Chou v. Chilton – Round Two

Chou v. Chilton – Round Two

      The case of Chou v. Chilton has again been reviewed by the Court of Appeals.  Chou v. Chilton, __ S.W.3d __, 2014 WL 2154087 (Ky. App. May 23, 2014).

      Chou was the 51% member and the managing member of Ram.Chou LLC, a company engaged in the construction industry and structured to take advantage of certain minority set-aside programs.  After the LLC lost its Minority Business Enterprise (MBE) certification its activities were terminated.  Chou brought suit against the LLC’s other members, the Chiltons, alleging a variety of claims.

      In this dispute’s first trip to the Court of Appeals, the Court reviewed the counts from the perspective of a CR 17.01 “real party in interest” and found that Chou was seeking, for himself, damages for injuries suffered by the LLC.  In that he was not the real party in interest he could not bring those claims.  See Chou v. Chilton, 2012 WL 6526184 (Ky. App. Nov. 16, 2012).

     After remand, Chou added the LLC as a plaintiff and continued prosecuting the case.  The claims raised were for:

·                    judicial dissolution of Ram.Chou LLC;

·                    an accounting of the LLC’s assets;

·                    breach of the Chilton’s duty of loyalty;

·                    misappropriation of funds by the Chiltons;

·                    breach of fiduciary duty;

·                    breach of the covenant of good faith and fair dealing; and

·                    misrepresentation.

      Chou also sought punitive damages.  The trial court dismissed all of Chou’s individual claims on the basis of not being the real party in interest.  The Court of Appeals reviewed these claims seriatim to determine, as to each, whether Chou was the real party in interest.

Judicial Dissolution

      On the basis that the LLC Act, at KRS § 275.290(1), permits a member to bring an action for an LLC’s judicial dissolution, the Court of Appeals found Chou had standing to bring this claim.  2014 WL 2154087, *3.

Accounting

      Citing KRS § 275.306(2), the Court of Appeals wrote that “on a request for dissolution, the assets and liabilities of the company must be accounted for prior to distribution” and that “this would be the natural next step in the dissolution of the company.”  As Chou could move for the LLC’s judicial dissolution, the Court of Appeals held he could bring a claim for an accounting in connection therewith.  2014 WL 2154087, *3.

      More on this point below.

Breach of the Duty of Loyalty/Fiduciary Duty

      First equating a breach of the duty of loyalty and a breach of fiduciary duty, the Court noted that Chou, in reliance upon Patmon v. Hobbs, argues the rule to be “that every member of a [LLC] owes a duty of loyalty and fiduciary duty to every other member of the company.”  2014 WL 2154087, *4.  Rejecting that assertion the Court wrote:

If this is true, Chou would have standing to bring this claim against the Chiltons. This is not an accurate reading of Patmon. In that case, a previous panel of this Court held that managing members of a limited liability company have a fiduciary duty to other members of the company. Id. at 595. In this case, the Operating Agreement indicates that Chou is the managing member. The Chiltons did not owe a fiduciary duty to Chou; therefore, he has no standing to bring these claims.  2014 WL 2154087, *4.

      Judge Thompson would dissent from this aspect of the decision, writing:

The Patmon Court did refer to the duties of managing members throughout its opinion and, logically so, because the defendant was the managing member of the company. However, it did not exclude the members of a limited liability company from the same duties. Just as partners owe the utmost good faith to each and every other partner, members of a limited liability company owe a fiduciary duty to fellow members and the company. Patmon, 280 S.W.3d at 595.  2014 WL 2154087, *5.

            More on this point below.

Misappropriation

      The Court quickly dismissed this claim, noting that any recovery for misappropriation for the LLC would flow to the benefit of the LLC and not to Chou individually, even if the pool of assets from which he would receive liquidity distributions were increased thereby.  2014 WL 2154087, *4.

Good Faith and Fair Dealing

            The Court of Appeals began by noting that in every agreement there is an implied covenant of good faith and fair dealing and that the subject contract is the LLC’s operating agreement.  In that the operating agreement provided that members could sue other members for its breach, the Court of Appeals determined that Chou could bring this claim.  2014 WL 2154087, *4.

            More on this point below.

