Trial by Combat

Trial by Combat

      In an article published earlier this year in the Journal of Passthrough Entities, I considered the range of mechanisms for resolving disputes in business organizations. That article, Rock Paper Scissors Lizard Spock and Other Innovative Dispute-Resolution Mechanisms (HERE IS A LINK to that article) included a discussion of trial by combat. Therein, I noted that the recent Delaware decision had rejected trial by combat as an acceptable means of resolving disputes, and is well noted the problem that could arise under various state laws against dueling.

      By happenchance, I recently stumbled upon a short article discussing a New York case in which an attorney, who was alleged had assisted a client in an undertaking a fraudulent conveyance, demanded the right to protect his honor by a trial by combat. While the court would not ultimately award that remedy, it was acknowledged a trial by combat, at least in the view of that judge, remains available under New York law.

      HERE IS A LINK to that article.

Court of Appeals Addresses Enforceability of Prior Stock Restriction Agreement

Court of Appeals Addresses Enforceability of Prior Stock Restriction Agreement

      In a recent decision from the Kentucky Court of Appeals, considered the enforceability of a fourth shareholder agreement that, it had been intended, would be superseded by a fifth agreement. The plaintiff is this action, Rogers, asserted that, in that the fifth agreement was invalid, he was not bound by any shareholder agreement. The Court of Appeals, consistent with the decision of the trial court, would hold that the fourth agreement still bound his shares. Rogers v Family Practice Associates of Lexington, P S.C., No. 2015-CA-001991-MR and No. 2016-CA-000040-MR, 2017 WL 5180395 (Ky. App. Nov. 9, 2017).

      Not long before this decision, the Kentucky Court of Appeals issued a decision involving the plaintiff Rogers and the LLC related to Family Practice Associates. HERE IS A LINK to my review of that earlier decision.

      In this instance, all of the shareholders in the Family Practice Associates of Lexington executed, from time to time, a shareholder agreement. This agreement was apparently amended and restated each time a new doctor was admitted to the practice. The third and subsequent agreements provided that, upon ceasing to be employed by the practice, the shareholder would sell and the practice would purchase the shares at a price set pursuant to the formula detailed the agreement. Rogers clearly signed the fourth amended agreement containing that formula.

       Thereafter, a fifth amended agreement was prepared in connection with the addition of a new shareholder to the practice. That agreement was not, however, signed by the requisite percentage of the shareholders, and for that reason never became effective. Several years later, the practice advised Dr. Rogers that he was being terminated from the practice. Rogers refused to cooperate in the redemption of his shares, asserting that he had never signed the fifth amended agreement and it could not be enforced against him. In addition, he asserted that his shares would have to be repurchased as provided by the PSC statue, particularly KRS §§ 274.095(2), (4). The practice asserted that, even if the fifth agreement was unenforceable against him, the shares could be redeemed at the formula price set by the fourth amended agreement. Ultimately, Rogers sued the Family Practice and each of its shareholders on a variety of theories.

      Responding to cross-motions for summary judgment, the court held in favor of the Practice and the enforcement of the fourth shareholder agreement against the Rogers. In addition, it rejected notions that Rogers could make a claim against the directors and officers of the Corporation for breach of a fiduciary duty owed to him where those duties are owed to the corporation itself.

      On appeal, while it was agreed that the fifth shareholder agreement could not be enforced against Rogers, the fourth agreement still could be. The Court of Appeals found that:

[T]he Fourth Amended Agreement states that “no change, modification, addition or termination of this Agreement shall be enforceable unless in writing and signed by the party against whom enforcement is sought.” (Emphasis added by the Court of Appeals). No party is submitted any evidence of a signed writing terminating the Fourth Amended Agreement. Presumably, the Fifth Amended Agreement was meant to terminate and supersede the fourth; however, the Fifth Amended Agreement cannot work to terminate the Fourth Amended Agreement because Rogers, the party against whom enforcement is sought, never signed that agreement.

      The Court of Appeals never addressed the question of to whom the fiduciary duties of corporate directors and officers are owed.

 

More on to Whom Fiduciary Duties are Owed

More on to Whom Fiduciary Duties are Owed

      A recent decision from the Kentucky Court of Appeals, affirming the dismissal of a lawsuit alleging breach of fiduciary duties in a nonprofit corporation, turned on the question of to whom the duties were owed. Thompson v. Lake Cumberland Resort Community Association, Inc. No. 2016-CA-000145-MR, 2017 WL 4712520 (Ky. App. Oct. 20, 2017).

