Monday, February 27, 2017
Business Judgment Rule Misapplied with Respect to Contract Formation
In a recent decision from the Federal District Court for the Eastern District of Kentucky, the business judgment rule was misapplied in order to support a determination that a contract existed. Taylor v. University of the Cumberlands, Civ. No. 6:16-CV-109-GFVT, 2017 WL 512643 (E.D. Ky. Fed. 7, 2017).
This dispute arose out of efforts by James Taylor, the former President of the University of the Cumberlands, and his wife to enforce against the University certain deferred compensation arrangements providing for, by way of example, continued salary payments through the second to die of James and Dina Taylor, car allowances, phone allowances and a residence. Seeking to avoid these obligations, the University asserted that the agreement was unenforceable in that it lacked consideration. Initially, the Court rejected the suggestion that the only consideration provided by the Taylors was past performance, which cannot constitute consideration for a contract. Rather, the Court found that each of the Taylors undertook prospective obligations, thereby satisfying the consideration requirement.
But then the Court continued the analysis by noting that:
In contract issues such as these there is a presumption of universal application “that an admitted and duly executed writing is supported by a legal consideration, and the burden is cast on the one executing it to overcome that presumption.” Shrout’s Adm’r v. Vaughan, 204 S.W.2d 969, 970 (!947). Seeing that the disputed agreement has been signed by the Chairman of the Board of Trustees, an authorized representative of the University, both Plaintiffs, and a notary public, this presumption shall apply. The Plaintiffs further argue that the business judgment rule should apply, and the court should not question “adequacy of consideration” as to the Taylor Agreement, as the “Court is ill-equipped to second-guess the Board of Trustees regarding their determination of the value to the University of its continued association of the Taylors.” [R. 15 at 15.] Without citing authority, the Defense merely states that “the multitude of cases regarding the business judgment rule ... have no application to this Motion, which presents a purely legal question regarding the Disputed Agreement’s enforceability.” [R. 17 at 9.]
The Plaintiffs cite to an unpublished Kentucky Court of Appeals opinion, Davis v. Innwood Condo. Prop. Owners Ass’n, which finds that “the business judgment rule is codified for non-profit corporations” in the Kentucky Revised Statutes. Davis v. Innwood Condo. Prop. Owners Ass’n, No. 2013-CA-001221-MR, 2014 Ky. App. Unpub. LEXIS 500, at *10-11 (Ct. App. June 27, 2014). Seeing that the Defense does not cite authority to contest application of the business judgment rule in this context, and under belief that the University Board members entered into this agreement with “an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the [University],” the business judgment rule may apply in this context. Id. (citing Allied Ready Mix Co Inc. ex. Rel. Mattinglyv. Allen, 994 S.W.2d 4, 8 (Ky. App. 1998)). 2017 WL 512643, ** 5-6.
All of which is very interesting, but the business judgment rule has absolutely no application to determine whether there was consideration for a contract. The business judgment rule is in the nature of a policy of judicial abstention pursuant to which a court will not review a decision of the board of directors that does not involve a potential breach of the duty of loyalty absent a prima facia showing gross negligence or willful misconduct by the board. While the business judgment rule would have application in a challenge to whether the board made a proper decision in entering into the agreement with the Taylors, it has absolutely no application to the validity of the contract between the University (here a non-profit corporation) and the Taylors.
Friday, February 24, 2017
A Direct Versus Derivative Distinction; Allegations of Excess Compensation
Last fall, in a decision by the Ohio Court of Appeals, it held that the claims by a shareholder/partner to the effect that he was being “oppressed” by being deprived of dividends because the company earnings were being siphoned off as excess compensation was held to constitute a derivative, and not a direct claim. Kirila v Kirila Contractors, Inc., No. 2015-T-0108, 2016 WL 4426409 (Ohio App. Aug. 22, 2016).
