Thursday, December 29, 2016
Will No One Rid Me of This Turbulent Priest?
Today marks the anniversary of the murder in 1170 of Saint Thomas Becket. This murder has always been the most serious stain upon the reign of King Henry II
Of Norman descent (the movie Becket inaccurately has Henry referring to Becket as a Saxon), Becket rose to be appointed Lord Chancellor of England. While Chancellor Henry nominated Becket (who at this time was not a priest) to the position of Archbishop of Canterbury, clearly hoping that Becket would use his power as primate of England to mold ecclesiastical policy in favor of royal interests. Becket failed to do so, rather becoming an ascetic and placing the interests of the Church over those of the crown. Eventually he was forced to resign as Lord Chancellor.
The contest of wills between Henry and Becket over the Constitutions of Clarendon, they seeking to increase the power of the civil state over the Church and its constituents, led to a final break in the relationship, with Becket even fleeing England for France. Eventually he would return to Canterbury.
While in France and likely well into his cups, Henry made a statement (exactly what was said is lost to history – there are conflicting accounts) that was interpreted by four knights as a direction to kill Becket. They crossed the Channel and challenged Becket in Canterbury Cathedral, there killing him. Becket was canonized barely three years later, and the four assassins were excommunicated and ordered to go on pilgrimage to the Holy Land (at least one of them thereafter became a Templar). Henry would later do public penance at Becket’s shrine in Canterbury Cathedral.
There is a passing reference to Becket in The Lion in Winter.
Wednesday, December 14, 2016
Court Incorrectly Treats Assets of Dissolved LLC as the Assets of the LLC's Members
The procedure followed in Ceres Protein, LLC v Thompson Mechanical & Design, Civ. Act. No. 3:14-CV-00491-TBR-LLK, 2016 WL 6090966 (W.D. Ky. Oct. 18, 2016) upon the administration of dissolution of an LLC was simply incorrect.
Therein, Ceres Protein, LLC, a plaintiff in the action along with Shannon, one of its members, was administratively dissolved. Thereafter the defendants moved to substitute Tarullo, the other of Ceres Protein, LLC's members, for the LLC. When, ultimately, the LLC was reinstated, it was substituted back in for Tarullo, in effect returning the parties to the place they were at the initiation of the lawsuit.
The issue is that the LLC need never have been removed as a party to the suit. The dissolution of an LLC does not limit its capacity to participate in litigation. See KRS § 275.300(4)(a). Furthermore, dissolution does not vest in the members the property, including the legal rights, of the LLC. See KRS § 275.300(3)(a). But that is what the substitution of Tarullo purported to do.
The error of treating the members of Ceres Protein LLC as the owners, upon dissolution, of the LLC’s assets was ultimately corrected, but it should not have needed to be remedied in the first place.
Wednesday, December 7, 2016
The Assassination of Cicero
Today marks the anniversary of Cicero in 43 B.C. A lawyer, politician, writer and orator, his letters serve as both a source for the goings-on in a tumultuous period in Rome and as guidance for the art of letter writing.
Thinking Marc Antony to be little more than a thug, Cicero took the additional step of detailing his views in a series of speeches, hoping to reduce Antony’s influence for the benefit of Octavian, Caesar’s heir. When, however, Octavian and Antony joined forces in the Second Triumvirate, Cicero’s days were numbered, and he was “proscribed” (i.e., ordered executed and his property seized). While the depiction of his execution as portrayed in the HBO series Rome was true to his character, it in fact took place on a road with Cicero riding in a litter; he did not resist.
Monday, November 28, 2016
Allegations of Diversity Substantively Lacking Even as Question of Citizenship of Statutory Trust is Raised
Allegations of Diversity Substantively Lacking
Even as Question of Citizenship of Statutory Trust is Raised
In a recent decision from New York, a plaintiff bank’s complaint was dismissed for failure to adequately respond to repeated admonitions from the court as to the requirements for setting forth the basis of diversity jurisdiction. As the plaintiff, it was the obligation of US Bank to detail the citizenship of the various parties to the dispute. It failed to do so both as to itself and as to Rome Savings Bank, the holder of a subordinate lien on the property for which foreclosure was sought. In addition, the court raised the question of whether the bank, as the trustee, was the correct party in interest or, weather, statutory trust for which it served as the trustee should be treated as the real party in interest. U.S. Bank Trust, N.A., As Trustee for LSF Master Participation Trust v. Dupre, No. 6:15-CV-0558 (LEK/TWD), 2016 WL 5107123 (N.D.N.Y. Sept. 20, 2016).