            The case was remanded to the trial court “for proceedings consistent with this opinion.”

More on the Claim for an Accounting

      The primary weakness of the Court of Appeal’s statement that Chou has the right to move for an accounting is that the statute cited, namely KRS § 275.300(2), does not support an accounting claim.  KRS § 275.300(2) does not include the word or by its terms provide for an “accounting.”  That subject statute sets forth a nonexclusive list of the activities that may be undertaken by a LLC subsequent to its dissolution.  These are simply rights of the LLC, and no member, as a member, is afforded any rights thereby. 

      The problem here may be one of nomenclature, but it is important nomenclature.  An “accounting,” as that term is utilized in the law of unincorporated business organizations, is a dispute resolution mechanism amongst the owners by which they resolve any inter-se claims and distribute the remaining assets in accordance therewith.  See, e.g., Rev. Unif. Part. Act § 807, 6 (pt. I) U.L.A. 206 (2001); KRS § 362.1-807.  The Kentucky LLC Act does not contain such a provision.  While, at common law, an obligation to account can exist amongst fiduciaries, imposing upon the Chiltons an obligation to account to Chou would have to be premised first upon the determination that the Chiltons owed Chou a fiduciary obligation.  In that KRS § 275.300(2) does not support an action for an accounting, and as this Court of Appeals panel found that the Chiltons did not themselves stand in a fiduciary relationship with Chou, the order of an accounting was normatively in error.

More on the Claim for Breach of the Implied Covenant of Good Faith and Fair Dealing

      The Court’s conclusion that Chou had standing as a real party in interest to bring a claim for breach of the implied covenant of good faith and fair dealing as to the Chiltons alleged obligations under the Operating Agreement is somewhat unsatisfactory in its lack of precision as to what claims may be brought.  This is not to say that the implied covenant of good faith and fair dealing does not exist in operating agreements.  To the contrary, the LLC Act is specific that it does.  See KRS § 275.003(7).  Rather, the criticism is that the Court did not delve into the counter-party of the obligations allegedly breached to determine whether they exist only in favor of the LLC or in favor of another member.

      By way of example, assume an operating agreement in which a member, A, makes a commitment to the LLC on a particular day in the future, to contribute $10,000 to the LLC’s capital.  Consider another provision which obligates A to teach member B how to operate the LLC’s accounting system.  Upon A’s breach of the commitment to contribute additional capital to the LLC, it is difficult to see how any other member could bring a claim for that breach.  Rather, even as the operating agreement is a multi-lateral agreement amongst the LLC and all of the members (KRS § 275.015(20); id. § 275.003(3)), the contribution commitment was given only to the LLC and only it is the “real party in interest” who may object to a failure to perform thereon.  As to the second provision, it is a bilateral commitment between one member to another member for which, upon lack of performance by A, B would presumably have a right to bring a claim for breach. 

      The decision by the Court of Appeals does not identify the provisions of the LLC Act that Chou asserts were violated by the Chiltons.  By failing to parse those individual provisions to see whether they were for the benefit of the LLC, the benefit of other particular members, or mixed, the Court of Appeals failed to fully address the question of whether Chou could bring a claim for breach of the provisions and the related implied covenant of good faith and fair dealing.

More on the Breach of the Duty of Loyalty

      Both the majority decision and the dissent are off-base as to the question of the duty of loyalty.

 

      The majority decision found that under Patmon the managing member owes a fiduciary duty of loyalty, the Chiltons were not managing members, and therefore they did not have a duty of loyalty.  The fault here was reliance upon Patmon rather than the statute.  The Kentucky Supreme Court has decreed that LLCs are creatures of statute.  See Pannell v. Shannon, __ S.W.3d __, 2014 WL 1101472, *7 (Ky. March 20, 2014):

In fact, “limited liability companies are creatures of statute,” controlled by Kentucky Revised Statutes (KRS) Chapter 275,” Turner v. Andrew, 413 S.W.3d 272, 275 (Ky. 2013) (quoting Spurlock v. Begley, 308 S.W.3d 657, 659 (Ky.2010)), not primarily by the common law. To the extent that common law doctrines could arguably govern limited liability companies, the Kentucky Limited Liability Company Act “is in derogation of common law,” KRS 275.003(1), and the traditional rule of statutory construction that “require[s] strict construction of statutes which are in derogation of common law shall not apply to its provisions.” Id. Thus, to the extent the statutes conflict with common law, the common law is displaced.