       This suit arose in connection with allegations by the plaintiffs as to the legitimacy of the board of a nonprofit corporation (i.e., had it been properly elected/appointed) and claims for breach of fiduciary duty by those on the board. With respect to the legitimacy of the board, the court had ordered a new election. The plaintiffs, however, continued to contest the legitimacy of that board, and, in consequence, the legitimacy of its determinations with respect to the discharge of the corporation’s assets, maintaining that “if the election was not proper under the By-laws of the Association, those expenditures were ultra vires.” 2017 WL 4712520, *1.

      As noted by the Court of Appeals, while this litigation was pending, the Kentucky Supreme Court issued its opinion in Ballard v. 1400 Willow Council of Co-Owners, Inc., 430 S.W.3d 229 (Ky. 2013). In that decision, the Supreme Court held that the fiduciary duties owed by the directors of a nonprofit corporation are owed to the corporation itself, and not to the individual members thereof.  HERE IS A LINK to my review of that decision.

       From there, the court parsed the various allegations made by the plaintiffs, finding that they could only the brought derivatively as any breach of the duties would have been of duties owed the corporation. In particular, the court focused upon the wording of the Nonprofit Corporation Act and where it provides for either an action for injunctive relief or an action for damages. Ultimately, the court determined that the authority cited provided for injunctive relief, but not damages. For example, the court wrote:

The Thompsons assert that Del Spinas had numerous conflicts of interest, causing the Thompsons damages that rose to the level of ultra vires acts, as stated under Kentucky Revised Statutes (KRS) 273.173. However, KRS 273.173 provides for injunctive relief where a member seeks to stop an unauthorized act by the board, it does not include an action for damages. The statute then sets out the conditions under which the corporation, but not individual members, could void such an action. Because the cause of action lies with the Board and not the individual members, the Thompsons do not have any claim under KRS 273.173. 2017 WL 4712520, *3.

      That may not, however, be the end of the story. The Thompson’s have filed with the Kentucky Supreme Court a petition for discretionary review. In that petition, they paint a story significantly different than that described by the Court of Appeals noting, for example, that there have been no ongoing dispute with respect to the validity of the election above referenced.  The petition for discretionary review also, inter alia, points out the need for allowing suits such as this to proceed on a derivative basis so that the directors and officers of nonprofit corporations may be held liable for breaches of fiduciary duty. The necessity of the court recognizing derivative actions in nonprofit corporations, notwithstanding the fact that there is no “derivative action” provision in the Kentucky Nonprofit Corporation Acts, was a point I addressed in an article titled Who Will Watch the Watchers?: Derivative Actions in Nonprofit Corporations. HERE IS A LINK to that article.

“No Hit, No Foul” Does Not Apply to Breaches of Fiduciary Duty

“No Hit, No Foul” Does Not Apply to Breaches of Fiduciary Duty

      In a recent decision from Kansas, there was affirmed an award of punitive damages against a corporate officer notwithstanding the fact that the transaction breaching the fiduciary duties had been unwound. In effect, although the corporation suffered no net damages, the disloyal officer was still subject to an award of punitive damages. Still Corporation, Inc. v. Still, No. 116910, 2017 WL 5507708 (Kan. Ct. App. Nov. 17, 2017).

      Still was a 25% shareholder and the president of Still Corporation. He structured a transaction in which he would purchase from the corporation 197 acres of land for $90,000. It was ultimately determined that the value of the land was between $450,000 and $532,000. While certain other shareholders in the corporation, in their capacity as corporate officers, signed off on the deal, ultimately the corporation filed suit against Still for fraud and breach of fiduciary duties. Ultimately Still announced that he would return the property to the corporation, at which time the District Court entered a judgment that canceled and voided the deed conveying the land from the corporation to Still, declared that Still and his spouse had no ownership rights in that land, and directed Still at his spouse to assist in providing necessary documents to return title on the property to the corporation.

      Thereafter, a bench trial was held to assess whether the company’s claim for punitive damages against Still for breach of fiduciary duty would have any value. The trial court, considering the Kansas statute for punitive damages, awarded the corporation $85,000. Still filed this appeal.

      The Court of Appeals found that the amount of the punitive damages fell clearly within the range that is appropriate under Kansas law. As to the validity of the claim itself, the court discussed the fiduciary duties of corporate officers and directors. The award of punitive damages, ab initio, was justified in that:

In short, Still, as the corporate president, breached a fiduciary duty by engineering his purchase of company assets at what he understood to be far less than their true value. A breach of fiduciary duty will support awards of both actual and punitive damages.

      The court dismissed Still’s suggestion that the knowledge of at least aspects of the transaction by the other shareholders should militate against his exposure, observing:

Still has suggested any punitive award ought to be excused or moderated because the other shareholders should have known the approximate value of the land he purchased. Assuming that to be true, the suggestion misses the point. Still had a duty to act faithfully in the interest of the shareholders rather than scheming to fleece them if he could get away with it. The other shareholders had a right to rely on Still’s performance of that duty as the company’s president. They were not obligated to police his actions for malfeasance or dishonesty, and they did not somehow forfeit the corporation’s right to relief by failing to scrutinize this transaction.