As to Rome Savings Bank, US Bank was called to task for not pleading its jurisdiction of organization or its form of organization. As to the last point, it plead that “Rome Savings Bank is a corporation or other business entity.”, a statement characterized as saying “effectively nothing about how its citizenship is properly determined.”
Even more surprising was that US Bank was apparently unable to correctly plead its own citizenship. A statute applicable to national banks such as US Bank provides that they are citizens of the state in which is located the main office as set forth in the articles of association filed with the Comptroller of the Currency. US Bank plead the location of its “principal executive offices” and “principal place of business.”
Here, US Bank failed to provide its articles of association, and failed to state anywhere in its memorandum that Delaware is the state listed as the location of its main office in the articles of association. Because US Bank failed to provide its articles of association or other comparable evidence of the bank’s main office, as it was directed to do in the Court’s July Order, the Court finds that US Bank has not sufficiently established its citizenship for purposes of diversity jurisdiction. 2016 WL 5107123, *3.
Even beyond U.S. Bank’s failure to properly establish its own citizenship, it has also failed to show that its citizenship alone may be counted when bringing suit on behalf of the LSF8 Master Participation Trust. In Americold Realty Trust v. Conagra Foods, Inc., 136 S. Ct. 1012 (2016), the Supreme Court addressed the diversity citizenship of a real estate investment trust (“REIT”) created under Maryland law. Noting that states “have applied the ‘trust’ label to a variety of unincorporated entities that have little in common with” traditional, gift-based trusts, the Court found that for business trusts that are separate legal entities and can sue or be sued in their own right, the citizenship of all the trust’s shareholders or beneficiaries is dispositive. Id. at 1016–17.
The court raised the question of whether US Bank, on behalf of the LSF8 Master Participation Trust, could proceed in its own name, in which instance only its citizenship would have been at issue, or whether the citizenship of all of the participants in that trust would as well be at issue. Applying the Americold decision, even as it criticized counsel for not well addressing the jurisdictional question, the court wrote:
U.S. Bank responds to Americold by noting that, unlike the REIT at issue in that case, here U.S. Bank brought suit in its own name as trustee and was “authorized to act on behalf of” the trust under the trust instrument. Indeed, the Court in Americold left intact the rule that “when a trustee files a lawsuit in her name, her jurisdictional citizenship is the State to which she belongs—as is true of any natural person.” 136 S. Ct. at 1016 (citing Navarro Sav. Ass’n v. Lee, 446 U.S. 458, 465 (1980)). This rule, however, only applies when the trustees are the real parties in interest to the controversy, meaning, among other things, that they are “active trustees whose control over the assets held in their names is real and substantial.” Navarro, 446 U.S. at 462–66.
While the Court asked U.S. Bank to provide evidence on this point (namely, the trust instrument), it has utterly failed to do so. The trust agreement attached to the Second Memorandum was almost completely redacted, and the only visible portion remaining—cited by U.S. Bank as apparently showing its active control over the trust—states that U.S. Bank “shall have only such rights, powers and duties as are specifically and expressly required by this Agreement.” If anything, this provision seems to expressly reject the idea that U.S. Bank is an active trustee with real and substantial control over the trust’s assets (and thus that U.S. Bank is the real party in interest under Navarro). If the rest of the trust agreement shows differently, U.S. Bank has rendered this impossible to determine by filing an otherwise completely redacted version of this document.
Despite U.S. Bank’s argument, this Delaware statutory trust seems precisely like the type considered by the Supreme Court in Americold, and U.S. Bank has failed to demonstrate that it is a real party to the controversy that can proceed in its own right and without reference to the citizenship of the trust’s beneficiaries, cf. Del. Code Ann. tit. 12, § 3804(a) (“A statutory trust may sue or be sued [in its own name] ....”). For all of these reasons, this action must be dismissed for lack of subject matter jurisdiction. 2016 WL 5107123, *4.
Clearly the Americold decision must be addressed anytime a party to the case brought under federal diversity jurisdiction involves a “trust.”