This Court must therefore first look at the controlling statutory law.

Upon review of the statute the Court would have seen the “switch” set forth in KRS § 275.170(4).  In that Ram.Chou LLC was member-managed, determined as provided in its articles of organization (see KRS § 275.165(1)), the duty of loyalty is owed by all members.  To that end the Court’s dismissal of Chou’s claims for breach of the duty of loyalty was erroneous.

            This is not to say the Court’s conclusion that Chou could not in his own name bring a claim for breach of the duty of loyalty was incorrect.  Rather, this is a case of right answer, wrong reason.  The LLC Act, in addition to defining the duty of loyalty and saying who owes it, defines also who is its beneficiary, namely the LLC.  See KRS § 275.170(20 (“account to the [LLC] and hold as trustee for it”) (emphasis added).  Chou could not bring a claim for himself based upon the Chilton’s breach of the duty of loyalty, not because no duty was owed by them (it was), but because Chou was not its beneficiary.

            As to the dissent, it was correct in referencing the statue to determine who owes the duty of loyalty.  It failed, however, to appreciate that the same statute defined the beneficiary of the duty.  Further, the dissent’s repetition of Patmon’s analogy of LLC members to partners is contrary to the statutory language it had just cited and the Pannell v. Shannon directive that LLCs are not creatures of the common law.

 

Chou v. Chilton, Round Two(2)

Chou v. Chilton, Round Two(2)

      In 2014, the Kentucky Court of Appeals issued a decision parsing the claims brought by Chou and classifying them as claims he could bring for his own account versus claims that could be brought only on behalf of the LLC. HERE IS A LINK to my review of that decision.

      That determination was apparently appealed to the Kentucky Supreme Court.  In order dated March 25, 2015, discretionary review of that ruling was denied.  However, the Supreme Court did order that the decision of Court of Appeals not to be published.

Derivative Actions in Kentucky LLCs

Derivative Actions in Kentucky LLCs

 

In its current form, the Kentucky LLC Act is silent as to derivative actions.  That silence does not equate, however, to a determination that there are not derivative actions in Kentucky organized LLCs. Rather, as derivative actions are a question of equitable standing, they exist independent of an enabling statute. See also Carter G. Bishop and Daniel S. Kleinberger, Bishop & Kleinberger on Limited Liability Companies ¶ 10.07[2] (2012 and 2014-2 cum. supp.)  (“Many LLC statutes expressly authorize derivative actions, but some do not. This distinction should make little difference. Derivative litigation began in the corporate context over 150 years ago without the benefit of statutes, and remains essentially equitable in nature.”)

           

Numerous courts, with respect to LLCs organized in Kentucky, have entertained actions that are either expressly characterized as derivative or in which the rules applicable to derivative actions, including the direct versus derivative distinction, have been applied.   For example:

 

·         Pixler v. Huff, Civ. Act. No. 3:11-CF-000207-JHM, 2012 WL 3109492 (W.D. Ky. July 31, 2012) (in the context of an LLC, applied the test traditionally applied in corporations as to the direct versus derivative distinction and determined whether certain claims brought by a member could be brought only on a derivative basis);

 

·         id., 2012 WL 3109492, *3 (“Therefore, Plaintiff may maintain her claims against the Defendants only where she has suffered an injury that is separate and distinct from that which would be suffered by other members or the LLC as an entity.”);

 

·         R.C. Tway Co. v. High Tech Performance Trailers, LLC, No. 3:2012-CV-00122, 2013 WL 842577, *3 (W.D. Ky. Mar. 5, 2013) (“Each of the claims identified above clearly alleges that High Tech or Hanusosky violated some duty it owed directly to [Performance Trailers], thus causing [Performance Trailers] injury.  As [Performance Trailers] is the allegedly injured party for each of these claims, it is the one that is entitled to enforce the rights granted by substantive law.  Accordingly, [Performance Trailers] is not a nominal party, but instead is a real party in interest as to those claims.”);

 

