Friday, July 22, 2016

Finally, Some Clear Direction On Diversion Of Business Opportunity: Patmon v. Hobbs III

Finally, Some Clear Direction On Diversion Of Business Opportunity:
Patmon v. Hobbs III

Last Friday, the Kentucky Court of Appeals issued its third decision in the Patmon v. Hobbs, No. 2014-CA-001411-MR, 2016 WL 3886831 (Ky. App. July 15, 2016). This third opinion acknowledges certain of the errors made in Patmon v. Hobbs I, clarifies the measure of damages upon the diversion of an opportunity and perhaps most importantly adopts a strict test as to the defense that a venture was financially unable to act upon the opportunity. In doing so, the Court of Appeal cited the article I wrote with Professor (now Dean) Tom Geu on Patmon I, namely The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 (2010).

      Grossly oversimplifying the dispute, Hobbs, purporting to act as the managing member of an LLC, unilaterally transferred for no consideration certain contract rights and other assets of the LLC. Hobbs was a co-owner of that transferee company. Patmon, another member of the original LLC, brought an action charging Hobbs with having breached his fiduciary duties to the LLC. In the first Patmon v. Hobbs decision, Patmon v. Hobbs, 280 S.W.3d 589 (Ky. App. 2009), it was ultimately held that he might have done so, but that Patmon would have the burden, on remand, showing that the LLC could have performed on the transferred contracts. While the ultimate conclusion that Hobbs was bound by fiduciary obligations was (and is) normatively correct, the analytic path used in the decision was hopelessly flawed. Those errors were reviewed in the Analytic Protocol article; HERE IS ALINK to that article. The decision has as well been parsed, including against subsequent amendments to the LLC Act, via its annotation; HERE IS A LINK to that annotation (see Exhibit 7.7.2). Also, since Patmon I was decided, the LLC Act has been amended to cut off further misinterpretation of the Act as to both the statutory definition of the fiduciary duties in LLCs and the availability of a “fairness” defense to the appropriation of company assets. See KRS §§ 275.170(1), (2), as amended by 2010 Ky. Acts, ch. 133, § 32 (expressing labeling the various provisions is the duty of care and the duty of loyalty owed in LLCs); KRS 275.170(2) as amended by 2012 Ky. Acts, ch. 81, § 106.

      After remand and another appeal, the Court of Appeals considered the further actions of the trial court.  See Patmon v. Hobbs, 2014 WL 97464 (Ky. App. Jan. 10, 2014.) inding that the trial court did not resolve necessary issues, the Court of Appeals criticized the measure of damages it had employed. HERE IS A LINK to my review of that decision.

      After that remand and another appeal, now this case comes to the Court of Appeals for a third time. Cutting to the chase, it continues to be unhappy with the work done by the trial court, and the case has for the third time been remanded.
      The first substantive portion of the opinion calls the trial court to task for not providing, as it had been previously directed to do so, specific findings of fact and conclusions of law. On that basis the reversal and remand was granted. Slip op. at 11. “Nevertheless, we find it helpful to further explain the trial court’s on remand as described in Patmon I. Id.
      From there, the Court of Appeals (Judges Dixon, Lambert and Thompson) first addressed who had the burden of proof on the question whether the LLC had the financial wherewithal to perform on the leases that had been transferred. Hobbs had defended on the basis that the LLC could not perform, so it was in effect deprived of nothing by the transfer of the leases. “Hobbs defended his actions opining that American Leasing did not have the financial ability to take advantage of the O’Reilly.” Slip op. at 4. Patmon asserted that the burden should be upon Hobbs to prove the absence of the ability to perform, while Hobbs responded that Patmon I had allocated that burden to Patmon and that under the “law-of-the-case” that allocation could not be revisited. Over several pages the Court all but said that this allocation of the burden should have been upon Hobbs, but under the law-of-the-case rule it must in this case be as set forth in Patmon I. “There is some appealing logic to the reasoning that the inability of the Corporation (sic - this case involves an LLC) to undertake the diverted opportunity as an affirmative defense to be proven by the defendant.” (slip op. at 14), but:

[W]e agree with Hobbs that the law-of-the-case doctrine applies to the holding in Patmon I that Patmon had some burden to demonstrate that American Leasing had the financial ability to take advantage of the O’Reilly leases to prevail under the doctrine of diversion of business opportunity.
Although we must apply the legal principles pronounced in Patmon I to the facts as stated in that opinion, the law-of-the-case doctrine applies only to the extent that an issue was actually resolved….  Although Patmon I placed the burden of proof on Patmon on remand to demonstrate American Leasing had the financial ability to perform the O’Reilly leases, Patmon I did not address the proof necessary to meet that burden. We now do so. Slip op. at 14.

