The Jewel Doctrine; More from Dean Weidner

The Jewel Doctrine; More from Dean Weidner

      The Jewel Doctrine posits that, upon the dissolution of a partnership (and especially a law firm), business that is being performed at the time of dissolution continues to be an asset of the partnership. Hence, the proceeds of that work will be applied to the satisfaction of partnership obligations with the balance split amongst the partners (now former partners) in accordance with their respective sharing ratios. In connection with the breakup of major money center law firms, most precipitated by the 2008 economic crisis, the firms to which those partners went have asserted that the Jewel Doctrine should not apply, and they should keep all of the proceeds of the transferred projects. In contrast, those in charge of the winding up and termination of those failed firms, many having significant third party debts, have argued that the Jewel Doctrine should apply. This is a topic that Tara McGuire and I addressed in an article titled Conflicting Views as to the Unfinished Business Doctrine, 46 Texas Journal of Business Law 1 (2015).  HERE IS A LINK to that article.

      Most recently, Dean Don Weidner, whose credentials include having served as the Reporter on the Revised Uniform Partnership Act, has published a piece in the Florida Bar Journal  titled Leaving Law Firms With Client Fees: Florida’s Path. In this article, Dean Widener argues that the Jewel Doctrine is correct, especially as to contingent fee cases, and that as well it should be applied beyond situations of a law firm’s dissolution.  HERE IS A LINK to Dean Weidner’s article.

Trial Court and Court of Appeals Puts the Court Before the Horse in Piercing Case

Trial Court and Court of Appeals Puts the Court Before the Horse in Piercing Case

       In Albakri v. A& M Oil Co., Inc., No. 2016-CA-000740-MR, 2017 WL 4862510 (Ky. App. Oct. 27, 2017), the Court of Appeals considered and rejected a trial court’s decision to pierce the veil of a single shareholder corporation.  That decision to pierce had been granted prior to the time the corporation’s liability was determined and necessarily prior to the time piercing needed to be considered.  The cart, the remedy of piercing, was put before the horse, that being the joint question of is the corporation liable and can the corporation satisfy the judgment.

      Ahmad Albakri (“Albakri”) was the sole shareholder/officer/director of Jorusa International, Inc., a Kentucky corporation (“Jorusa”); Jorusa owned and operated a gas station under the name of Tony’s Food Mart.  A&M Oil Co., Inc. (“A&M”) supplied fuel to the gas station.  Some payment for the gas was via automatic receipt of credit card payments on sales with the balance by invoice from A&M to Jorusa.  For reasons not detailed in the opinion the relationship between A&M and Jorusa ended, and at that time A&M claimed an account receivable of $19,903.82; The opinion does recite that “Albakri sold the gas station around the same time the invoices that are the subject of the instant case went unpaid.” 2017 WL 4862510, *5. A&M filed suit for that amount, plus interest at the rate of 18%, and tendered with the complaint a credit agreement and personal guarantee.  In answering the complaint, Albakri claimed the signature on the credit agreement and the guarantee was not his.  After an initial round of discovery, A&M amended its complaint to add Albakri as a defendant, asserting that he is jointly and severely liable on the amount owed.

      And then the cart began to precede the horse. A&M moved for summary judgment to (1) pierce Jorusa’s veil and hold Albakri liable for its debt and (2) find Albakri/Jorusa liable to A&M in the amount sought.  The trial court held that factual questions precluded summary judgment as to the liability, but granted summary judgment as to the piercing “claim”.

       At trial, a handwriting expert opined that the signature on the credit agreement and the guarantee were not those of Albakri.  An A&M representative testified that he witnessed Albakri sign the two documents.  The court would hold ultimately that Albakri did not sign those agreements, but held as well that his lack of execution went only to the enforceability to the 18% interest on late payments.  The trial court awarded A&M judgment for $19,903.82 plus interest at 8%; the 18% interest in the credit agreement and the provision for attorney fees were rejected as that agreement had not been signed by Albakri. It denied a motion to reverse its determination that Jorusa’s veil should be pierced.

      The Court of Appeals would reverse the decision to pierce Jorusa, but on grounds that are at best confusing. 

Piercing the Veil

      Turning to the propriety of the order piercing the veil, the standard of Inter-Tel Technologies, Inc. v. Linn Station Properties, LLC, 360 S.W.3d 152 (Ky. 2012) was recited.  HERE IS A LINK to my prior review of that decision.  From there the various elements of the trial court’s decision to pierce were scrutinized.