Alabama Divorce Court Went Too Far in Assigning to Spouse the Assets of an LLC

Alabama Divorce Court Went Too Far in Assigning to Spouse the Assets of an LLC

      In a recent decision from the Court of Civil Appeals of Alabama, it reviewed a divorce decree from what is clearly a contentious dispute. The court addressed, however, one important issue of the law of LLCs. Whaley v. Whaley, 2017 WL 5507928 (Ala. Ct. App. Nov. 17, 2017).

      A crucial rule of the law of limited liability companies is that the LLC owns its own property, and in turn the members own an interest in the LLC. The members do not have an ownership interest in the LLC’s property. This rule was ignored, however, by the trial court in this dispute when, with respect to K2 Enterprises, LLC, an entity in which the husband was apparently the sole owner, then was transferred to the wife K2’s “real property, equipment, contractual rights, intellectual property, proprietary information, patents, patent applications, processes, licenses, leases and other property rights.”

      The Court of Appeals set aside this award on the basis that it went well beyond the husband’s “transferable interest” in the LLC to reach the property that the LLC owned. On that basis, remand was ordered.

A Novel Claim Against Departed Disloyal Employees

A Novel Claim Against Departed Disloyal Employees

       A recent decision out of Alabama considered and, at least for purposes of a motion to dismiss, allowed to stand allegations brought against disloyal employees based upon federal and state of the computer fraud laws. Sunil Jupta, M.D., LLC v. Franklin, Civ. Act. No. 17-00335-N, 2017 WL 5196392 (S.D. Ala. Nov. 9, 2017).

      Franklin, a former member of the LLC, identified in the opinion by its assumed name RSI (incorrectly identified as being a “Delaware limited liability corporation”), left for employment with another venture. Thereafter, Wilson and Payton applied for employment with that same new company. As set forth in the complaint:

Before resigning from employment with RSI, “… Franklin instructed Wilson and Payton to download confidential RSI patient data from RSI’s practice management system on a portable hard drive provided by Franklin.”

      Again, as alleged in the complaint, Wilson and Payton proceeded to do exactly that. In response, the plaintiff brought an action against the defendants charging them with violation of the Computer Fraud and Abuse Act (18 U.S.C. § 1030) and the Alabama Digital Crime Act (Ala. Code § 13 A-8-112).

      The balance of the decision is focused upon whether there exist a private cause of action under either of these statutes and whether the necessary elements had been satisfied by the conduct of Franklin/Wilson/Payton. Ultimately the court found that they were.

      I review this case only because the use of these computer crime statutes creates an interesting opportunity for plaintiffs who charge that disloyal employees/officers downloaded company information before departing for a new venture. Doing so has always been improper as a breach of the fiduciary duties imposed upon officers and employees. These statutes create an additional path of imposing liability.

The 2017 Amendments to Kentucky’s Business Entity Statutes

The 2017 Amendments to Kentucky’s Business Entity Statutes

      Forthcoming from the Louisville Law Review published by the University of Louisville School of Law is the The 2017 Amendments to Kentucky’s Business Entity Statutes. Even as this article is forthcoming, the final draft thereof has been posted to both the SKO website and SSRN.

      HERE IS A LINK to that article.  When the final version is available, it will be substituted.

Joan Heminway

Joan Heminway

Joan Heminway, who I am fortunate to count as a friend, is a professor at the University of Tennessee School of Law. Joan is a force of nature. She regularly publishes on a blog, she regularly publishes articles and another commentary, she is a highly regarded lecturer in the classroom and speaks at essentially every significant conference around the country (or so it would seem heard from her Facebook feed).  Several times she has presented at the LLC Institute.  She is as well the co-author of a widely respected textbook used in business association classes.

I along with uncountable others have on numerous occasions been the beneficiary of her insights and direction. Recently her contributions as a mentor were recognized by the Association of American Law Schools with the Business Associations Outstanding Mentor Award. 

It is important to note that while this award recognizes Joan’s mentoring of other legal scholars, she is as well an outstanding mentor of law students.  As observed by mutual friend Nelson Irvine:

I just witnessed Joan mentoring one of her students a couple of weeks ago, when she engaged me in a short series of emails exchanged with one of her students regarding an issue of corporate law in Tennessee.  I am sure we all have witnessed such occasions. This recognition is most appropriate and a timely expression of appreciation for her remarkable contributions to scholarship and to the study and teaching of the law at its best.   She is indeed an outstanding mentor.

            HERE IS A LINK to the Law School’s press release on this award.

