This blog, written by Thomas E. Rutledge, focuses primarily on business entity law in Kentucky. Postings on contract law, contractual and statutory construction, and the entity law of other jurisdictions appear as well. There may as well be some random discussions of classical, medieval and renaissance history.
Wednesday, June 4, 2014
Chou v. Chilton – Round Two
Chou v. Chilton – Round Two
The case of Chou v. Chilton has again been reviewed
by the Court of Appeals.Chou v. Chilton, __ S.W.3d __, 2014 WL
2154087 (Ky. App. May 23, 2014).
Chou was the 51% member and the
managing member of Ram.Chou LLC, a company engaged in the construction industry
and structured to take advantage of certain minority set-aside programs.After the LLC lost its Minority Business
Enterprise (MBE) certification its activities were terminated.Chou brought suit against the LLC’s other
members, the Chiltons, alleging a variety of claims.
In this dispute’s first trip to
the Court of Appeals, the Court reviewed the counts from the perspective of a
CR 17.01 “real party in interest” and found that Chou was seeking, for himself,
damages for injuries suffered by the LLC.In that he was not the real party in interest he could not bring those
claims.See Chou v. Chilton, 2012 WL 6526184 (Ky. App. Nov. 16, 2012).
After remand, Chou added the
LLC as a plaintiff and continued prosecuting the case.The claims raised were for:
·judicial dissolution of
·an accounting of the
·breach of the Chilton’s
duty of loyalty;
funds by the Chiltons;
·breach of fiduciary
·breach of the covenant
of good faith and fair dealing; and
Chou also sought punitive
damages.The trial court dismissed all
of Chou’s individual claims on the basis of not being the real party in
interest.The Court of Appeals reviewed
these claims seriatim to determine,
as to each, whether Chou was the real party in interest.
On the basis that the LLC Act,
at KRS § 275.290(1), permits a member to bring an action for an LLC’s judicial
dissolution, the Court of Appeals found Chou had standing to bring this
claim.2014 WL 2154087, *3.
Citing KRS § 275.306(2), the
Court of Appeals wrote that “on a request for dissolution, the assets and
liabilities of the company must be accounted for prior to distribution” and
that “this would be the natural next step in the dissolution of the
company.”As Chou could move for the
LLC’s judicial dissolution, the Court of Appeals held he could bring a claim
for an accounting in connection therewith.2014 WL 2154087, *3.
More on this point below.
of the Duty of Loyalty/Fiduciary Duty
First equating a breach of the
duty of loyalty and a breach of fiduciary duty, the Court noted that Chou, in
reliance upon Patmon v. Hobbs, argues
the rule to be “that every member of a [LLC] owes a duty of loyalty and
fiduciary duty to every other member of the company.”2014 WL 2154087, *4.Rejecting that assertion the Court wrote:
If this is true, Chou would have
standing to bring this claim against the Chiltons. This is not an accurate
reading of Patmon. In that case, a previous panel of this Court held
that managing members of a limited liability company have a fiduciary duty to
other members of the company. Id. at 595. In this case, the Operating
Agreement indicates that Chou is the managing member. The Chiltons did not owe
a fiduciary duty to Chou; therefore, he has no standing to bring these
claims.2014 WL 2154087, *4.
Judge Thompson would dissent
from this aspect of the decision, writing:
The Patmon Court did refer to the duties of managing members throughout
its opinion and, logically so, because the defendant was the managing member of
the company. However, it did not exclude the members of a limited liability
company from the same duties. Just as partners owe the utmost good faith to
each and every other partner, members of a limited liability company owe a
fiduciary duty to fellow members and the company. Patmon, 280 S.W.3d at 595.2014 WL 2154087, *5.
on this point below.
The Court quickly dismissed
this claim, noting that any recovery for misappropriation for the LLC would
flow to the benefit of the LLC and not to Chou individually, even if the pool
of assets from which he would receive liquidity distributions were increased
thereby.2014 WL 2154087, *4.
Faith and Fair Dealing
The Court of Appeals began by noting
that in every agreement there is an implied covenant of good faith and fair
dealing and that the subject contract is the LLC’s operating agreement.In that the operating agreement provided that
members could sue other members for its breach, the Court of Appeals determined
that Chou could bring this claim.2014
WL 2154087, *4.
on this point below.