Wednesday, November 23, 2016
No Implied “Disinterested” Limitation in Approving Transfers of LLC Interest
Peter Mahler, in his blog New York Business Divorce, has provided an excellent review of the decision recently handed down in Huang v. Northern Star Mgmt. LLC, 2016 N.Y. Slip Op. 32194(u) (Oct. 24, 2016). HERE IS A LINK to that review. I write as well to emphasize the question of whether a vote of the members must be disinterested and the application of the rule of independent legal significance.
Tai Huang was a member in Northern Star Management LLC, a New York LLC, holding a 13.5% interest therein. Ling Lian Huang held another 13.5% interest, while Jian Chai Qu held a 6% interest; those three comprised the “Minority Members.” The balance of the 67% interest in Northern Star (“NSM”) was held by four unnamed and otherwise undifferentiated members (the “Majority Members”).
After the settlement of litigation between the Minority Member and the Majority Members regarding the financing of NSM property, the Majority Members effected a cash-out merger of the Minority Members. This was accomplished by (i) the Majority Member casing to be created NewCo; (ii) the Majority Members transferring to NewCo their respective interests in NSM, receiving in return interests in NewCo; (iii) NewCo approving, as the Majority Member of NSM, a merger of NewCo with and into NSM pursuant to which all other members of NSM (i.e., the Minority Members) would be cashed-out.
The Minority Members sought to set aside the merger on the basis that NewCo was not a member of NSM because the Majority Members’ transfers of LLC interests to its violated § 9.3 of the NSM operating agreement. Section 9.3 of the NSM Operating Agreement provided that:
[a] Member may freely transfer his interest in [NSM] to another person or entity…, only with the prior majority consent of other Members either in writing or at a meeting called for such purpose. If majority Members do not approve of the transfer, the transferee shall have no right to participate in the management of the business and affairs of [NSM] or become a Operating Member.
The Minority Members would assert that § 9.3 required the approval of a disinterested majority of the members in order to effect a transfer of interests in NSM to NewCo. The court refused to read into the operating agreement a limitation to the “disinterested” membership. Rather:
Despite the Huangs’s contentions, Section 9.3 of the NSM Operating is completely devoid of the term “disinterested,” which is the crux of the Huangs’s application. The plain language of the provision the Huangs cite to clearly permits a member to transfer their membership interest upon approval by a simple majority of members. It does not state that a majority of the disinterested members is required, as the Huangs assert (emphasis added by court).
From there the court concluded:
NSM and NewCo clearly established that for each of the four Majority Members each obtained majority consent from the other three Majority Members for their respective transfers. In each instance, the three non-transferring Majority Members held over 33% of the NSM membership interests, which was the collective NSM membership interest of the Minority Members. Consequently, the Minority Members never held enough membership interest in NSM to prevent or challenge the transfers.
The first takeaway is that absent the operating agreement requiring a disinterested vote, one will not be implied. Nothing too surprising there, although it should be recognized that where “unanimous” consent is required, courts have inserted a disinterested requirement to avoid absurd results. See, e.g., Young v. Ellis, 172 Wash. App. 1014 (Wash. Ct. App. Div. 2, Dec. 4, 2012) (where managing member of LLC was named in the operating agreement, and amendment of operating agreement required unanimous consent of the members, court rejected as “absurd” suggestion that managing member could be removed only with his consent. Rather, the operating agreement’s general rule of majority consent of the members would apply to removal of managing member.).
Perhaps of greater import, the court did not aggregate the Majority Members in assessing the transfer of the LLC interests in NSM to NewCo. Rather, each members’ assignment was approved, inter alia, by the other members within the Majority Members; it was as if there were four distinct transfers, each approved by the other of the Majority Members. Had there been aggregation, none of the Majority Members could have voted to admit NewCo as a substitute member, and only the Minority Members, they not participating in the capitalization of NewCo, could have done so. Assuming disaggregation of members who are acting in concert is the correct rule, it presents questions as to how an operating agreement should provide for disinterested votes. Consideration needs to be given to whether and when aggregate treatment will be provided for, being aware that on certain facts aggregation may have the effect of vesting control in a minority.
The default rule under the Kentucky LLC Act is that the admission of an assignee requires the approval of a “majority-in-interest” of the members. See KRS § 275.265(1). The Act is express that the member seeking to assign a limited liability company interest may not (unless there is a contrary provision in the operating agreement) vote with respect to the admission of the assignee as a member. Id. It is, however, silent as to collective action by several members, and is likewise silent as to an assignee’s inability to vote with respect to admission as a member vis-à-vis an additional traunch of interests.
