This blog, written by Thomas E. Rutledge, focuses primarily on business entity law in Kentucky. Postings on contract law, contractual and statutory construction, and the entity law of other jurisdictions appear as well. There may as well be some random discussions of classical, medieval and renaissance history.
Court Addresses Corporate and
LLC Derivative Actions, Pleading of Futility
In a decision issued last week
by the Federal District Court for the Eastern District of Kentucky (Judge Reeves),
there was addressed the requirements for bringing a direct, versus a
derivative, action in the context of both the corporation and the LLC. Also
considered in detail was the requirements for pleading demand futility. Smith v. Tarter, No. 5:17-334-DCR, 2018
WL 506227 (E.D. Ky. January 22, 2018).
Smith, along with other
individuals, filed, in the alternative, direct and derivative claims with
respect to a corporation, the Tarter Companies, identified as “the largest
manufacturer of farm gates and animal management equipment in North America,”
and certain related LLCs. It was alleged that defendants Joshua Tarter and
Thomas Gregory, including a company they organized, all were funneling assets
of the Tarter Companies to themselves. Specifically, they used a company they
organized, QMC Industry Company, Ltd. (“QMC”), as the vehicle through which
they would source products in China. However, Tarter and Gregory would cause QMC
to markup its prices vis-à-vis what it was paying the Chinese manufacturer, in
effect capturing, uniquely for themselves, some of the cost savings that would
have otherwise been enjoyed by the Tarter Companies.
In response to the complaint,
the defendants filed a motion to dismiss.
The court began its analysis
with the direct claims bought with respect to the corporation’s, beginning its
analysis by noting that the plaintiffs “have not alleged that they sustained
any personal injuries apart from the costs and a loss of cost savings allegedly
incurred by the Tarter Companies.” 2018 WL 506227,*4. Then applying the rule
that a shareholder may not bring a personal claim unless they are able to show
injury other than to the corporation, and that claims based upon the diminution
of share value are derivative in nature, the direct claims were dismissed for
lack of standing.
Turning to the direct claims
brought with respect to the LLCs, the plaintiffs asserted that they had the
standing to bring them as, inter alia,
they are parties to the operating agreement and the defendants were charged
with violating same. Judge Reeves rejected this assertion, holding rather that,
again, the alleged injuries were to the business entity, and in consequence
thereof any suit to remedy same needed to be on a derivative basis. He cited in
support KRS § 275.337. To that end, the court wrote:
plaintiffs have not plausibly alleged that they sustained any injury as members
of the Tartar LLCs that is not indirect or incidental to the Tartar LLCs’
expenditure of costs and loss of cost savings. As a result, they lack standing
to bring an individual capacity action to redress those injuries. Accordingly,
the plaintiffs lacked standing to maintain an individual capacity action either
as shareholders of the Tartar Corporations or as members of the Tartar LLCs, and
their individual capacity claims must be dismissed. 2018 WL 506227, *5.
Turning then to the derivative
counts, the court began by noting the “heightened pleading standards” under
Federal Rule of Civil Procedure 23.1 applicable with respect to derivative
actions, particularly the obligation that the plaintiff “state with
particularity” the efforts “made to prod the entity into bringing the action on
its own behalf, and any reason the plaintiff failed to make such an effort or
the effort was unsuccessful”. In addition to FRCP 23.1, there were cited the
equivalent provisions of the Kentucky Business Corporation and the Kentucky Limited
Liability Company Acts.
Relying upon both Kentucky and
Delaware law, the situations in which demand futility is available were
discussed. Here, it was found that the only defendant with an ownership
interest in the Tartar Companies is Joshua Tartar, owning 16.6%. The plaintiffs
own 50% of that company, and the remaining balance of 33.47% was owned by
non-parties to this action who are members of Joshua Tarter’s family. It was
determined that the plaintiffs had not plead with particularity why those other
owners could not or would not exercise legitimate business judgment with
respect to the matter. Specifically, the plaintiffs had failed to make “particularized
factual allegations” that would give rise to “a reasonable doubt” that the
siblings would “not exercise independent and disinterested business judgment.”
2018 WL 506227, *6. In this respect, the court adopted a Delaware rule as to
determining whether a director is interested in a transaction thereby unable to
exercise independent business judgment:
Delaware law, a director is considered “interested” if he or she: (i) received
a personal financial benefit that was not shared by the other stockholders from
the challenged conduct; (ii) might suffer a “materially detrimental impact”
from the proposed legal action; or (iii) was incapable, due to domination and
control, of objectively evaluating a demand to assert the company’s claims.
2018 WL 506227, *7 (citations omitted).
In that the plaintiffs had not
alleged any of these disabling factors, they had not satisfied their obligation
to plead demand futility. Rather, “The plaintiffs have plead no facts
indicating that the desire to maintain control of 50% of the Tartar Companies
together with Joshua Tartar would undermine Joshua Tartar’s siblings’
independent judgment.” Id.
The complaint was dismissed
without prejudice, so subject to statute of limitations issues, presumably,
after appropriate demand, the complaint could be refiled.
