Alleged Oral Cross-Purchase Agreement Fails Under New York Statute of Frauds; Counsel Disqualified

Alleged Oral Cross-Purchase Agreement Fails Under New York Statute of Frauds; Counsel Disqualified

      In a recent decision from New York, there was a decision, not extraordinary in and of itself, with respect to enforcement of an alleged oral cross-purchase agreement between the members of an LLC. Perhaps of greater interest, the court disqualified the LLCs attorney from further involvement in the dispute. Deerin v. Ocean Rich Foods, LLC, 2018 N.Y. Slip Op. 00820, 2018 WL 736212 (App. Div. 2^nd Dept. N.Y. Feb. 7, 2018).

      Ocean Rich Foods was organized in 2006 amongst Richard Marino, Dean Berman and Douglas Deerin. In 2008, the company bought $1.5 million life insurance policies on each of the members; the LLC was the beneficiary of each policy. At some point in time cross-purchase agreements were drafted providing, inter alia, that upon a member’s death, the LLC would use the proceeds of the life insurance policy to in whole or in part fund the redemption of the interest of the deceased member. Those agreements were not, however, ever executed by any of the members. After Deerin passed away, his estate would assert that there existed an oral cross-purchase agreement pursuant to which the proceeds of the policy on his life should be paid over to the estate. Under New York law, a contract must be in writing if it “is not to be completed before the end of a lifetime.” N.Y. General Obligations Law § 5-701(a)(1). As the cross-purchase agreement, alleged to have been orally (but not in writing) existed between the members could not be completed before the end of a lifetime (i.e., it would require a death before it would be triggered), the alleged oral agreement failed under the New York statute of frauds. 2018 WL 736212,*2.

      Turning to the question of disqualification, it appears this effort was initiated only after Marino and Berman submitted affidavits to the effect that the members had decided to not execute the written cross-purchase agreement. The plaintiff’s argument for disqualification was summarized by the court as follows:

Here, the plaintiff alleged in an affidavit that the defendants’ counsel was involved in the formation of Ocean Rich, and the defendants’ counsel admitted that he had represented Ocean Rich in “various past matters.” Council’s prior representation of Ocean Rich “was in fact representation of its three shareholders,” whose competing interest are at issue in this action. Likewise, council’s involvement in the formation of Ocean Rich and his representation of it against third parties was “substantial related” to the present action. 2018 WL 736212,*3 (citations and editorial edits omitted).

      From there the court determined that disqualification was appropriate, writing:

Since the defendants’ counsel was “in a position to receive relevant confidences” from the decedent, whose estate’s interests “are now adverse to the defendant[s’] interests,” the Supreme Court should have granted that branch of the plaintiff’s cross motion which was to disqualify the defendants’ counsel.

      A pair of thoughts on this decision. First, with respect to the statute of frauds barring the alleged oral cross-purchase agreement, the statutes of fraud of the various states are different from one another. Kentucky does not have the limitation relied upon in New York. That doesn’t mean that an oral cross-purchase agreement is enforceable and does not violate the statute of frauds, but rather that, under Kentucky law, the alleged oral agreement would need to be compared to the Kentucky statute of frauds. To that end, the statute of frauds under the Uniform Commercial Code might as well apply.

      With respect to the disqualification, I cannot speak to New York law, but if Kentucky law were applied, this nonchalant disqualification of counsel would be inappropriate. Under Supreme Court Rule 1.13, representation of a business entity does not mean that the attorney is in an attorney-client relationship with the constituents (in this instance the members of an LLC). If the deceased disclosed confidential information to the LLC’s attorney when there was no existing attorney-client relationship between the attorney and the decedent, he did so without a reasonable expectation of privilege or that the information could not later, when advantageous to the LLC and disadvantages to him, be utilized. All in all, this case should not be allowed to stand for the proposition that the attorney who serves as counsel for an LLC may not, when a member later brings suit against the LLC, continue to represent its interests.