Involved in this case were a collection of corporations and partnerships in which the plaintiff Kirila was either a minority partner or a minority shareholder. Perhaps tellingly in a dispute such as this, the person controlling the corporations and the partnerships was the plaintiff's father. Essentially, the plaintiff alleged that he was being “oppressed” and his claims were ultimately boiled down to an assertion that he was being injured because the corporation was making excess payments to various employees, as well as retirement plans, thereby depriving him of any return on his equity position in the various ventures. The complaint would ultimately be dismissed on the basis that, if injury resulted from these overpayments, that injury was first suffered by the corporation, and then only speculatively by a shareholder. For that reason, the claims needed to be brought as a derivative action. In this case, they were not.
Thursday, February 23, 2017
Kentucky Court of Appeals Affirms Piercing the Veil
In a decision rendered last Friday, the Kentucky Court of Appeals affirmed the determination that the veil of an LLC should be pierced, primarily on the basis, it would appear, that the company was undercapitalized. Roscoe v. Angelucci Acoustical, Inc., No. 2012-CA-001933-MR, 2014-CA-000536-MR, 2017 WL 655488 (Ky. App. Feb. 17, 2017).
In 2006, Lexhold Partners II Lot 14-A Exclusive, LLC (“Lexhold Partners”) was awarded the contract to construct a building now occupied by Hewlett-Packard. Although, apparently, the property is owned by the University of Kentucky, Lexhold Partners holds the lease vis-a-vis Hewlett-Packard. In order to affect this project, another LLC, Lexhold Premier Commercial Contractors, LLC (“Premier”), was formed. Upon completion of the project, Premier was dissolved. Roscoe, one of the defendant in this action, was one of the two “managing partners” of each of Lexhold Partners and Premier. It should be noted that, throughout this opinion, partnership and corporate terminology is intermixed even as the decision is about an LLC.
Premier subcontracted with Angelucci Acoustical, Inc. (“Angelucci”) for the installation of drywall and acoustical ceilings. That subcontract had a price of $396,240.30. The building was completed, and occupancy undertaken, even as Angelucci continued to complete certain tasks. Angelucci alleged that it incurred an additional $88,053.70 in completing those additional task, while Roscoe alleged that they were simply additional punchlist items included in the original purchase price. Angelucci filed suit against Premier, Lexhold Partners and Roscoe seeking those additional amounts. Angelucci sought and was awarded partial summary judgment; that ruling became final, and Roscoe did not appeal.
Nearly a year later, on bases not fully identified in this decision, the trial court pierced the “corporate” veil of Premier (the general contractor) to hold Roscoe liable on the $88,053.70 (plus interest) judgment. This appeal followed. However, in connection therewith, Roscoe did not file a supersedeas bond. Roscoe thereafter failed to comply with requirements as to judgment discovery and, notwithstanding having entered into a settlement agreement in the amount of only $30,000, he failed to discharge that obligation. After hearing, the trial court issued a judgment against Roscoe totaling $334,785.34, which amount included compensatory and punitive damages and attorney’s fees. Roscoe then filed this appeal.
With respect to the piercing claim, the decision of the Court of Appeals is somewhat cryptic as to why that was permitted. It appears that facts justifying piercing were as follows:
· “the two managing members of the Lexhold Partners are the same to managing members of Lexhold Premier, Roscoe and Oliver. They developed Lexhold Premier Commercial Contractors, LLC solely for the purpose of serving as the general contractor for the project. This construction project was the only asset of Lexhold Premier.”; and
· in two instances, Lexhold Partners was identified as the “owner” of the property (Angelucci was not a party to either of these agreement).
Quoting from the trial court, the Court of Appeals observed that:
As in Inter-Tel, Lexhold Partners caused Lexhold Premiere to be obligated to pay Angelucci for work performed on the subject property and then rendered it unable to pay. Lexhold Partners limited the value of the sole asset of Lexhold Premiere and caused it to bear the brunt of the failure to pay subcontractors while Lexhold Premiere derive the benefit of the improvements to real property by its lease agreement with the landowner and agreement with HP.