Indiana Courts Reject Physician’s Efforts to Loot LLC

 

Indiana Courts Reject Physician’s Efforts to Loot LLC

      In a recent decision from Indiana, the Court of Appeals affirmed certain determinations made at the trial court that a physician’s conduct vis-a-vie the LLC in which he was a one third owner were improper, and that the language he cited to validate his conduct was inapplicable. Joshi v. Apollo Medical Group, LLC, Ct. App. Case No. 82A01-1612-CT-2842, 2017 WL 4414302 (Ind. Ct. App. Oct. 5, 2017).

      Apollo Medical Group, LLC had three members, Drs. Joshi, Elfar and Guiao; each owned a one third interest therein. Under Apollo's amended and restated operating agreement, the company was managed by its members, each required to “exercise business judgment in participating in the management of the business operations and affairs of the Company.” The operating agreement went on to provide that a member “shall incur no liability to the Company or to any of the Members as a result of engaging in any other business or venture, whether or not competitive, disclosed or undisclosed.” A third relevant provision of the Operating Agreement provided: “A Manager shall not be required to have the management of the Company as his or her sole and exclusive function, and may have other business interests and may engage in other activities in addition to those relating to the Company. “In addition to Apollo, there was organized AMG Management Services, LLC. Each of the three owners in Apollo were one-fourth owners therein. In addition, Gary Pilibosian was a member of that company.  It providing management, administrative and other non-physician services to certain of Apollo’s clients. For reasons not discussed in the opinion, Joshi did not want Pilibosian to share in AMG’'s business, but Joshi was unable to convince either Elfar or Guiao to exclude him. As set forth by the Court of Appeals:

In September 2016, Dr. Joshi told Drs. Elfar and Guiao that he intended to divert business away from AMG in an attempt to limit Pilibosian’s financial benefit and that if the other members did not agree with him, he would funnel any new business to a new company and that “Apollo would be dead.” Drs. Elfar and Guiao objected to the plan and told Dr. Joshi that they would not participate in the scheme to cheat Pilibosian.

      Joshi then did exactly what he threatened to do. For example, he contacted two clients of Apollo, misrepresenting to them its current status with the effect that both terminated their agreements with Apollo. When a prospective client sought a proposal from Apollo for services, he diverted it to himself. He as well diverted Apollo’s physical mail and emails to himself, depriving the other owners of the LLC access thereto. When finally challenged in a letter from Apollo’s attorney, his counsel indicated that he had a “unfettered right to engage in activities that are competitive with Apollo.” Ultimately, Apollo would bring a complaint against Dr. Joshi, seeking relief including a temporary restraining order and preliminary injunction. After oral arguments a preliminary injunction was granted, and it was from the granting of that preliminary injunction that this appeal was taken.

      Before the Court of Appeals, with respect to the “likelihood of success on the merits” component, Joshi focused upon the alleged breach of fiduciary duty, arguing that the language above quoted from the operating agreement modified his fiduciary duties to the company. The Court of Appeals rejected that determination. Rather, while an operating agreement may “modify, negate, and/or limit duties, including fiduciary duties,” the court found that this language is not sufficient to do so. Rather, in order to modify or negate fiduciary duties, they being “fundamental and paramount to the smooth operation of companies,” any modification or negation “must be explicit.” The court determined that, in this instance, the language quoted above was not an explicit modification or negation of fiduciary duties.

       Applying a belt and suspenders analysis, the court went on to determine that even if the language quoted above modified Joshi’s fiduciary duties, it did not sanction the conduct in which he engaged in this case. Rather, while he could have other business interest, he could not engage in conduct that actively undermined Apollo. In addition, while the operating agreement may allow members to engage in competitive activities, that did not extend to undermining and sabotaging Apollo's current business relationships. “And it would certainly not include a right to hijack Apollo’s website, email, and mail.”

      The Court of Appeals, as did the trial court, went on to find that the weighting of the harms was in favor of Apollo, as was the question of public interest. With respect to the scope of the preliminary injunction, Joshi argued it went too far in that it did not reset the status quo. The Court of Appeals found to the contrary, the status quo being the circumstances as they existed prior to the time Joshi sought to undermine Apollo. “Therefore, the trial court’s order on these matters merely maintain the status quo as it existed before the current controversy arose.”

A Most Unsatisfying Opinion With Respect to Kentucky Public Policy and the Termination of Attorneys

A Most Unsatisfying Opinion With Respect to Kentucky Public Policy and the Termination of Attorneys

      In a decision rendered by the Kentucky Court of Appeals in August, from which no appeal has been taken to the Kentucky Supreme Court, it was held, inter alia, that there is essentially no public policy exemption to the generally applicable rule of “employment at will” in Kentucky with respect to attorneys and violations of the ethical rules by which we are bound. Greissman v. Rawlings and Associates, PLLC, No. 2016-CA-000055-MR and No. 2016-CA-000062-MR, 2016 WL 3567838 (Ky. App. Aug. 18, 2017).