      The Court would require that Patmon demonstrate (presumably in further disputes this burden will be upon the defendant) that the LLC was able to utilize the opportunities. Crucially, at this juncture the Court would also define what is the standard for insolvency such that it will release a fiduciary from the charge of having diverted an opportunity.

       The Court began by reviewing foreign law to the effect that only actual insolvency as a defense to the diversion of what is otherwise a company opportunity. Slip op. at 14-15. Quoting Klinicki v. Lundgren, 678 P.2d 1250 at 1253-54 (Or. App. 1984), the Patmon III Court wrote:
To allow a corporate fiduciary to take advantage of a business opportunity when the fiduciary determines the corporation to be unable to avail itself of it would create the worst sort of temptation for the fiduciary to rationalize an inaccurate and self-serving assessment of the corporation’s financial ability and thereby compromise the duty of loyalty to the corporation if a corporate fiduciary’s duty of loyalty conflicts with his personal interest, the latter must give way. Unless a corporation is technically or de facto insolvent, a determination whether a business opportunity is corporate or personal does not depend on the corporation’s relative financial ability to undertake the opportunity. Slip op. at 15.

It went on to state:
We hold that unless American Leasing was insolvent or legally prevented from performing the O’Reilly leases, Hobbs must compensate it for his diversion of the O’Reilly leases. The trial court is instructed to make the requisite finding. Slip op. at 16-17 (emphasis added).

      The Court then turned to how damages are to be measured. Previously the trial court had in effect awarded Patmon a percentage interest in the net proceeds realized by Hobbs from the disposition of the leases transferred from the LLC. That measure was rejected. Rather, first Hobbs is liable to the LLC for the full measure of the benefits and the gains generated from the use of those assets. “KRS 275.170 requires that Hobbs completely disgorged himself of any benefits received.” Slip op. at 18. Those benefits are to go to the LLC, rather than directly to Patmon. Further, “in addition to statutory damages, if the trial court finds on remand the American Leasing is not financially insolvent, the measure of damages is the lost profits the corporation (sic - LLC) would have received had the opportunity not been diverted.” Slip op. at 18-19. The Court noted as well that pre-judgment interest may be in order. Slip op. at 19.
      Then, returning to Patmon I and Patmon II, the LLC is to be dissolved, and in the course thereof the trial court may reset the sharing ratios between the members. Slip op. at 9.

This decision is important for a variety of reasons including:
·         Recognition of the separation of LLCs from the common law of corporations and partnerships (Slip op. at 13);
·         Recognition of the prior error in the allocation of the burden of demonstrating inability to perform, strongly hinting that in the future the burden is upon the person alleging the inability to perform;
·         Defining actual insolvency as the threshold for an inability to perform;
·         Giving teeth to the statutory directive that, in the event of the diversion of company assets from an LLC, the person effecting the diversion is obligated to remit to the LLC all gains and benefits derived therefrom;
·         Specifying, on remand, that the trial court is not to accept the price at which Hobbs ultimately transferred the LLCs assets, but rather to independently determine their fair market value;
·         Affirmation of the rule that, upon dissolution of the LLC, sharing ratios may be reset in order to, on an equitable basis, account for Hobbs’ a breach of duty; and
·         Raising, with respect to the award of damages to the LLC, the possibility of an award of prejudgment interest.
      For myself, I have been far from reticent in criticizing the decision rendered in Patmon I. This Patmon III decision goes a long way to bringing Kentucky’s law on fiduciary duties in LLCs into compliance with the LLC Act and more generally principles of fiduciary duty law.

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