Assume there is an LLC with 8 equal (12.5%) members. Five of those members want to transfer their interests to Laura (not already a member). In series, each of the five could transfer their interests to Laura as follows:
Laura’s Cumulative Interest Pre-Assignment
Assignment & Admission of Laura as a Member Approved By:
Laura’s Cumulative Interest Post-Assignment
Members 2, 3, 4 & 5 (57.14% of all interests other than those held by Member 1)
Laura and Members 3, 4 & 5
Laura and Members 4 and 5
Laura and Member 5
Applying the rule of independent legal significance (see KRS § 275.003(5)), members 6, 7 and 8 have had no voice with respect to Laura’s admission as a member. If, however, that result is not desired, then the operating agreement will need to: (i) waive the application of the rule of independent legal significance; (ii) adopt a test for aggregation; and (iii) provide that the participants in an aggregated transaction may not vote with respect to the admission of the assignee as a member.
Monday, November 21, 2016
More on the Mortgage Grader Decision
Previously I wrote on the decisions of the New Jersey trial and Appellate Division courts regarding the Mortgage Grader dispute and the question of whether a dissolving LLP must continue to maintain malpractice insurance in order for the firm’s partners to enjoy limited liability. Here are links to the discussions of the decision of the decision of the Appellate Division and how the case was presented to the New Jersey Supreme Court.
Earlier this year the New Jersey Supreme Court issued its decision in the case, reversing the decision of the Appellate Division and holding that malpractice insurance need not be maintained during the winding-up phase.
The Journal of Passthrough Entities has just published my review of that decision; HERE IS A LINK to that article.
Friday, November 18, 2016
Indiana Court Of Appeals Applies Venerable Rule Of "No Backsies" To Withdrawal From LLC
In a decision rendered last week by the Indiana Court of Appeals, it applied the general venerable rule of “No Backsies” with respect to a former member's effort to bring challenges to his removal from an LLC. Stocker v Sundholm, No. 02A-03-1603-PL-615, 2016 WL 568-5422 (Ind. App. Nov. 7, 2016).
Stocker had been a member, as well as an “employee,” of an Indiana LLC named Attero Tech LLC. On the basis that Attero’s business model had changed and Stocker's services as an employee were no longer needed, on June 23, 2011 he was provided with a notice of termination of employment, effective immediately. Thereafter, on September 1, a special meeting of the members of Attero was noticed for the purpose of discussing a buyout of Stocker's interest in the LLC. Stocker did not attend that meeting. However, thereafter, Stocker was presented with a withdrawal and redemption agreement pursuant to which his interest in the company would be redeemed. That agreement was accepted by Stocker, signed and delivered. The company has been performing on its redemption obligations. It contained a comprehensive release of claims against Attero and various of its representatives. Specifically, the release provided:
Departing Member [Stocker] hereby releases and forever discharges [Attero] respective directors, officers, employees, agents, shareholders, subsidiaries, affiliates, successors and assigns from any and all claims, demands, proceedings, causes of action, orders, obligations, contracts, agreements, debts and liabilities whatsoever, whether known or unknown, suspected or unsuspected, both at law and in equity, which [Stocker] now has or has ever had against [Attero] arising prior to the Effective Date; provided, however, that nothing contained herein shall operate to release obligations of [Attero] arising under this Agreement.
Nearly 4 ½ years after he signed the agreement, Stocker filed an action alleging a variety of claims including breach of contract, breach of fiduciary duty and fraud in the inducement. All of these claims were dismissed on summary judgment, and that was affirmed by the Court of Appeals.
The court found that the allegations that Stocker had been forced out of the company in breach of the operating agreement were barred by the release he had already given. Specifically, if he thought there had been a breach of the operating agreement, he would have known about that at the time he entered into the release. “Thus, by signing the Release, Stocker chose to forgo any breach of contract claims against the Defendants, including the one asserted herein.” 2016 WL 6585422, *3.
Likewise, with respect to the claim for breach of fiduciary duty, Stocker had knowledge of the facts underlying that claim prior to the time he executed the release. Having executed the release, that claim is barred.
With respect to the claims for fraudulent inducement, the court found that “‘Stocker had a duty to conduct due diligence to review any representations made by Attero and the Defendants in the Release’ before signing the Release” id.