Similarly, it appears that the second scenario identified in Inter-Tel applies as all assets that could or should have been part of Lexhold Premiere were moved beyond the reach of legitimate creditors and have been retained largely by Lexhold Partners. Roscoe concedes that Premiere was formed for the sole purpose of trying to escape the hassles and liabilities associated with being a general contractor[,] and he and Oliver wanted to keep the money “in house.” Premiere had no assets other than the $5,247,000 contract with Lexhold Partners and was in Roscoe’s terms a “pass-through.” Moreover, Partners has reaped all of the benefits from this construction project and currently receives revenue from its lease with the sole tenant of the building, Hewlitt-Packard. That was the purpose of its original lease with “Commonwealth of Kentucky for the use and benefit of the University of Kentucky acting by and through the Board of Trustees of the University of Kentucky.” To allow Partners and Roscoe to escape liability under these circumstances would, in fact, sanction fraud and promote injustice against Angelucci and the other subcontractors.
What steps were undertaken by Roscoe in order to render Lexhold Premier unable to satisfy its obligations, thereby effectuating a fraud, was not detailed by the Court of Appeals. In the underlying opinion and order issued by the Fayette Circuit Court (Judge Goodwine), it had been found that:
[B]oth Lexhold Premier and Lexhold Partners worked on the same project and had no other business. Lexhold Premier’s sole asset was its contract with Lexhold Partners. The two companies have the same member-managers and nearly identical operating agreements. Minutes were not kept for company meetings. Bill Boshong performed work for both entities but Lexhold Partners paid the entire amount of his bill. Derek Roscoe only performed work for Lexhold Partners but was paid by Lexhold Premier as well. Lexhold Partners paid cost attributable to Lexhold Premier, and vice versa. Slip op. at 8.
Then, after reciting a number of other circumstances in which the companys’ assets were apparently intermingled, it was observed that:
It is clear to this Court that Lexhold Partners and/or Roscoe exercise complete dominion and control over Lexhold Premier. Roscoe and/or Oliver provided for or guaranteed 100% of the startup costs to fund Lexhold Premier. They set the contract amount of $5,247,000 that they would pay Lexhold Partners, i.e themselves. There is no evidence that Lexhold Premier followed any corporate formalities; Roscoe and/or Oliver used the companies’ that funds interchangeably and funds from one paid the expenses of the other. Whether premier was paid the $5,247,000 due under its contract with Partners was solely within the discretion of Partners. Roscoe conceded that Premier paid him certain “expenses which connected to his work" on the project. He also conceded that he directed Premier to pay his son sums that he believed were due him. Slip op. at 10.
The court would go on to find that the assets of Lexhold Premier, the general contractor, had been “moved beyond the reach of legitimate creditors and have been retained largely by Lexhold Partners,” with the result that “Partners has reaped all of the benefits of this construction project and currently receives revenue from its lease with the sole tenant of the building, Hewlett-Packard. … to allow Partners and Roscoe to escape liability under these circumstances would, in fact, sanctions fraud and promote injustice against Angelucci and the other subcontractors.” Slip op. at 11-12. Again, how the assets were moved so as to be unavailable to Angelucci and other creditors is not detailed.
From that same order it becomes clear that the question of the name of the property owner relates to a challenge to Angelucci’s mechanics lien.
From the perspective of the law of piercing, this decision is in several respects disturbing. First, while on the facts piercing may have been justified, the Court of Appeal’s affirmance without a detailed recitation of those facts leaves the reader wondering what truly happened. Second, the continued reference to the “corporate” veil in the context of an LLC is simply incorrect and as well glosses over the problem that the courts have not identified whether and to what extent the Inter-Tel Technologies test for piercing will be different for LLCs versus corporations. Third, justifying, at least in part, the piercing of an LLC based upon the failure to satisfy “corporate formalities” is at best confusing. While corporations are obligated to have meetings and keep minutes, the LLC Act does not require either meetings or minutes. If, in this particular case, the operating agreement dictated that meetings would be held and minutes kept, then there may have been a failure to follow a contractually assumed obligation. If that was the case, it was not detailed by either the Court of Appeals or the trial court. Conversely, if there was no such contractual obligation, supporting a ruling on piercing based upon the failure to do what is not required is nonsensical.