      Carol Greissman (“Greissman”) alleged that her termination from Rawlings and Associates, PLLC (‘Rawlings”) was improper in that it was triggered by her refusal to sign a Confidentiality and No Solicitation Agreement (the “Agreement”) that she believed violated certain ethical rules, specifically Rule 5.6. Under the Agreement, Rawlings, had she signed it, would have agreed that while employed and for three years following, she would not without Rawlings prior written consent “solicit, contact, interfere with, or attempt to divert any customer served by Rawlings, or any potential customer.” As described by the Court of Appeals, “Rule 5.6 prohibits an attorney from agreeing to restrict his or her right to practice after leaving an employer.”

       Because Rawlings believed that the Agreement violated Rule 5.6, she refused to sign it. Thereafter, Rawlings terminated her employment. She then brought suit against Rawlings, alleging that Rule 5.6 set forth Kentucky public policy and that termination for refusal to violate public policy is an exception to the rule of employment-at-will, her termination was wrongful. In response, Rawlings asserted that Rule 5.6 and the other rules of the Kentucky Supreme Court did not constitute “public policy” justifying an exception from the rule of employment at will. The trial court would deny the motion to dismiss (Rule 12.02) filed by Rawlings but would, ultimately on summary judgment, rule in Rawling’s favor. While the court would find that Rule 5.6 does constitute Kentucky public policy, it also found that a “savings clause” in the Agreement protected Rawlings from any violation thereof. On that basis, she was not terminated for refusing to violate Kentucky law, and her termination was on that basis legitimate.

      The Court of Appeals will focus upon the question of whether the rules of professional conduct promulgated by the Kentucky Supreme Court governing the conduct of Kentucky attorneys satisfy the public policy component. Parsing a variety of cases which looked to Kentucky's statutory law and Constitution as the basis of public policy, in the course thereof rejecting a variety of other sources such as federal and state regulations, it would ultimately conclude that the rules of the Supreme Court do not embody public policy. Hence, even a direct violation of Rule 5.6 would not support a claim for an exception from the employment at will doctrine.

      This opinion creates a significant gap in the law. Unique of all the professions, attorneys are not subject to regulation by statutes passed by the Kentucky General Assembly. Rather, the regulation of the legal practice is governed by rules promulgated by the Kentucky Supreme Court. This bifurcation is consequent to separation of power principles. It is for that reason that, for example, while the General Assembly could pass the limited liability company act and declared that LLCs may be used by any business or professional practice, it required a separate rule from the Kentucky Supreme Court to squarely enable attorneys to utilize that form.

      With the Greissman decision, attorneys may not cite the rules of professional conduct by which we are bound as the basis for public policy. In consequence, a law firm may terminate an attorney for refusing to sign and could require an attorney to sign an agreement that violates Rule 5.6 (or any other rule) without risk that a court will find that termination improper. While it is conceivable that the terminated employee could bring an action, presumably via the Kentucky Bar Association, challenging that action, that will be at best a torturous path.

       Other states follow different rules, treating as public policy the rules promulgated by various state supreme courts with respect to the regulation of attorneys. Those decisions avoid the gap that the Greissman opinion has in Kentucky created.

 

Assignees and Rights to Inspect Books and Records

Assignees and Rights to Inspect Books and Records

      In a recent column from his blog New York Business Divorce, Peter Mahler reviewed a trial court decision in which a Minnesota court afforded the assignees of certain interest in an LLC the right to inspect the LLC’s books and records. That case, otherwise unreported, is Lotton v Savich Herfords, LLC. Professor Dan Kleinberger, a mutual friend of Peter Mahler and I, served as an expert witness in this case arguing that, at least upon the facts there presented, the assignees should be afforded the right to inspect books and records so as to protect their rights, as assignees, to distributions from the venture. Peter’s review of this issue is titled Can the Bare Naked Assignee Demand Access to LLC Records. HERE IS A LINK to that blog posting.

From my perspective, the holding in that case was wrong.

      Partnership law, going back to the UPA (1914), has embodied the principle of In Delectus Personae, often rendered as “pick your partner.” To that end, while the economic rights in a partnership are freely transferable, the right to participate in the partnership's management is restricted to those persons who have been admitted as partners. See generally Rutledge, In Delectus Personae and Proxies, 14 J. Passthrough Entities 43 (July/Aug. 2011); HERE IS A LINK to that article. This rule was carried forward into limited partnership law, the RUPA (1997) and every LLC Act that has been adopted in the country. That an assignee is not afforded the right to inspect books and records is the natural consequence of the rule that they do not participate in the management of the venture. That this is the rule, and that this rule may at times impose burdens upon assignees, is recognizing by the fact that certain states, via statute, have afforded assignees the right to inspect books and records. It cannot be said that denying assignees document inspection rights is an oversight or unintended consequence of the law.