·         Chou v. Chilton, __ S.W.3d ___, Nos. 2009-CA-002198-MR, 2009-CA-002284-MR, 2014 WL 2154087 Ky. App. May 23, 2014) (“[The LLC] and not Chou himself would benefit from any recovery for breach of the operating agreement, fraud, misappropriation, breach of fiduciary duty or gains taken by the defendants.  While Chou may or may not receive funds from [the LLC] on dissolution of that company, any wrongs for breach of the operating agreement, fraud, misappropriate, breach of fiduciary duty or gains taken by the defendants perpetrated by any of the [defendants] or possibly [a separate LLC controlled by the defendants] would be wrongs against [the LLC] and not Chou individually.”); and

 

·         Turner v. Andrews, 413 S.W.3d 272 (Ky. 2013) (rejecting effort by the sole member of an LLC to bring on his own behalf (rather than on behalf of the LLC), a claim for lost profits.).

 

It bears noting that the Kentucky LLC act is atypical in not expressly addressing derivative actions in LLCs. The vast majority of the states, including Delaware, have an express derivative action statute. See Del. Code Ann. tit. 6, §§ 18-1001 through 18-1004.  See also Revised Prototype LLC Act, 67 Bus. Law. 117, 194-198 (Nov. 2011) (providing for LLC derivative actions at §§ 901-908); 1 Ribstein & Keatinge on Limited Liability Companies, appendix 10-2 (listing derivative action and related provisions of the various LLC Acts).

 

Court of Appeals New Opinion in Ziegler v. Knock is a Confused Mix of Partnership and LLC Law, Fiduciary and Contract Law

Court of Appeals New Opinion in Ziegler v. Knock is a Confused
Mix of Partnership and LLC Law, Fiduciary and Contract Law

      In October, 2012,  the Court of Appeals issued its opinion in Ziegler v. Knock, affirming the trial court’s determination that there had been a breach of duty in accepting a secret commission but dismissing the action based upon a choice of venue provision in the subject agreements.  Ziegler v. Knock, No. 2008-CA-002160-MR, 2012 WL 5273999 (Ky. App. Oct. 26, 2012).  By its determination of improper venue the Court’s decision as to breach of fiduciary duty was rendered dicta.  That decision was reviewed here in Decision of Trial Court Reversed, Inter Alia, For Lack of Jurisdiction (posted Nov. 19, 2012).

      Presumably on a motion for reconsideration, the Court of Appeals issued a new decision in this case.  See Ziegler v Knock, No. 2008-CA-002160-MR (Jan. 18, 2013).  Like the prior holding it is designated “Not to be Published.”  On October 16, 2013, the Kentucky Supreme Court denied discretionary review.  The petition for discretionary review was restricted to the proper venue question.  That being the case I held off on a substantive review of the decision.  Ultimately it has serious issues.

      In this decision, on the basis that the question of venue had not been raised in a timely manner, the Court of Appeals determined that Ziegler had waived that defense.  Ergo, the Court of Appeal’s affirmance of the trial court’s ruling stands, and the matter would not be re-litigated in Ohio.

      Which brings us back to the primary point, namely Ziegler’s breach of duty.  The contract between Ziegler and Knock contained a warranty that Ziegler was not to receive a direct or indirect commission on the acquisition of the property to be acquired by TZG III, LLC, the acquisition vehicle formed by Zigler and Knock.  In fact, Ziegler received a $72,000 commission on the sale.

      While the ultimate determination that Ziegler’s conduct was improper is without question correct (at this point I’m not considering the effect of the release signed by Knock and Ziegler), the analysis applied by the Court of Appeals mixes concepts that are and should be distinct from one another.  Ergo, it might be a case of right answer, wrong reason.

      First is the issue of structure and the beneficiaries of fiduciary duties.  David and Richard Knock were the members of Knock Investments, LLC.  Ziegler Group, LLC appears to have been wholly-owned by Michael Ziegler.  Knock Investments, LLC and Ziegler Group, LLC in turn formed and were the members in TZG III, LLC; that LLC was the actual purchaser of the strip mall.  The agreement to form TZG III, LLC was labeled a “Membership Interest Purchase Agreement,” and it was in that document Ziegler represented he was not receiving a commission.