More broadly, the courts’ language with respect to related special-purpose business organizations is very troubling. Blanket statements to the effect that the companies were related and had the same members/management structure, and on that basis piercing was justified, dangerously simplifies proper piercing analysis. It has long been the law that the organization of various business ventures for the purpose of limiting liability (i.e., partitioning various asset pools into different ventures with the intent and objective of exposing each to only a certain class of creditor claims) is an accepted business practice. There is no question that the utilization of these structures in an abusive manner should not be allowed and that piercing should be a possible remedy for that abuse. The structures themselves are not, however, ab initio abusive or improper, and flippant language to the effect that related ventures should, for that reason, be pierced is unjustified. Rather, while related, special-purpose entities may be particularly at risk for violating the rules as to when piercing is justified, there should not be any implication that piercing is justified because of relatedness.
Wednesday, February 22, 2017
Bankruptcy Court Refuses to Enforce Contractual Default Rate of Interest
In recent decision from the Bankruptcy Court for the Western District of Kentucky (Judge Lloyd), efforts by the lender to enforce a default rate of interest, that being the original rate of interest +5%, were rejected. In re: Perkins, Case No. 16-10383(1)(12), 2017 WL 439319 (E.D. Ky. Bankr. Feb. 1, 2017).
BB&T had extended a series of loans, all secured by a farm property. Important for the ultimate decision, the loans were over secured based on the value of the collateral.
The loan documents, which were at a variety of interest rates, each provided that, on default, a default contractual rate of interest, that being the original interest rate +5%, would apply. BB&T requested an order from the court to award to get interest at that rate. In response, the Bankruptcy Court noted that it considers the award of interest “based on the facts inequities of each case.” and that:
Case law establishes that a presumption arises in favor of the contractual rate of interest that is subject to rebuttal based on equitable considerations. The presumption is rebutted where the evidence establishes that the default rate is significantly higher than the pre-default rate without any justification being offered for the difference.
In this instance, the Court found that that rebuttal was successful. This rebuttal was based upon the fact that the default rate of interest was this at least double wide had previously been agreed upon. Essentially, that increased rate of interest did not serve to protect BB&T, as the creditor, from nonpayment. Rather, the excess value of the collateral had already accomplished that goal. Further, application of the default rate of interest in favor of BB&T would have significantly reduced the size of the estate with the result that it would “materially decrease payment, if not completely eviscerate payments to the unsecured creditors in this case.”
Tuesday, February 14, 2017
Under the New York Limited Liability Company Act, an operating agreement may be amended by a simple majority of the members (this rule may itself be modified in the operating agreement to, for example, raise the threshold to unanimity). Kentucky has the same majority rule with the same ability to modify it in a written operating agreement. In the Shapiro case, the New York Supreme Court (the trial court) held that, in a three member LLC, all of the members having an equal interest in the company, a majority thereof could adopt a new operating agreement. This case was reviewed in Peter Mahler’s blog New York Business Divorce (HERE IS A LINK to that posting). I reviewed the decision as well, particularly with respect to its application in Kentucky. HERE IS A LINK to that posting.
Recently, the Appellate Division in New York (the intermediate Court of Appeals) has substantially affirmed (it tweaked the reasoning) the trial court’s decision. Peter Mahler has, as always, provided an outstanding review of the decision; HERE IS A LINK to that discussion.
Monday, February 13, 2017
Kentucky Supreme Court Passes on Reviewing Holding That Shareholders Do Not Owe One Another Fiduciary Obligations
Kentucky Supreme Court Passes on Reviewing Holding That Shareholders Do Not Owe One Another Fiduciary Obligations
As previously reviewed (HERE ISA LINK to that posting), the Kentucky Court of Appeals has held that shareholders in a corporation, in their capacity as shareholders, do not stand in a fiduciary relationship with one another. See Conlon v. Haise, No. 2014-CA-001581-MR, 2016 WL 5485531 (Ky. App. Sept. 30, 2016).
After this decision was handed down, the plaintiff (Conlon) sought review and reversal of this decision by the Kentucky Supreme Court. Last Friday the Kentucky Supreme Court issued its ruling that it would not be reviewing the decision. While it did direct that the decision of the Court of Appeals not be published, as this is the only point decision of a Kentucky court, it may be cited as precedent.