Delaware Jurisdiction to Issue Charging Order

Delaware Jurisdiction to Issue Charging Order

      In a recent decision from Delaware, the primary question was whether it is the Chancery Court, the Superior Court, or both that has the capacity to issue a charging order. Bridev One, LLC v. Regency Centers, L.P., 2018 WL 824976 (S. Ct. Del. Feb. 9, 2018).

      Essentially, the defendant who was subject to the sought charging order asserted that only the Chancery Court could issue a charging order. After parsing the statute and various changes made in the jurisdictional authority of the various courts, it was held that the Superior Court, coincident with the Chancery Court, has the authority to issue a charging order.

      In addition, the defendant asserted that the information relied upon to determine that he was at least likely a member of the LLC was “stale.” The court found the relied upon information was sufficient. The court went on to observe that “Either way, discovery in aid of execution would be appropriate.”

Sixth Circuit Court of Appeals Strikes Down Residency Requirement for Tennessee AlcoholicBeverage Licensees

Sixth Circuit Court of Appeals Strikes Down Residency Requirement for Tennessee Alcoholic Beverage Licensees

      In a decision rendered February 21, the 6^th Circuit Court of Appeals affirmed the decision of the trial court that declared unconstitutional, on Commerce Clause grounds, Tennessee statutes imposing residency requirements with respect to licensees. Byrd v. Tennessee Wine and Spirits Retailers Association, No. 17-5552 (5^th Cir. Feb. 21, 2018).

      Tennessee had a statute that imposed broad residency requirements on those who would seek to have a license to manufacture, distribute or sell alcoholic beverages. With respect to an individual, Tennessee required that an individual seeking a license must have “been a bona fide resident of [Tennessee] during the two-year period immediately preceding the date on which the application is made to the commission.” Tenn. Code § 57-3-204(b)(2)(A). With respect to corporations seeking a license, it was required that that same two-year bona fide residency requirement be applied to any officer, any director and any stockholder. Two prospective licensees challenged these statutes on the grounds that they impede interstate commerce. In effect, in order to receive a license, a person would need to move to Tennessee and be resident there for two years before filing. With respect to corporate entities, that requirement would apply to all of the perspective officers, directors and shareholders.

      There exist a tension, recognized through a long string of cases, between the 21st Amendment and the Commerce Clause. The 21st Amendment vests in the states the ability to regulate the manufacture and trade in alcoholic beverages. In contrast, the Commerce Clause invalidates state efforts to erect protectionist barriers, treating inter-state commerce differently than intra-state commerce. Of most recent vintage, in Granholm v. Heald, the Supreme Court declared invalid state statutes that allowed intra-state shipments of wine while forbidding inter-state shipments. This is a topic I previously considered, including in an article co-written with Micah C. Daniels, Who's Selling the Next Round: Wines, State Lines, the 21st Amendment and the Commerce Clause, 33 N. Ky. L. Rev. 1 (2006).

      In this instance, affirming the determination of the trial court, the 6^th Circuit Court of Appeals found that these residency requirements violated the Commerce Clause. There was a dissenting opinion, and it is noteworthy that the majority decision responded to (and in my view refuted) the dissent in a series of detailed footnotes distributed throughout the opinion.

      Ultimately, this is yet another opinion confirming that states do not have unilateral authority to impose restrictions on the alcoholic beverage industry that have the effect of impacting inter-state commerce, restrictions applicable not only to the alcoholic beverages themselves, but also the privilege of engaging in that industry.

Disclosure of LLC’s Membership in Diversity Cases

Disclosure of LLC’s Membership in Diversity Cases

       In order to determine whether a lawsuit may be in Federal court under diversity jurisdiction, the court must know the citizenship of the LLC. That citizenship is, in turn, determined by reference to the citizenship of the LLC's members. A recent decision out of the Federal District Court for Maryland rejected efforts to keep that information out of the public record. Smith v. Westminster Management, LLC, Civ. No. JKB-17-3282, 2018 WL 572867 (D. Md. January 26, 2018).