      In the Lotton decision, the judge wrote:

In cases where the member who transferred the financial rights remains alive and retains governance rights, that member can act to protect the rights of his assignees. Where, as here, the rights were transferred upon the death of a member, there is no one left with governance rights to protect the interests of the assignees and there must be some mechanism for the assignees to protect their financial interest.

Further, the court recited the axiom of equity, namely that where there was a right, there must be a duty whose breach would give rise to a remedy.

      What, in my view, the court failed to acknowledge is that not every perceived imposition involves a legally cognizable right. There is a venerable principle of equity law, Damnun Absque Injuria, that not every damage gives rise to a legally cognizable injury, is here applicable. As described in the United States Supreme Court in Alabama Power Co. v. Ickes, 302 U.S. 464, 479 (1938).

“if the act complained of does not violate any of his legal rights, it is obvious, that he has no cause to complain…” Want to write and want of remedy are justly said to be reciprocal.… The converse is equally true, that where, although there is damage, there is no violation of the right no action can be maintained.

Setting aside those few legislatures that, in particular statutes, have afforded an assignee the right to inspect books and records, which rights should pursuant to those laws be enforced, the objections of assignees that they are denied the right to inspect books and records falls within Damnun Absque Injuria. While a mere assignee may believe they are being damaged, none of their rights have been negatively impacted.  The organizational statutes governing the partnership/limited partnership/LLC provide that the assignee has no right to inspect books and records. The courts should not view themselves as in a position to, under the guise of equity, modify this rule.  Yes, it is entirely true that this leaves an assignee, previously characterized by Professor Kleinburger as being a “bare naked assignee,” with few if any remedies, absent the venture’s dissolution, to enforce the rights to receive the distributions that would have otherwise gone to the assignor. The fault of that situation arising lies with the assignor for not putting in place mechanisms to protect the interests of his or her assignees. Neither the venture nor the other participants therein should bear the burden of that lack of forethought.

Federal District Court Addresses the Direct Versus Derivative Distinction in LLCs

Federal District Court Addresses the Direct Versus Derivative Distinction in LLCs

      In a recent decision from the Federal District Court for the Eastern District of Kentucky (Judge Bunning), a complaint was dismissed where it brought what were derivative claims, but in the guise of direct claims. On that basis, the complaint was dismissed. DT Grat Jmt, LLC v. Keeney, Civ. Act. No. 17-101-DLB-CJS, 2017 WL 5194063 (E.D. Ky. November 9, 2017).

       Keeney, the defendant herein, served as the manager of a series of 13 limited liability companies collectively referred to as the “Park Companies.” The plaintiffs herein were members in the Park Companies. They alleged, in the complaint, that Keeney had engaged in a pattern of fraudulent conduct, self-dealing and mismanagement of the various Park Companies. In addition, Keeney owned four other business entities (the “Kenney Business Entities”) that, in turn, provided services to the Park Companies; the plaintiffs did not have an ownership interest in any of those companies. It was alleged that park Companies assets were diverted to the Keeney Business Entities.

      Various of the operating agreements of the Park Companies provided that an annual budget would be presented to the members for consideration, and that “the budget must be approved in writing by the Members.” It was alleged that Keeney had failed to tender proposed budgets, but had continued to disperse assets from the Park Companies. Also, those same operating agreements required that related party transactions have the approval of a majority of the members. It was alleged that payments had been made by various of the Park Companies to the Keeney Business Entities without that approval. Based upon information that came to light once Keeney, at the plaintiffs request, began marketing the Park Companies for sale, and after a forensic audit, it was determined that Keeney had, without the approval required by the operating agreement, transferred to the Keeney Business Entities nearly $12 million. Suit was then brought against the defendants alleging breach of contract, breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and fraud. The defendants then filed a motion to dismiss under Rule 12(b)(6).

Necessary Parties

      The defendants argued that the proper plaintiffs in this action should be the 13 LLCs comprising, collectively, the Park Companies, and not the individual members thereof. Specifically:

Defendants believe that those limited-liability companies are the real parties in interest because “individual members of LLCs may only bring claims in their individual capacity when they have suffered a separate and distinct injury from that of the LLC.” Defendants argue that the current Plaintiffs have not suffered an injury that is separate and distinct from the injury allegedly suffered by the Park Companies. Thus, defendants contend that the Plaintiffs’ claims are derivative, and under Rule 17(a), the Court must substitute the current Plaintiffs for the 13-limited liability companies collectively referred to as the Park Companies. 2017 WL 5194063, *3 (citations omitted).