The court, in conclusion, wrote:
In short, the undisputed evidence shows that Stocker was presented with the Release, which provided for redemption of his units in Attero and included mutual release provisions covering the Defendants. Stocker voluntarily signed the Release and thereafter accepted payments made by Attero in accordance therewith without objections. Having duly executed the Release, Stocker is barred from bringing his claims of breach of contract and breach of fiduciary duty. Stocker’s claim for fraud in the inducement also fails because the alleged misstatements concern matters that would have been known or should have been known by Stocker at the time he signed the Release, and yet he voluntarily signed the Release. The trial court did not err in granting summary judgment in favor of the Defendants.
Wednesday, November 16, 2016
A Partnership/Joint Venture Requires an Agreement to Share in Losses
A recent decision from the Appellate Division of the New York Supreme Court concluded that no joint venture existed absent an agreement to share losses. Maor v. Blu Sand International, Inc., 38 NYS3d 907 (Mem) (Supreme Court, App. Div., First Dept. Oct.20, 2016).
This being a memorandum opinion, the background facts are not set forth, so the nature of the underlying agreement between the plaintiff and the defendant is not clear. Still, the Appellate Division determined that the defendant was entitled to summary judgment. The claims for which summary judgment was granted include those for an accounting based on, apparently, the alleged joint venture/partnership. As to the claim for an accounting, it was dismissed because the plaintiff it failed to show a necessary fiduciary between the parties.
As for the allegation that there existed a joint venture (partnership) between the plaintiff and the defendant, that allegation was rejected as there was no evidence proffered that the plaintiff had agreed to participate in the losses as well as the profits of the venture.
Friday, November 11, 2016
I mean, who writes this stuff? (III)
Recently I did a quick Google search and was able to locate operating agreements that can be downloaded off of the internet for free. Based on my review, you get exactly what you pay for. In fact, one of these “free” operating agreements essentially guarantees increased legal fees later on. But as is said, “You can pay me now or you can pay me later.”
Keep in mind that an operating agreement defines the relationship amongst the members of an LLC. Invariably, there will be some dispute between the members of the LLC that must be resolved by reference to the operating agreement and the underlying LLC Act. If the operating agreement does not provide clear resolution, either by dictating an answer or clearly dictating the mechanism by which the dispute will be resolved, there is the recipe for a law suit.
So let’s just consider just a few of the points of this “free” operating agreement.
1. First, with respect to formation of the LLC, this agreement provides:
The Members hereby form a Limited Liability Company (“Company”) subject to the provisions of the Limited Liability Company Act as currently in effect as of this date. Articles of Organization shall be filed with the Secretary of State.
Initially, this operating agreement describes a process for the formation of an LLC that is exactly backwards. An LLC is formed not by agreement of the members, but by the filing of articles of organization with the Secretary of State. You cannot form an LLC before the articles of organization are filed. That, however, is exactly what this agreement provides.
2. That operating agreement goes on to provide:
1.4 TERM. The Company shall continue for a perpetual period.
(a) Members whose capital interest as defined in Article 2.2 exceeds 50% vote for dissolution; or
(b) Any event which makes it unlawful for the business of the Company to be carried on by the Members; or
(c) The death, resignation, expulsion, bankruptcy, retirement of a Member or the occurrence of any other event that terminates the continued membership of a Member of the Company; or
(d) Any other event causing the dissolution of this Limited Liability Company under the laws of the State of __________.
Initially, demonstrating a lack of attention to the agreements structure, why is “this Limited Liability Company” utilized in 1.4(d) when the defined term “Company” is already set forth in section 1.1.?
Evidencing even further lack of attention to both the structure of the document and as well its wording, what is the effect of any of the events set forth in 1.4(a)-(d)? The lead in sentence simply states “The Company shall continue for a perpetual period.” Nowhere is it provided that the perpetual existence shall be qualified by any of 1.4(a)-(d).
If it is intended that the events set forth in 1.4(a)-(d) shall effect the dissolution of the LLC, it really should have said so.