     This suit, filed originally in state court, alleged that the defendants “engaged in various practices to wring fees from these tenants, including baselessly threatening eviction, charging various late fees and legal fees, and misallocated rent payments to pay for these fees, causing the tenants to come up short on their rent.” Those defendants included Westminster Management LLC and JK2 Westminster LLC, companies whose membership included Jared Kushner, son-in-law of the current president, as well as other members of the Kushner family. After removing the action to Federal court on the basis of diversity jurisdiction, they sought, in effect, to file disclosure as to the membership of these LLCs under seal on the basis that otherwise they could be deprived of the right to an impartial decision and that there needed to be protected the privacy of “remote to disinterested investors/families.” 2018 WL 572867, *5.

       These efforts were rejected. The court found that the information with respect to the members of the LLC used to determine whether diversity jurisdiction exists constitute a judicial records that, presumably, are to be of public record. The court found as well that the claimed privacy interests were not sufficient to overcome the presumption of public availability. In doing so, the court cited additional cases from Florida and Wisconsin.

The Death of Michelangelo

The Death of Michelangelo

      Today marks the anniversary of the death in 1564 of Michelangelo Buonarroti.

      Originally trained by means of an apprenticeship in sculpture, he had previously spent time as well living with the family of a stone mason.  While living with the mason he was struck and his nose was broken; the consequences of the mishap can be seen thereafter in his portraits.  Before reaching the age of thirty, Michelangelo created any number of significant works, including the Pieta, now in the Vatican, and his statue of David, which remains in Florence.  He as well created the statue of Moses with Horns (the horns being based upon a translaion error in the Bible) that is a portion of the tomb of Pope Julius II; the final tomb was far smaller than intended.

He was a contemporary of Leonardo da Vinci, Raphael and Titian.

      Although throughout his life he claimed he was a sculptor and not a painter, Michelangelo created innumerable paintings, most memorably the frescos on the ceiling of the Sistine Chapel and as well as the Last Judgment painted on the alter wall of the chapel.  Famously, Michelangelo’s portrait appears in the latter, appearing on the flayed skin of St. Bartholomew.  Today, the Cardinals of the Roman Catholic Church gather under those paintings when called upon to elect the next Bishop of Rome.

      Michelangelo had also been commissioned (although the work was never put in place) to provide a new façade to a basilica in Florence and as well served as the architect for St. Peter’s Basilica in Rome.  With respect that second project, much of the current shape of the basilica is his invention as is the design of the dome.

      While he died in Rome, Michelangelo was buried in Florence. As recorded by Vasari:

They [those gathered for his funeral] did so eagerly that those who could approach near and get a shoulder under the bier could indeed count themselves fortunate, for they realized that in the future they would be able to boast of having carried the remains of the greatest man their arts had ever known.

     February 18 is also the anniversary of the death in 1546 of Martin Luther.  Following the admonition that if you don’t have anything nice to say about somebody you should say nothing , ....

More on Purpose

More on Purpose

Last  year, in the Journal of Passthrough Entities, I published a short article on the importance of the “purpose” clause in LLC operating agreement and  similar business entity documents. HERE IS A LINK to that article.  Just before that article was released Peter Mahler, in his blog New York Business Divorce, wrote about the Mace v. Tunick decision; HERE IS A LINK to that posting.  Thanks to Peter’s lead, I was able to incorporation Mace v. Tunick into my article.

 

There have been further developments in the Mace case, and Peter has written about them in a posting titled The Purposeless Purpose Clause Makes a Comeback – Or Does It?; HERE IS A LINK to that posting.

 

Essentially, the LLC at question had a generic purpose clause, allowing it to engage in any activity in which an LLC may engage.  It was created to own the real estate from which a particular business operated.  The minority owner in the operating business eventually retired and was redeemed.  The operating business was then relocated out of state.   The majority owner of the LLC wanted it to remain in business, and he had the LLC lease the property to a third-party, but at a substantially lower rate than it had been receiving.  The minority owner wanted to liquidate the property and receive a liquidating distribution.

 

The plaintiff argued that the facts and circumstances, namely that the LLC’s purpose was to hold and lease property to the operating business, was no longer possible and that judicial dissolution of the LLC should follow.  That position was rejected as the purpose clause in the LLC’s documents was clear an unambiguous and therefore not subject to modification by parol evidence.