Undercapitalization

      In what appears to have been a typo, Albakri had in an answer to an interrogatory said that Jorusa “was ever capitalized in any amount.” 2017 WL 4862510, *2.  The Court of Appeals attached meaning to this typo, writing:

First, the trial court found Jorusa was never capitalized in any amount.  This finding is erroneous.  Albakri admitted only that “Jorusa International, Inc. was ever capitalized in any amount.” (Emphasis added). 2017 WL 4862510, *8.

      The court thus justified a determination that the corporation was properly capitalized because over time it had paid over $300,000 of payments to A&M, and in total they had done business “likely approaching one million dollars.”  On the basis that only $19,903.82 or 2% of the total transactions had not been paid, “None of this evidence demonstrates that Jorusa was undercapitalized.” 2017 WL 4862510, *8.  It then cited a 9^th Circuit decision, Perfect 10, Inc. v. Giganews, Inc., 847 F.3d 657 (9^th Cir. 2017), in which it was found that a company with $1.7 million of net assets and equity was not undercapitalized.

      Which is entirely beside the point.  The suggestion that the interrogatory answer was not a typo is disingenuous, and “ever” must mean “never”; no other reading is possible.  Second, capital and retained earnings are the cushion to satisfy debts when cash flow is not sufficient.  The mere fact that over a period of time cash flow was sufficient to pay debts as they came due does not evidence that the venture has any capital, much less that the capital is adequate. 

      In effect, the Court of Appeals reversed a determination of inadequate capitalization by: (i) a let’s just say curious interpretation of an interrogatory answer that would seem to admit under-capitalization; (ii) a discussion of cash flow that does not go to the question of adequate capitalization; and (iii) without any evidence of capitalization.

Formalities

      The trial court had relied upon a pair of administrative dissolutions of Jorusa to evidence a lack of respect for formalities.  Relying upon Inter-Tel Technologies, 360 S.W.3d at 157 for the requirement that in order to support piercing disregard of formalities must be “egregious,” the Court of Appeals wrote that the failure “to file necessary documents with the Secretary of State twice during the corporation’s existence…. is hardly egregious.” 2017 WL 4862510, *9.

Failure to Pay Dividends

      With respect to the failure to pay dividends, another point relied upon to pierce, the Court of appeals began by noting that Albakri never admitted that the corporation never paid dividends, but rather only that he was unaware whether it paid dividends.  2017 WL 4862510, *9. Even had the corporation never paid dividends, (which the Court of Appeals treated as a factor in failure to observe formalities (“But assuming, arguendo, that no dividend as paid, that fact alone does not demonstrate an egregious failure to follow corporate formalities.”) even though under Inter-Tel it is its own factor), the court explained why that could have been proper as whether to pay dividends is a question left to the board of directors and there are tax reasons for not declaring dividends. What the court failed to note is that the double taxation of dividends is a problem only in C-corporations, and dividends were tax favored in S-corporations vis-a-vis salary. How Jorusa was taxed was never addressed even as the Court of Appeals wrote:

Here, A&M proffered no proof that Jorusa was either capable of distributing a dividend or that doing so was a wise choice in light of the double taxation for dividends.  And, most importantly to the veil-piercing analysis, A&M proffered no proof that Albakri was egregiously ignoring corporation formalities by exercising his discretion and not making a distribution.  Thus, the trial court’s reliance on the second factor is erroneous. Id.

Domination of Corporation by Shareholder

      The trial court had found that piecing was justified because Albakri dominated and controlled Jorusa.  See 2017 WL 4862510, *3.  The Court of Appeals rejected that conclusion, writing:

After Inter-Tel was rendered, and effective July 12, 2012, the General Assembly amended KRS 271B.6-220 by adding subsection 3: “(3) That a corporation has a single shareholder is not a basis for setting aside the rule recited in subsection (2) of this section.” Thus, it appears the fact that Albakri was the sole shareholder of Jorusa should not be a consideration in our piercing-the-corporate-veil analysis. It likewise follows that Albakri, as the sole shareholder and manager of Jorusa, would also exercise dominion and control over the company. At minimum, this factor in and of itself does not justify piercing the corporate veil. 2017 WL 4862510, *9 (footnote omitted).

