribution, to the extent paid, came from Hawley.  Ultimately the trial court “concluded that Kaufman lacked an ownership interest in HLK.”  This appeal followed.

      The Nevada Supreme Court came down on Kaufman’s side.  Under the Nevada LLC Act a capital contribution may be in the form of a promise to contribute, and a failure to do so creates a claim in favor of the LLC against the defaulting member.  N.R.S. § 86.391.  The statute did not define a consequence of a failure to perform as being a forfeiture of the membership interest.

      HLK, LLC was being dissolved, so the outstanding question was what was Kaufman’s sharing ratio in the net proceeds.  If his membership interest was forfeited his ratio would have been 0%.  The Court rejected forfeiture.  The operating agreement defined Kaufman’s interest, and he was entitled to that portion of the net proceeds after satisfaction therefrom of the outstanding liability.

      The Kentucky LLC Act is in this respect similar to that of Nevada, allowing a contribution in the form of a commitment to contribute (KRS § 275.195(2)) and providing that the LLC’s remedy for a failure to contribute is a claim in damages for cash.  KRS § 275.200(3).

      It bears noting that good drafting can avoid this problem.  An operating agreement may obligate a signatory to make a contribution (see KRS § 275.200(1)) and may provide any of a variety of consequences for the failure to perform including that he or she is not a member until the contribution is made or for forfeiture of the interest upon default.  See KRS § 275.003(2).

Rules of Professional Conduct and Employment-at-Will

Sixth Circuit Court of Appeals Hold That Requirement That Attorney Violate Ethical Rules Does Not Constitute an Exception to the Rule of At-Will Employment

      A recent decision out of the Sixth Circuit Court of Appeals held, inter alia, that an assertion by an attorney that he was fired for his refusal to violate what he understands to be his ethical obligations under the Kentucky Rules of Professional Conduct will not constitute an exception to Kentucky’s rule of employment-at-will.  Gadlage v. Winters & Yonker, Attorneys at Law, PSC, ___ Fed. Appx. ___, 2013 WL 5749547 (6^th Cir. Oct. 24, 2013).

      Anthony Gadlage, an attorney, was dismissed from his employment by the Winters & Yonkers firm (W&Y) alleging due to his refusal to refer clients to the “Ask Gary” medical service providers.  In his wrongful discharge suit, he asserted that the rules applicable to Kentucky attorneys fall within the scope of the “public policy” exception to Kentucky’s general applicable rule of employment-at-will.  Gadlage also asked the Federal District Court to certify to the Kentucky Supreme Court the question of whether “a violation of the Kentucky Supreme Court Rules can form the basis of a wrongful discharge claim as a ‘public policy’ exemption to the employment-at-will doctrine.”  

      The trial court upheld W&Y’s motion to dismiss for failure to state a claim on which relief can be granted.  On a motion for reconsideration, the District Court refused to certify the question believing it had already been sufficiently addressed by the Kentucky Supreme Court. 

      Curiously, while the Sixth Circuit acknowledged that Greissman v. Rawlings & Associates, No. 12-CI-00744 (Oldham Cr. Ct. Apr. 8, 2013) and Isaacs & Isaacs, PSC v. Rigor, No. 05-CI-7688 (Jefferson Cir. Ct. Oct. 18, 2010) both held, inter alia, that the Rules of Professional Conduct may support a public policy exception to the rule of at-will employment, the Court of Appeals retreated from the question, upholding the dismissal on what is effectively an insufficient pleading standard, namely:

Even if obligatory Supreme Court Rules can ground a public-policy exception to the at-will doctrine, Gadlage does not allege a singular particularized Rule violation in his complaint or in his appellate briefing.  He relies instead on vague and generalized statements about third-party conflicts of interests and obligations to clients.  Gadlage has thus failed to state a claim that is “plausible on its face.”

      A dissenting opinion by Judge White would have referred to the Kentucky Supreme Court the question Gadlage sought to be certified and she would also have found that the pleadings were sufficient to avoid dismissal.

      With due respect to the majority, I found this decision to be quite unsatisfactory.  The Kentucky Supreme Court alone has the final voice on the interpretation and application of the Rules of Professional Conduct.  The Sixth Circuit’s affirmance of the trial court’s refusal to certify the question, not wanting to “trouble” the Kentucky Supreme Court, is without justification.  In fact, not “troubling” the Supreme Court with this question has created uncertainty as this decision and those in the Greissman and Isaac cases are in conflict; a certification would have provided a clear opportunity for its resolution.