      One point of contention was whether the Knocks could individually be plaintiffs, or whether only Knock Investments, LLC had standing.  The Knocks were not individually parties to the Membership Interest Purchase Agreement.  Still the trial court allowed them to proceed individually, a decision not set aside by the Court of Appeals in either of its decisions.

      The problem with this conclusion is that it is manifestly erroneous.  The rights and claims of an LLC are not the property of its members.  See, e.g., KRS § 275.010(2) (LLC is a legal entity distinct from its member); id. § 275.250 (interest in an LLC is personal property); id. § 275.240(1) (property of LLC is that of the LLC and not of the members); Chou v. Chilton, Nos. 2009-CA-002198-MR, 2009-CA-002284-MR, 2012 WL 6526184 (Ky. App. Nov. 16, 2012) (individual member of LLC could not in his own name bring claim for breach of fiduciary duties owed to the LLC); R.C. Tway Co. v. High Tech Performance Trailers, LLC, 2013 WL 842577 (W.D. Ky. Mar. 6, 2013) (claim for misappropriation of company assets belongs to the LLC); Bobbitt v. Russellville Mobile Park, LLC, No. 2007-CA-00684-DG (Ky. App. Sept. 12, 2008, modified Oct. 17, 2008) (member of LLC, seeking to represent the LLC in court proceeding, engaged in unauthorized practice of law; member was not an attorney and the interests of the LLC were not those of the member). 

      Knock Investments, LLC, being a party to the Membership Interest Purchase Agreement, had standing to object to its breach.  The Knocks, not being parties to that agreement and absent other facts (e.g., intended third-party beneficiaries) not set forth in the opinion, had no standing.

      Turning to the substance of the dispute, Ziegler represented that he was not earning a commission on the sale of the property.  In fact he did receive a commission, and the court properly held him to account for his breach of that covenant.  The problem is in the muddled manner in which it did so.

      In explaining Ziegler’s liability for accepting the commission the Court wrote:

… because Knock Investments, LLC is a closely held entity owned by the Knocks individually, and because the Knocks were asserting claims of fraud and misrepresentation in their individual capacities rather than through the corporate entity, they had standing to assert their individual interests as members of the limited liability corporation. Ziegler and TZG have cited no statutory law or case law in support of their assertion that this conclusion was erroneous. The trial court's rulings are presumptively correct, and the burden rests with the appellants to demonstrate error. Boggs v. Burton, 547 S.W.2d 786 (Ky. App. 1977).

… The trial court determined that if Ziegler had not breached his fiduciary and contractual duty to forgo a commission, the purchase price of Park Plaza could have been lowered. In the alternative, the court determined that at the very least, the Knocks were entitled to a percentile share of the commission which they could have reinvested in the project or disposed of in some other manner. The basis of the court's conclusion on this issue is that as partners with mutual fiduciary duties, the Knocks and Ziegler were vested with the right to reap the benefits of their joint venture commensurate with their percentile ownership interest. Since Ziegler secretly received a 2% commission, the court concluded that equity demanded that the Knocks also benefit from that commission commensurate with their percentile ownership interest in the venture. The court awarded to the Knocks a 74% interest in the commission based on their 74% interest in the project. Since the relationship of partners imposes upon each the obligation of good faith and fairness with respect to partnership affairs, Betts v. Smither, 310 Ky. 402, 220 S.W.2d 989 (Ky. App. 1949), and since Ziegler unduly benefitted from his acceptance of a commission in violation of his fiduciary duty and the Membership Interest Purchase Agreement, we find no error in the court’s determination that the Knocks are entitled to a pro rata share of the commission.

      The Court, in these few sentences, mixed a significant number of concepts.

      First, even between those who stand in a fiduciary relationship with one another, is a breach of a contractual obligation a breach of fiduciary duty?  Assume that the receipt of a secret commission is a breach of fiduciary duty.  As was here the case that limitation was reduced to a contractual obligation.  There is then a breach of the obligation.  Does there now arise a decision for breach of fiduciary duty, breach of contract, or both?  The Court seemed to assume both, but it is not obvious that is correct.  Fiduciary duties are gap-fillers.  Conceptually, where the express contract addresses the point, there is no gap to be addressed by fiduciary obligation? 