 

On that basis the minority member’s petition for judicial dissolution failed. Peter Mahler’s posting provides numerous insights as to the application of this decision.

No Partnership When Written Agreement Said No Partnership

No Partnership When Written Agreement Said No Partnership

       In a summary order issued by the United States Court of Appeals for the Second Circuit, it affirmed the determination that a particular business relationship was not a partnership because the purported partners, in writing, stated that it was an independent contractor relationship. Galvastar Holdings, LLC v. Harvard Seel Sales, LLC, No. 17-1571 (2^nd Cir. Jan. 16, 2018).

      In this case, one of the two parties to a business relationship asserted that it was a joint venture with, consequently, fiduciary obligations between the two parties. The trial court rejected this assertion, that conclusion was affirmed by the Second Circuit. After reciting the elements of a joint venture, the court pointed to the terms of a pair of agreements that provided:

The relationship of Galvstar and Harvard under this agreement shall be solely that of independent contractors. Nothing contained herein or any other documents comprising a part hereof shall be deemed to constitute or create a relationship of agency, joint venture, partnership or any relationship other than that as herein specified.

      In that the two participants were not partners/joint ventures, no fiduciary duties arose.

Questions on Bankruptcy Remoteness Certified to Fifth Circuit

Questions on Bankruptcy Remoteness Certified to Fifth Circuit

      Earlier this year, the United States Bankruptcy Court for the Southern District of Mississippi certified certain questions to the Fifth Circuit Court of Appeals, all relating to the ability to organize a venture as “bankruptcy remote.” In re: Franchise Services of North America, Inc., Case No. 1702316EE (Bankr. S.D. Miss. Jan. 17, 2018).

      For a number of years, there has existed a question of whether a particular business entity can structure itself as being “bankruptcy remote” with the effect that those remoteness provisions will be upheld. This reflects the tension between the law generally holding that it is against public policy to contract away the right to receive bankruptcy protections in contrast to the ability of participants in a business venture to, by contract, structure their relationship as they see fit. In a pair of 2016 decisions, In Re: Lake Michigan Beach Pottawattamie Resort, LLC and In Re: Intervention Energy Holdings, various bankruptcy remote structures were struck down. HERE is a link to my review of the In Re: Lake Michigan decision and HERE is a link to my review of the In Re: Intervention Energy Holdings decision. Most recently, Judge Schaff, in  In Re Lexington Hospitality Group, LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017) held that another bankruptcy remote structure was unenforceable.

      In this case, the bankruptcy court is asking the Court of Appeals to pass upon a certain bankruptcy remoteness structure referred to as a “Golden Share.” In the Golden Share structure, the right to veto a bankruptcy filing is held by an equity owner. This is in contrast to many of the other structures in which case the right to limit bankruptcy was vested in a creditor.

The “Nerve Center” of a Newly Formed Corporation

The “Nerve Center” of a Newly Formed Corporation

      An LLC, for purposes of federal diversity jurisdiction (28 U.S.C. § 1332) has the citizenship of each of its members. Where a member is a business corporation, the LLC will be attributed with both the corporation’s jurisdiction of organization and that in which it maintains its principal place of business, determined under the US Supreme Court’s “nerve center” test. What is the jurisdiction of incorporation is a straightforward question of positive law. For a corporation that has a significant operating history, determining where is the “nerve center,” the place at which the executive decisions are made, can be determined from that history. A recent case, however, faced the question of what would be the nerve center of a corporation that was newly organized. 3123 SMB LLC v. Horn, No. 16-55304, 2018 WL 445479 (9^th Cir. Jan. 17, 2018).

      In this instance, a California LLC had been operating for some period of time. Embroiled in litigation, and shortly before filing a lawsuit against the LLC’s former attorney, the ownership of the LLC was restructured. As restructured, the sole member in the LLC was a business corporation incorporated in Missouri. In turn, its directors and officers were domiciled in California. The new corporation’s organizational documents provided that the annual meeting of the Board of Directors would be held in Missouri.