3. Section 3.2 this operating agreement provides that “The Members shall determine and distribute available funds annually or at more frequent intervals as they see fit.” So the members decide if the distribution will be made. However, Section 4.2 of the same agreement goes on to provide that the “Members that are not Managers shall take no part whatever in the control, management, direction, or operation of the Company’s affairs.” But isn’t deciding to make a distribution participation in the management of the Company’s affairs? The two provisions are in contrast with one another, especially when it is noted that Section 4.3 affords to the managers the power to make all decisions with respect to “the management or all or any part of the Company’s assets.” Simply put, the drafting is bad in that it is inconsistent.
4. The agreement goes on, in Section 4.9, to recite certain documents that must be kept, including a copy of the “Certificate of Formation.” This is curious in that Section 1.1 calls for the company to file Articles of Organization with the Secretary of State.
5. Section 5.1 of this operating agreement provides that a manager shall be entitled to compensation “commensurate with the value of such services.” The agreement does not address who has the authority to make the determination of a manager’s compensation. Is it intended that that fall within the authority of the managers as set forth in Section 4.3? Is it actually intended that the managers have the unilateral authority to set their own compensation? However, if it is intended that the members determine the appropriate compensation of the managers, that is nowhere set forth in the agreement.
6. This same agreement, at Section 6.2, goes on to provide:
MEMBER’S ACCOUNTS. The Managers shall maintain separate capital and distribution accounts for each member. Each member’s capital account shall be determined and maintained in the manner set forth in Treasury Regulation 1.704-1(b)(2)(iv) and shall consist of his initial capital contribution increased by:
(a) any additional capital contribution made by him/her;
(b) credit balances transferred from his distribution account to his capital account;
and decreased by:
(a) distributions to him/her in reduction of Company capital;
(b) the Member’s share of Company losses if charged to his/her capital account.
First, why in the second (b) subparagraph is Member capitalized while member is not otherwise capitalized in this Section 6.2. Also, what is up with rotating among “his,” “him/her” and “his/her”?
That aside, what is described in this provision as to how the capital accounts will be maintained is inconsistent with the cited regulation. It is impossible for the managers to both comply with the cited treasury regulation and the express provisions of this operating agreement. It must only be assumed person who wrote this agreement does not have an appreciation for the requirements of how capital accounts must be maintained in order that the LLC will satisfy the alternative test for substantial economic. I am going out on a limb here and will posit that the author of this document would be mystified by the phrase “alternative test for substantial economic effect.”
As mentioned above, you get you pay for. Badly written operating agreements are often worse than not having an operating agreement at all. Failure at the beginning of the relationship that will be an LLC to clearly define the rights and responsibilities of the parties does little more than set up the ultimate litigation. Repeating myself from prior postings, I am always amazed at the willingness of general practitioners to draft operating agreement. While nobody will “take a stab” at writing a 401(k) plan, it seems everybody thinks they can write an operating agreement.
Thursday, November 10, 2016
The Off-Again, On-Again Limits on Arbitration Clauses in Nursing Home
There is in Kentucky a famous case dealing with the enforceability (or not) of an agreement to arbitrate disputes arising out of residency in a nursing facility. The name of that case, Ping v. Beverly Enterprises, Inc., 376 S.W.3d 581 (Ky. 2012), brings to mind the back-and-forth nature of a ping-pong match. This is a worthy analogy for certain recent developments in arbitration law.
Earlier this year, the U.S. Department of Health and Human Services’ Centers for Medicare and Medicaid Services issued a rule that barred nursing homes from requiring patients to agree to arbitrate claims. As such, any patient claims would be resolved by lawsuits filed in court. While arbitration clauses pre-existing the regulation’s effective date (Nov. 28, 2016) would remain in effect and be enforceable, from the effective date of the rule, they could not be put in place.
The rule is not long-lived. On November 7 a federal district court in Mississippi issued an injunction barring the enforcement of the new rule. But for this injunction, it would have gone in effect on November 28. Therefore, at least for the time being, nursing homes that receive either Medicare or Medicaid reimbursement (and there are very few that do not), may continue to include arbitration clauses in their admission documents.
Friday, November 4, 2016
As I have otherwise noted, a significant portion of my practice is devoted to both writing operating agreements and as well reading operating agreements written by others. Sometimes, in the latter role, I am just shocked by what I read.
For example, recently I was reviewing an operating agreement, written by an attorney in another law firm here in Louisville (I’m not going to disclose either the attorney or the firm), which contained a provision modifying (well, maybe modifying) the fiduciary duties that applied in the LLC. The Kentucky LLC Act expressly permits the modification of the fiduciary duties provided that such is done in a written operating agreement. See KRS § 275.170. It needs to be understood, however, that modifying fiduciary duties is a very complicated procedure for which a series of questions must be addressed. Fail to address any of those questions, and ambiguity is created.