            Here the court of appeals went too far. The 2012 amendment to KRS § 271B.6-220 was in response to the Rednour decision and the piercing of an LLC on the basis that it had only a single member. See Rutledge, The 2012 Amendments to Kentucky’s Business Entity Statutes, 101 Kentucky Law Journal Online 1, 3 (2012). HERE IS A LINK to that article, wherein it was observed at footnote 20:

See White v.Winchester Land Dev. Corp., 584 S.W.2d 56, 61 (Ky. Ct. App. 1979) (“[M]ere ownership and control of a corporation by the person sought to be held liable is not alone a sufficient basis for denial of entity treatment.”). These amendments to the corporate and LLC acts should be read not as removing sole or near–sole ownership from the list of factors considered in whether a predicate case for piercing may be made, see Inter–Tel Techs., Inc. v. Linn Station Props., LLC, 360 S.W.3d 152, 167–68 (Ky. 2012), but rather as precluding piercing on that basis alone.

It remains possible for a single shareholder corporation to suffer domination jut as a single-shareholder corporation may not be dominated. Under Inter-Tel, “domination” results in “a loss of corporate separateness.” Inter-Tel, 360 S.W.3d at 165. Domination is not itself a factor in support of piercing, but rather a component of alter ego analysis.

But That’s Not the Problem

      Okay, so in the view of the Court of Appeals the trial court misapplied the Inter-Tel Technologies factors in finding that the veil of this corporation should be pierced.  But that is not really the problem.  Rather, it did so in the context of reviewing a determination to grant A&M partial summary judgment, and made its ruling in the context of the rules governing a review of a grant of summary judgment.  2017 WL 4862510, *8.  Except that piercing is a remedy, and a court’s grant of a remedy is not subject to review under the standard which governs the grant or denial of summary judgment. 

But the Bigger Problem Is

      Still, the bigger problem is that the Court of Appeals did not apply Inter-Tel in determining whether the trial court’s piercing of Jorusa was appropriate.  Under Kentucky law, piercing may take place under either of two alternative tests:  alter ego or instrumentality.  The various factors are employed in these tests.  As written in Inter-Tel (360 S.W.3d at 165):

A Kentucky trial court may proceed under the traditional alter ego formulation or the instrumentality theory because the tests are essentially interchangeable.  Each resolves to two dispositive elements: (1) domination of the corporation resulting in a loss of corporate separateness and (2) circumstances under which continued recognition of the corporation would sanction fraud or promote injustice.

      While it is true the Court of Appeals found that none of the Inter-Tel factors was present (a questionable conclusion as set forth above), it never reviewed how they would be employed in either an alterego or instrumentality analysis.

But Even Then, the Real Problem Was

      The real problem here is that summary judgment should never have been requested, much less either denied or granted, in this dispute.  The trial court, presumably following the lead of the plaintiff, treated piercing as a cause of action.  But it isn’t.  Rather, piercing is an equitable remedy employed to allow a judgment-creditor to collect a judgment against the owners of a judgment-debtor.  This is a central point made in Phaedra Spradlin v. Beads and Steeds Inns, LLC (In re Howland), ___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, *4,  2017 U.S. App. LEXIS 222 (6th Cir. Jan. 3, 2017) (HERE IS A LINK to a review of that decision).  Indeed, the Inter-Tel decision described piercing as being an “equitable remedy.”

      Piercing should not have been a point of consideration until (1) the corporation’s liability (if any) was determined and (2) it was found that the judgment could not be collected from the corporation.  Then and only then should A&M have sought to pierce the veil of Jorusa in order to hold Albakri liable for the deficiency.

So Begins Gloriana

So Begins Gloriana

       On this day in 1558 Mary Tudor, who would later have foisted upon her the moniker “Bloody,” died, leaving the English throne to her half-sister Elizabeth. Where Mary's reign of just over 5 years was one of tumult at the highest political levels, for at least a significant and perhaps a majority of the population it was a return to the preferred old ways, a view put forth expertly by Professor Scarisbrick in his The Reformation and the English People. Elizabeth's reign would by contrast be seen as one of peace and growth, later dubbed the Gloriana. Elizabeth would rule until 1603.

The Importance of the “Purpose” Clause of the LLC’s Operating Agreement

The Importance of the “Purpose” Clause of the LLC’s Operating Agreement

       In an article recently published in the Journal of Passthrough Entities, I considered the importance of a customized “purpose” clause in an LLC’s operating agreement (guidance which is equally applicable to partnership agreements) and the consequences of a generic “any lawful purpose” provision. That article is Purpose: If You Do Not Know Where You Are Going, How Will You Know If You Have Arrived, 20 J. Passthrough Entities 37 (Nov./Dec./2017).

       HERE IS A LINK to the article.