      The challenge before the court was whether the nerve center of the corporation would be Missouri, as set forth in the organizational documents, or California.

      The court would ultimately determine that the statement in the organizational documents that the principal executive activities would be discharged in Missouri would be given effect. The outcome of that determination was that the LLC was a citizen of Missouri with the capacity to bring its malpractice suit against its California attorney in federal court.

No Breach of Fiduciary Duty in Fraudulent Stock Transfer Agreement, But There Was a Breach of Contract and a Violation of the Implied Covenant of Good Faith and Fair Dealing

No Breach of Fiduciary Duty in Fraudulent Stock Transfer Agreement, But There Was a Breach of Contract and a Violation of the Implied Covenant of Good Faith and Fair Dealing

      In a recent decision by a US District Court in Arkansas, it was held that, where a shareholder engaged in a fraudulent share transfer agreement, there was no breach of fiduciary duty. However, on the same facts, there was a breach of the implied covenant of good faith and fair dealing. Morrison v MC Express LLC, Case No. 3:17-CV-00144 BSM (E.D. Ark. Jan. 9, 2018).

      Mitchell started a trucking business, MC Express, Inc. He enlisted Morrison for assistance in obtaining customers. Morrison agreed to do so in return for both commissions and stock in the MC Express. In 2002, Morrison and Mitchell executed an agreement providing that there would be transferred to Morrison 10% of Mitchell’s stock in the MC Express upon “the removal of Chuck Mitchell’s personal liability by the holders of the debts owed by MC Express, Inc.” Morrison, with Mitchell’s knowledge and consent, held himself out as a “minority member” in the corporation.

      For over 10 years, no stock was transferred to Morrison pursuant to the March 29, 2002 agreement. In November, 2012, Mitchell, without Morrison’s knowledge, changed the name of the company to “MC Express Leasing” and formed a new LLC under the name “MC Express.” He then began to transfer many of the assets of the corporation to the LLC with the effect that the corporation was left undercapitalized. Then, December 2016, Mitchell told Morrison, inter alia, that Mitchell had never been personally liable on the debts of MC Express and for that reason Morrison would never be entitled to the 10% of the stock.

       Initially, the court found that there had been a breach of contract. Mitchell never guaranteed any of the bank debt or other obligations of MC Express, so the condition precedent to the transfer of the shares to Morrison had always been satisfied. In addition, by having transferred assets from MC Express to the newly organized LLC, in which Morrison had no and would have no ownership interest, Mitchell violated the implied covenant of good faith and fair dealing. “Morrison, however, presumably did not enter into an agreement to receive stock in an undercapitalized and pilfered corporation.”

       With respect to the claim for fiduciary duty, it was rejected on what may be a somewhat questionable basis. The court found that, while fiduciary obligations are owed to shareholders, Morrison never became a shareholder, and therefore cannot claim the benefit of those obligations. Understandable, but there exist a lingering question as to whether Mitchell, by having violated the stock transfer agreement and in so doing deprived Morrison of the rights to formally acquire the shares and thereby become a shareholder, should be able to hide behind his improper actions to deprive Morrison of the breach of fiduciary claim.

Effort to Reverse Pierce P.S.C. Rejected

Effort to Reverse Pierce P.S.C. Rejected

      In a typical case seeking to pierce the veil, a judgment-creditor seeks to hold the shareholders the corporation or the members in an LLC, the corporation or LLC being the judgment-debtor, liable for the obligations of the business entity. More rarely, we see efforts to hold a business entity liable for the debts of its owners. In certain instances, a judgment-creditor of a member or shareholder will seek to access the assets of the corporation or LLC in order to satisfy the judgment. This is referred to as outsider reverse piercing. Occasionally, we will see efforts by shareholder or a member to have a corporation or LLC ignored so as, intentionally, to make the assets of the business organization directly accessible by the owner. This is referred to as “insider reverse piercing.” In a case decided just last week by the Kentucky Court of Appeals, it rejected an effort by a shareholder in a professional service corporation (“P.S.C.”) to effect an insider reverse pierce and thereby claim coverage under an insurance policy. Isaacs v Sentinel Insurance Company, Limited, No. 2017-CA-000204-MR, 2018 WL 663001 (Ky. App. Feb. 2, 2018).