      In opposition, the plaintiffs asserted that this is it this action is direct, not derivative, they asserted:

Specifically, plaintiffs argue that the important distinction is that the alleged misdeeds involve wrongs to certain members - not all members - of the 13 limited-liability companies that are collectively referred to as the Park Companies. That is, because the misdeeds were to the benefit of some members of the limited-liability companies - Defendants - and to the detriment of other members of the limited-liability companies - Plaintiffs. Plaintiffs believe that it is this distinction that makes plaintiffs the real parties in interest, rather than the 13 limited-liability companies known as the Park Companies. Thus, Plaintiffs argue that they are entitled to bring a direct claim for the distinct harms they suffered from the Defendants’ misconduct. 2017 WL 5194063, *4 (citations omitted).

       The court would agree with the defendants in this action, holding, inter alia, that is the various of the Park Companies that should be the plaintiffs in this action, noting, for example, that the allegations were that monies were transferred from the Park Companies.

       At oral argument, the plaintiffs argued that the Kentucky LLC Act, specifically KRS § 275.337(1), allows them to bring a direct action against the defendants. The court noted, however, that the condition of that provision is a requirement that “the member can prevail without showing an injury or breach of duty to the company.” In this case, it was found that the plaintiffs could not meet this burden. Rather, finding that the crux of the claims were that assets and other funds were misappropriated from the Park Companies, the actions complained of assert an injury to the LLCs, not to the individual plaintiffs.

Breach of the Operating Agreements

      The plaintiffs also asserted that the defendants had violated certain of the terms of the operating agreements, alleging that this gave rise to a direct cause of action. Noting that the existence of the LLCs was a condition precedent to the existence of these claims, the Court found that the claims are necessarily derivative. Specifically:

“But for the limited liability companies, those claims would not exist.” Trident-Allied Assocs., LLC v Cypress Creek Assocs., LLC, 317 F.Sup. 2d 752, 754 (E.D. Mich. 2004). Those “very Agreements… served as the basis for the creation of the LLC in the first instance.” Id. (citing Trademark Retail, Inc. v Apple Glenn Investors, LP, 196 F.R.D. 535, 540 (N.D. Ind. 2000)). Put simply, Plaintiffs’ claims are derivative, not direct, whether styled as breach of contract, breach of fiduciary duty, or fraud. 2017 WL 5194063, *6.

      Having determined that the various Park companies are the real parties in interest, the court determined that diversity jurisdiction would be lacking, and the action was dismissed.

       All of that is well and good, but in discussing the fiduciary duties of the members of an LLC, there was some incorrect dicta presented with respect to fiduciary duties. Specifically, the opinions provides in part:

Defendants' duty ran to both the members of the limited-liability companies into the limited-liability companies themselves. The liability of members and managers of limited-liability companies is outlined in Ky. Rev. Stat. Ann. § 275.170. In Kentucky, a managing member of a limited-liability company owes fiduciary duties to other members of the limited-liability company and to the limited-liability company itself. Patton v Hobbs, 280 S.W.3d 589, 595 (Ky. Ct. App. 2009). Although it may be true that Plaintiffs, as members of the 13 limited-liability companies that formed the Park Companies were owed fiduciary duties by Defendant Keeney, so too were the limited-liability companies. 2017 WL 5194063, *5.

But Still Some Problems as to Fiduciary Duties

      With respect to the reference to KRS § 275.170, the court, in a footnote, wrote:

To summarize the statute, “a member or manager must account to and hold as trustee for a limited liability company any profit or benefit to right from the use of company property by that member or manager including, but not limited to, confidential, proprietary, or other matters entrusted to that person's status as a manger (sic manager) or member.”, quoting from Patton v Hobbs.

The problems with these statements include:

 

·         KRS § 275.170 does not outline liability, but rather outlines fiduciary duties/standards of culpability;

·         The statute bifurcates the fiduciary duties between those of care and loyalty;

·         While the duty of care is owed, in a member-managed LLC, by each member to each other member and to the company, the duty of loyalty is owed only to the company;

·         The central holdings of Patton v Hobbs had been significantly undercut by subsequent amendments to the LLC Act making express that the statutory formula sets forth the only fiduciary duties of the members and managers; and

·         While the alleged diversion of assets from the Park Companies implicated the duty of loyalty (nobody would complain that they diverted the assets in a sloppy manner, thereby implicating the duty of care), that duty of loyalty is owed only to the LLC and not amongst the members.

Recovery Denied on an Illegal Contract

Recovery Denied on an Illegal Contract

      In a recent decision from the Kentucky Court of Appeals, it refused to grant any relief to the plaintiff for recovery under an illegal contract. Varner v. Kingfish Capital Partners I, LP, No. 2016-CA-001415-MR, 2017 WL 5952867 (Ky. App. Dec. 1, 2017).