The case was remanded to the trial
court “for proceedings consistent with this opinion.”
on the Claim for an Accounting
The primary weakness of the
Court of Appeal’s statement that Chou has the right to move for an accounting
is that the statute cited, namely KRS § 275.300(2), does not support an
accounting claim.KRS § 275.300(2) does
not include the word or by its terms provide for an “accounting.”That subject statute sets forth a
nonexclusive list of the activities that may be undertaken by a LLC subsequent
to its dissolution.These are simply
rights of the LLC, and no member, as a member, is afforded any rights
The problem here may be one of
nomenclature, but it is important nomenclature.An “accounting,” as that term is utilized in the law of unincorporated
business organizations, is a dispute resolution mechanism amongst the owners by
which they resolve any inter-se
claims and distribute the remaining assets in accordance therewith.See,
Unif. Part. Act § 807, 6 (pt. I) U.L.A. 206 (2001); KRS §
362.1-807.The Kentucky LLC Act does not
contain such a provision.While, at
common law, an obligation to account can exist amongst fiduciaries, imposing
upon the Chiltons an obligation to account to Chou would have to be premised
first upon the determination that the Chiltons owed Chou a fiduciary
obligation.In that KRS § 275.300(2)
does not support an action for an accounting, and as this Court of Appeals
panel found that the Chiltons did not themselves stand in a fiduciary
relationship with Chou, the order of an accounting was normatively in error.
on the Claim for Breach of the Implied Covenant of Good Faith and Fair Dealing
The Court’s conclusion that
Chou had standing as a real party in interest to bring a claim for breach of
the implied covenant of good faith and fair dealing as to the Chiltons alleged
obligations under the Operating Agreement is somewhat unsatisfactory in its
lack of precision as to what claims may be brought.This is not to say that the implied covenant
of good faith and fair dealing does not exist in operating agreements.To the contrary, the LLC Act is specific that
it does.See KRS § 275.003(7).Rather, the criticism is that the Court did not delve into the
counter-party of the obligations allegedly breached to determine whether they
exist only in favor of the LLC or in favor of another member.
By way of example, assume an
operating agreement in which a member, A, makes a commitment to the LLC on a
particular day in the future, to contribute $10,000 to the LLC’s capital.Consider another provision which obligates A
to teach member B how to operate the LLC’s accounting system.Upon A’s breach of the commitment to
contribute additional capital to the LLC, it is difficult to see how any other
member could bring a claim for that breach.Rather, even as the operating agreement is a multi-lateral agreement
amongst the LLC and all of the members (KRS § 275.015(20); id. § 275.003(3)), the contribution commitment was given only to
the LLC and only it is the “real party in interest” who may object to a failure
to perform thereon.As to the second
provision, it is a bilateral commitment between one member to another member
for which, upon lack of performance by A, B would presumably have a right to
bring a claim for breach.
The decision by the Court of
Appeals does not identify the provisions of the LLC Act that Chou asserts were
violated by the Chiltons.By failing to
parse those individual provisions to see whether they were for the benefit of
the LLC, the benefit of other particular members, or mixed, the Court of
Appeals failed to fully address the question of whether Chou could bring a
claim for breach of the provisions and the related implied covenant of good
faith and fair dealing.
on the Breach of the Duty of Loyalty
Both the majority decision and
the dissent are off-base as to the question of the duty of loyalty.
majority decision found that under Patmon
the managing member owes a fiduciary duty of loyalty, the Chiltons were not
managing members, and therefore they did not have a duty of loyalty.The fault here was reliance upon Patmon rather than the statute.The Kentucky Supreme Court has decreed that
LLCs are creatures of statute.See Pannell v. Shannon, __ S.W.3d __,
2014 WL 1101472, *7 (Ky. March 20, 2014):
In fact, “limited liability
companies are creatures of statute,” controlled by Kentucky Revised Statutes
(KRS) Chapter 275,” Turner v. Andrew,
413 S.W.3d 272, 275 (Ky. 2013) (quoting Spurlock
v. Begley, 308 S.W.3d 657, 659 (Ky.2010)), not primarily by the common law.
To the extent that common law doctrines could arguably govern limited liability
companies, the Kentucky Limited Liability Company Act “is in derogation of
common law,” KRS 275.003(1), and the traditional rule of statutory construction
that “require[s] strict construction of statutes which are in derogation of
common law shall not apply to its provisions.” Id. Thus, to the extent the statutes conflict with common law, the
common law is displaced.
This Court must therefore first look
at the controlling statutory law.
review of the statute the Court would have seen the “switch” set forth in KRS §
275.170(4).In that Ram.Chou LLC was
member-managed, determined as provided in its articles of organization (see KRS § 275.165(1)), the duty of
loyalty is owed by all members.To that
end the Court’s dismissal of Chou’s claims for breach of the duty of loyalty
is not to say the Court’s conclusion that Chou could not in his own name bring
a claim for breach of the duty of loyalty was incorrect.Rather, this is a case of right answer, wrong
reason.The LLC Act, in addition to
defining the duty of loyalty and saying who owes it, defines also who is its
beneficiary, namely the LLC.See KRS § 275.170(20 (“account to the
[LLC] and hold as trustee for it”) (emphasis added).Chou could not bring a claim for himself
based upon the Chilton’s breach of the duty of loyalty, not because no duty was
owed by them (it was), but because Chou was not its beneficiary.
to the dissent, it was correct in referencing the statue to determine who owes
the duty of loyalty.It failed, however,
to appreciate that the same statute defined the beneficiary of the duty.Further, the dissent’s repetition of Patmon’s analogy of LLC members to
partners is contrary to the statutory language it had just cited and the Pannell v. Shannon directive that LLCs
are not creatures of the common law.