      Darrell Isaacs, a well-known personal injury plaintiff’s attorney in Louisville (a/k/a “Hammer”), was on January 19, 2015 injured while riding his bicycle on River Road, having been struck by Michael Baumann. Isaacs sued not only Baumann but also Sentinel Insurance, the firm that had written a policy to Isaacs’ firm, Isaacs & Isaacs P.S.C., of which he was the sole shareholder. Essentially (at least as I understand it), on the basis that Baumann did not have sufficient insurance, Isaacs was making a claim against Sentinel under the policies issued to the PSC. It bears noting that there is no suggestion that Isaac’s bicycle (which I understand to have been a Pinarello Dogma) was an insured vehicle under the Sentinel policy.

      Initially, the Court of Appeals dismissed the suggestion that the Sentinel policy covered Isaacs at the time of the accident.

So, an individual is entitled to UIM coverage if occupying a covered motor vehicle at the time of the accident. In short, the terms of UIM coverage set forth in the insurance policy are clear and unambiguous.

In this case, Isaacs was riding a bicycle at the time of the accident and was not occupying a covered auto. Under the clear and unambiguous terms of the insurance policy, Isaacs is not an insured entitled to recover UIM benefits. 2018 WL 663001, *3.

       The Court of Appeals as well rejected an effort by Isaacs to treat him and his PSC as “synonymous,” rejecting as well the argument “that the P.S.C. is nothing more than a ‘legal fiction’ for tax purposes only.” Rather, the court found:

In Kentucky, a professional service corporation (P.S.C.) is a corporate entity as set out in Kentucky Revised Statutes (KRS) 274.015. The corporation must provide professional service to the public of the type which requires as a condition precedent thereto, the obtaining of a license or other required legal authorization to perform the service.  This, licensed attorneys like Isaacs, are “qualified” persons under the statute who may form a P.S.C. to conduct their legal practice.  More importantly, a P.S.C. formed under KRS Chapter 274 has the “same powers, authority, duties and liabilities as a corporation formed under KRS Chapter 271B.”

Thus, a professional service corporation is a distinct legal entity under Kentucky law.  The formation of a P.S.C. under Kentucky law does not involve tax issues.  Rather, those issues look to an election under various federal tax laws by management as to whether the newly formed corporation will elect to be a C-Corporation or S-Corporation for tax purposes.  Isaacs’ argument that he is one and the same as his P.S.C. for insurance purposes because of a tax election is totally without legal merit under Kentucky law, as the record reflects he is a shareholder of the corporation.  Similarly, Isaacs’ argument that he is the named insured of the corporation’s automobile insurance policy by virtue of his stock in the P.S.C. is also without merit (citations omitted).

      And so ended the effort to reverse pierce the P.S.C.

The Bonfire of the Vanities

The Bonfire of the Vanities

      Today, February 7, marks the anniversary of the Bonfire of the Vanities, an event which took place in Florence Italy in 1497.

      Savonarola, a Dominican Friar, had been preaching against the material and artistic excesses present in Florence, arguing in contrast for a life of austerity. On February 7 was held the Bonfire of the Vanities, with “Vanities” including everything from ancient secular manuscripts to make up to mirrors to secular (as contrasted with religious) paintings. As recited in Ivan Cloulas (trans. Gilda Roberts), The Borgias at 134, “His hold over the Florentines was such that on February 7, 1497, on the Piazza della Signoria, he set up the famous ‘bonfire of the vanities,’ on which lascivious paintings, obscene books, lutes, pomades, perfumes, mirrors, dolls, playing cards, gaming tables, and scores of other articles were confined to the flames.” Exactly what was lost cannot be known.

      Savonarola would ultimately be excommunicated by Pope Alexander VI and suffered death by hanging in 1498; his body was burnt and the ashes cast into the river.