Fiduciary Duties of Members and Managers. Each Member and Manager shall have a fiduciary duty of good faith, loyalty and fair dealing towards the Company and the Members. Nothing in this paragraph [XX] shall be interpreted or applied to alter the explicit terms of this Agreement or the Act, including without limitation, the limitations set forth in this Agreement and the Act (including without limitation, KRS 275.150) on a Member’s obligation to contribute towards the liabilities of the Company or other Members.
Okay, let’s start breaking this down.
Initially, the LLC governed by this operating agreement has elected to be manager-managed. As such, pursuant to KRS § 275.170(4), while the managers owe fiduciary duties, the members do not. The first sentence of this provision provides, however, that each “member” shall owe a “fiduciary duty” to the company and to the members. As such, this provision imposes duties upon the members to which they would not otherwise be bound.
As recited above, members and managers owe the fiduciary duties of “good faith, loyalty and fair dealing.” However, none of these terms are defined in the operating agreement, and they are not elsewise well-defined in Kentucky law. As such, what is meant by an obligation of “good faith” is indeterminate. The same would apply to a fiduciary obligation of “fair dealing.” While there is the implied contractual covenant of “good faith and fair dealing,” that is a principle of contract, and not a fiduciary, law, so what is meant by that term cannot be applied in determining what are these fiduciary duties. Likewise, while there are a category of obligations that are generally categorized as falling within a fiduciary “duty of loyalty,” there is no freestanding definition of what is the fiduciary duty of loyalty. Ultimately, while the sentence has passed spellcheck, it is functionally ambiguous as to what are the fiduciary duties undertaken.
The above quoted language goes on to provide that “Nothing in this paragraph shall be interpreted or applied to alter the explicit terms of ... the Act.” Except it does exactly that. First, as noted above, this is a manager-managed LLC. The members, pursuant to the terms of the Act, do not owe fiduciary duties. The lead-in sentence of this provision, however, imposes fiduciary duties upon the members. In so doing, the language of the agreement serves to “alter the explicit terms of … the Act” with respect to who owes the fiduciary duties.
The Kentucky LLC Act contains comprehensive provisions as to what is the duty of care and what is the duty of loyalty imposed in an LLC. None of those formulae include either “good faith” or “fair dealing” as fiduciary obligations. As such, the language employed in this provision would again “alter the explicit terms of … the Act,” thereby potentially rendering the references to “good faith” and “fair dealing” nullities. Conversely, while the LLC Act does recognize a duty of loyalty, it provides specific requirements as to what is required of that obligation. Therefore, in order to avoid any alteration of the explicit terms of the Act, “loyalty” as employed in this operating agreement likely should be interpreted as in effect incorporating by reference the statutory duty of loyalty.
Under the language above quoted, the duty of loyalty is owed “the Company and the Members.” A duty of loyalty and may be interpreted as requiring that the balance fiduciary put the interest of the beneficiary of the fiduciary obligation above their own interest. Under the LLC Act, the duty of loyalty is owed only to the company; it does not as well run to the members of the company. Here, the duty would run as well to the other members. But how does that work? If a particular transaction will benefit the company but be to the detriment of one or more of the other members, or be to the advantage of one or more particular members but disadvantageous to the company, how is the duty of loyalty to be satisfied?
But then, as has been otherwise discussed, it is provided that nothing shall be “applied to alter the explicit terms of … the Act.” The Act is quite specific that the duty of loyalty is owed only to the company. For that reason, is the suggestion that the duty of loyalty should as well run to the other members of the essentially a dead letter?
I’m not going to even bother with the last clause of this provision beyond noting that the limited liability rule of KRS § 275.150 has absolutely nothing to do with the liability of a member or manager for their own breach of a fiduciary duty. If, for example, a manager expropriates a company asset, the manager is liable to the LLC for both the value of the asset and all of the gain realized from its use. The rule of limited liability enjoyed by members and managers does nothing to shield the manager from that liability.
Again repeating myself, I am always amazed at the willingness of general practitioners to draft operating agreements. While nobody will “take a stab” at writing a 401(k) plan, it seems everybody thinks they can write an operating agreement.