Asking a Court to Enforce an Illegal Agreement is at Best a Waste of Time

Asking a Court to Enforce an Illegal Agreement is at Best a Waste of Time

      In a recent case from New York, the court rejected efforts by a divorcing spouse to enforce claims on professional LLCs in which he, the husband, was precluded by law from owning. Specifically, the suit dealt with a number of dental practices which the husband served as the business manager. In turn, his wife was the dentist. Under New York law, only a dentist may own a dental practice. Essentially, he wanted the court to say that he had a contractual right to one half of the practices. The court rejected that notion. Savel v. Savel, short form order, index No. 006375-15 (Sup. Ct. Nassau County May 19, 2017).

      Peter Mahler, in his blog New York Business Divorce, reviewed this decision in a posting on November 6 titled Divorcing Husband not Smiling Over Court’s Rejection of Ownership Interest in Wife’'s Dental Practice.  HERE IS A LINK to that post.

IRS Addresses Tax Treatment of Conversion of LLC into Limited Partnership

IRS Addresses Tax Treatment of Conversion of LLC into Limited Partnership

      In a private letter ruling released on November 9, 2017, the IRS addressed the tax consequences of the conversion under state law of a limited liability company into a limited partnership. Private Letter Ruling 201745005 (August 4, 2017; released November 9, 2017).

      In this instance, a state law limited liability company taxed as a partnership desired to convert into a limited partnership. The LLC had as its members another LLC, it being taxed as a corporation, and an LLC taxed as a disregarded entity. In the course of the reorganization, those member entities, or their ultimate owners, would become the partners in the limited partnership.

      In reliance upon a Revenue Ruling 84-52 and Revenue Ruling 95-37, as well as application of Section 708 of the Internal Revenue Code, the IRS found that this transaction would not result in the termination of the LLC or any of its members recognizing taxable income.

Kentucky Court of Appeals Interprets and Applies “Or”

Kentucky Court of Appeals Interprets and Applies “Or”

      In a decision rendered at the end of September, the Kentucky Court of Appeals was called upon to interpret and apply “or” in an LLC’s operating agreement. In this instance, the reading of the plaintiff, whose expulsion and redemption from the LLC was sought, was rejected, and a more commonsense interpretation of the operating agreement was adopted. Rogers v Family Practice Properties of Lexington, LLC, No. 2015-CA-001557-MR, 2017 WL 4334111 (Ky. App. Sept. 29, 2017).

      The plaintiff, Rogers, practiced medicine with and was a shareholder in Family Practice Associates of Lexington, PSC (“Associates”). The Associates operated from property owned by Family Practice Properties of Lexington, LLC (“Properties”), an entity which had overlapping, but not entirely contiguous, ownership with Associates. The operating agreement of Properties, at Article 16.6, provided a mechanism under which the interest of a member could be redeemed, including:

In the event that (a) a Member is no longer employed by [Associates], or (b) in the case of any Members who are shareholders in [Associates], such Member is no longer a shareholder in [Associates].

      This dispute would turn upon the “or” between subsections (a) and (b) quoted above.

      In November, 2012, Rogers was advised by Associates that it was terminated his employment effective January 18, 2013. Thereafter, the members of Properties (except Rogers) held a meeting in which they elected to exercise the option to redeem his interest therein. While there was some back-and-forth with respect to the selection of appraisers, Rogers ultimately took the position that Properties had no right to redeem his interest because, while he was no longer employed by Associates, he remained a shareholder in Associates. On that basis, he asserted no right of redemption could take place. Rather:

Dr. Rogers argued that the Operating Agreement is plain and unambiguous and that the word “or” as used in Article 16.6 of the Operating Agreement is disjunctive. Accordingly, Dr. Rogers argued that the correct interpretation of Article 16.6 is that a member of Properties who is not a shareholder of Associates could be involuntarily bought-out of Properties once that member’s employment with Associates was terminated, but a member of Properties was/is also a shareholder of Associates could only be involuntary bought-out when that member ceased to be a shareholder of Associates.

      Finding that the contract was not ambiguous, a position adopted by all the parties hereto, the court began by noting “our interpretation of the Operating Agreement is limited to the plain meaning of its express terms.” From there it determined that:

As used in Article 16.6, the word “or” denotes that there are two alternatives, either which will give Properties the option to purchase a Member’s  interest. Dr. Rogers is undisputedly a Member of Properties, as defined in the recitals of the Operating Agreement. Therefore, Properties has the option to purchase his membership interest from him when either his employment with Associates or his ownership interest in Associates is terminated. Dr. Rogers was terminated from Associates effective January 18, 2013, triggering Properties’ right to exercise its option under Article 16.6(a). 2017 WL 4334111,*4 (emphasis in original).

      As such, the redemption of Rogers’ interest from Properties may proceed.