       Varner, resident in Kentucky, entered into an oral agreement with Kingfish Capital Partners I, L.P. (a hedge fund) to solicit persons and companies to invest therein. In connection with the funds invested, Varner claimed agreement that he would be paid a placement fee of 8.5% of the amount subscribed for. Varner ultimately invested $25,000 of his own money and Kingfish, and raised additional investments of $700,000. Ultimately, Varner was not paid by Kingfish, and he filed an action seeking payment. In response, Kingfish moved for summary judgment on the basis that the contract between itself and Varner was illegal and unenforceable.

      Under Kentucky Securities (Blue sky) law, subject to certain exceptions, a person must be licensed as a broker or agent with the Kentucky Division of Securities in order to be paid a commission on the sale of securities. Varner was not licensed. His efforts to argue he fell within certain exceptions were unsuccessful in that he did not meet the terms thereof. This doomed his claim for enforcing the oral agreement, the court writing:

In sum, under the facts alleged by Varner, i.e., that he acted as Kingfish’s agent in the sale of Kingfish’s securities and contracted for an 8.5% commission in connection with those sales, Varner is not exempt from the registration requirements of either the Kentucky or the federal securities laws. As a result, and as a matter of law, Varner violated those laws under his sworn factual allegations in this case.

       On the basis of a provision of the Securities Exchange Act of 1934 in voiding any contract made in contravention of its terms, and as the alleged agreement between Varner and Kingfish violated its terms, the agreement was unenforceable. A similar determination was made well under Kentucky law.

        Pivoting, Varner then claimed that, even if the contract is not enforceable, he should have a claim under a theory of unjust enrichment. This the court rejected on the basis that equitable relief would not be granted in connection with an unenforceable promise.

Federal District Court Denies Motion to Dismiss Complaint Alleging New Employer of Corporate Officer Aided & Abetted Breach of Fiduciary Duties

Federal District Court Denies Motion to Dismiss Complaint Alleging New Employer of Corporate Officer Aided & Abetted Breach of Fiduciary Duties

      In a recent decision from the federal district court (Judge McKinley), he denied a defendant's motion to dismiss a complaint alleging that the defendant’s new employer could not be charged with having aided and abetted the individual’s breach of fiduciary duty in leaving the prior employer. Vivid Impact Co., LLC v Ellis, Civ. Act. No. 3:17-CV-509-JHM, 2017 WL 5505024 (W.D. Ky. Nov. 16, 2017).

      As Stoll Keenon Ogden is representing the plaintiff in this action, no further commentary on this decision will be provided.

The Assassination of Cicero

The Assassination of Cicero

            Today marks the anniversary of Cicero’s assassination 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.

After the assignation of Julius Caesar, 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>  Ultimately 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.

Arkansas Court Considers and Rejects Preliminary Injunction Against LLC Member Who Was Looting the Company

Arkansas Court Considers and Rejects Preliminary Injunction Against LLC Member Who Was Looting the Company

Under Arkansas law, as is the law of Kentucky, one of the requirements for seeking injunctive relief is that the alleged injury cannot be redressed with monetary damages. In a recent decision from Arkansas, this rule was considered in the context of an allegation that an LLC’s member was looting the company. Finding that, if proven, the remedy could be addressed with monetary payment, the preliminary injunction issued by the trial court was vacated. Wait v. Elmen, 2017 Ark. App. 648 (Ark. App. Nov. 29, 2017).

Wait and Elmen, amongst others, were members of a series of LLCs that, between them, operated an apparently local chain of lingerie stores. Elmen, individually and on behalf of the LLCs, brought suit against Wait alleging “causes of action for conversion, breach of contract, fraud, gross negligence and breach of fiduciary duty.” These claims were brought on the basis that Elmen had used company assets to pay personal expenses, including:

Car payments, house payments, utility payments, insurance payments, and fringe benefits. In addition to these expenses, Elmen withdrew $100,000 from the various Cupid's entities to pay part of a $550,000 settlement with a former business partner and took money to help pay personal tax lien in favor of the IRS of over $100,000.

The trial court had granted a preliminary injunction against Wait, leading to this appeal.

Focusing upon the requirement that there be irreparable harm in order for injunctive relief to be granted, the court characterized the issue as:

Elmen alleges that Wait has diverted cash from the companies to pay personal expenses for himself and his mother and stepfather. Wait has also alleged to have increased his salary without proper authorization. We find this is the type of financial harm that is quintessentially reparable by monetary damages.

On that basis, the preliminary injunction was dissolved.

Congratulations to Peter Mahler and the New York Business Divorce Blog

Congratulations to Peter Mahler and the New York Business Divorce Blog

      In his blog New York Business Divorce, Peter Mahler has posted some thoughts with respect to the last decade and the development of his outstanding blog. HERE IS A LINK to that posting.

      If the law of business entities is of interest to you, you should definitely be following Peter.