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.