I do have a quibble with the
opinion, where it provides:
Griffin [v. Jones, 170 F. Supp. 3d 956 (W.D. Ky.
2016)] and Patmon [v. Hobbs, 280 S.W. 3d 589 (Ky. App.
2009)] established that, under Kentucky law, a managing member of a limited
liability company (“LLC”) owes fiduciary duties both to the LLC and its
Not recognized in this
decision is that after the Patmon
decision, KRS § 275.170, it defining the fiduciary obligations that are owed in
LLCs, was revised, eviscerating most of the Patmon
decision (it as well has been essentially set aside by the third opinion of the
Court of Appeals in that case) and that this case involves an alleged breach of
the duty of loyalty, which is owed only to the company (and not inter se of members). In addition,
fiduciary duties, including as to who owes them and to whom, are subject to
being altered in the operating agreement.A reference to the default rule has validity if and only if it has been
first determined that the operating agreement did not set forth a different
formula.Maybe, in this instance the
operating agreement was silent as to whom the duties were owed, and the default
rule applied.Alternatively, the
operating agreement was never reviewed. Either way, the opinion does not say.
LLC law provides for often
surprising results upon a member’s death. Essentially, unless different rules
are set forth in the operating agreement, the decedent’s rights as a member in
the LLC evaporate, and the estate has only a limited rights against the LLC and
the other members. Oftentimes the estate has no right to inspect the LLC’s
books and records, and absent a contrary provision in the operating agreement
the estate will be owed no fiduciary duties.
In a recent decision out of New
York, the court applying an operating agreement and Delaware law that are not
dissimilar from the laws of Kentucky, it was confirmed that the estate of what
had been the majority owner of a company operating a chain of luxury hotels was not
entitled to inspect the LLC’s books and records and was not owed fiduciary
duties. Estate of Calderwood v. ACE Group
Intl. LLC, 2017 NY Slip Op 08750 (App. Div. 1st Dept. Dec. 14,
This decision has been reviewed
in the New York Business Law Divorce; HERE IS A LINK to that review.
Florida Court Addresses Priority of Charging Orders
In a pair of recent decisions,
the Court of Appeals for the First District in the State of Florida has
provided guidance with respect to the priority of the lien created by a
charging order.This being a point
seldom addressed, the prior guidance largely being restricted to the McClure decision from Colorado, these
new decisions provide important guidance.Capstone Bank v. WinSouth Credit
Union, Case No. 01D-16-1484 (Nov. 30, 2017); Capstone Bank v. Perry-Clifton Enterprises, LLC, Case No.
01D-16-1094 (Nov. 30, 2017).
In the WinSouth Credit Union case, while the facts recited in the opinion
are rather sparse, WinSouth applied for a charging order against the interest
of John Richards and Christopher Richards, each in an unnamed Florida limited
liability company.Likewise, Capstone
Bank had applied for a charging order against the same interest, the question
was the priority of the orders.The
charging order issued in favor of WinSouth was based upon a judgment entered by
an Alabama court.Over a dissent, it was
determined that the Alabama judgment had not been properly domesticated in
Florida before the charging order was issued.On scanty analysis, the court went on to determine that the WinSouth
charging order should not have been issued, leaving that of Capstone with
While the dissent would
challenge the determination that the judgments against John Richards and
Christopher Richards were not sufficiently domesticated in Florida, it
explained why Capstone would still prevail, that based upon the timing of the
application for and receipt of the charging order.
In the Perry-Clifton case the dispute again began with an Alabama
judgment, this being a divorce decree.The question was whether a Alabama divorce judgment in favor of Christy
Richards constituted a charging order in favor of Christopher Richards’
interest in Perry-Clifton Enterprises, LLC.The divorce decree awarded to her all of Christopher’s interest in
Perry-Clifton Enterprises.While the
divorce decree was filed in Florida, no charging order was at that time
Thereafter, Capstone requested
and received from a Florida court a charging order against Christopher
Richards’ interest in Perry-Clifton.Christy
Richards, some six weeks later, sought to intervene in that action and filed a
motion to stay the issued charging order.The trial court determined that the Alabama divorce decree “itself
constituted a charging order” and had priority over that issued to Capstone
Bank.That determination would, in this
appeal, be reversed.
On the basis that a charging
order, issued by a court on motion, is the “sole and exclusive remedy” against
an interest in a Florida LLC, the court concluded that the charging order
issued in favor of Capstone Bank would have priority.
Based on statistics released
for the entirety of 2017 by the Kentucky Secretary of State’s office, LLCs
remained the dominant entity of choice. In 2017, some 23,550 LLCs were
organized in Kentucky. In turn, 2,070 for-profit corporations were organized.
Essentially, more than 11 LLCs were organized for every corporation created in
marks an interesting anniversary of an event that took place in the year 533
ad.On this day, a man named Mercurius
was elected Pope (the Bishop of Rome).He adopted as his papal name John II, believing that he should not as
Pope be known by his birth name, it being that of the Roman (pagan) god
Mercury.He was the first Pope to adopt
apapal name different from his own
More popes have been “John” than any
other name, most recently John XXIII. The last Pope to not adopt a regnal name
was Marcellus II, elected in 1555.