      Second, what was the source of the alleged fiduciary duty?  The covenant was that Ziegler, and not Ziegler Group, LLC, was not receiving a commission.  Was Ziegler a member in a member-managed LLC or a manager of a manager-managed LLC?  The opinion does not say.  On the basis that the Ziegler Group, LLC was wholly-owned by Ziegler, is he being held responsible for discharge of the LLC’s fiduciary obligations?  The opinion does not say.   Did the operating agreement identify Ziegler as a fiduciary?  The opinion does not say.  Has USACafes been adopted as Kentucky law?  Essentially we are told that Ziegler violated a fiduciary duty without being provided any direction as to the source of that duty.

       Third, where was the breach of fiduciary duty?  Even assuming Ziegler was a fiduciary and that he accepted the commission, it does not necessarily follow that there was a breach.  What fiduciary duty was violated?  Subject to “First” above I have no doubt there was a breach, but the Court needs to tell us what it was and why.

       Fourth, if this is a case about a breach of fiduciary duties rather than contractual duties, why did the court use a contract measure of damages, namely putting the Knocks back in the same position they would have been but for the breach?

       Fifth, and going back to the point above on standing, whey is the recovery to the individual Knocks rather than either the TZG III, LLC or to Knock Investments, LLC?  Chou v. Chilton and the statutory law make clear that injury to the LLC, in this instance TZG III, LLC (if there had been no commission to Ziegler then TZG III, LLC’s purchase price for the subject property would have been lower), is to be addressed for the account and benefit of the LLC.

       Sixth, from where came this reference to “partners”?  Members in an LLC are members and they owe the duties and enjoy the benefits of members as defined by the LLC Act.  Partners in a partnership are partners and they owe the duties and enjoy the benefits of partners as defined in the law of partnerships.  Partnership law, by its express terms, does not apply among the members in an LLC.  See KRS § 362.1-202(2).  Yes, in LLCs there exists an obligation of good faith and fair dealing, but that is a principle of contract law that is confirmed by the LLC Act.  See KRS § 275.002(7).  And as good faith and fair dealing is a principle of contract law (and not the law of fiduciary duty), it cannot be the basis for the fiduciary duty Ziegler violated.

      It is clear that Ziegler’s conduct was improper, but this decision does little to illuminate why or to provide guidance for the analysis of future disputes.

      Which brings us back to the question of the effect of the mutual release, an issue to which the existence of the fiduciary duty is crucial.  Assuming a third-party independent relationship, a mutual release will be binding upon each party, and each party, in entering into such an agreement, is bound and required to look out for its own interest.  Where, in contrast, one bound by a fiduciary relationship seeks a release from the beneficiary of that relationship, the release is effective if and only if the fiduciary has made full and complete disclosure to that beneficiary.  See, e.g., Restatement of (Third) of Agency § 8.05.   Ziegler sought to avoid liability in this dispute by refereeing a mutual release that had been entered into.  Knock sought to avoid the application of that release on the basis that Ziegler was a fiduciary.  While the court may, ultimately, have been normatively correct in setting aside the release on the basis that Ziegler owed a fiduciary duty, its analysis was so muddled that little can be taken away from it.  For example, if Ziegler owed a fiduciary relationship, had that situation so broken down by the time that the mutual release was entered into that Knock had no right to expect Ziegler to be acting in a fiduciary, as contrasted with an arms-length independent, role?  Such determinations matter.  They were, however, ignored in this decision.

 

Connecticut Court of Appeals Upholds Separateness of Single-Member LLC

Connecticut Court of Appeals Upholds Separateness of Single-Member LLC

      A recent decision of the Connecticut Court of Appeals has (yet again) affirmed that an LLC and its member(s) are separate, and that claims belonging to the LLC are not as well claims of the members.   O’Reilly v. Valletta, 55 A.3d 583 (Conn. App. Nov. 20, 2012).

      Hub Associates, LLC and its sole member, O’Reilly, brought suit against Robert Pformer with respect to the use of certain real property leased by the LLC from a condominium association of which Pformer was a board member.  Those claims were dismissed by the trial court.  For reasons that are not entirely clear, O’Reilly, but not the LLC, initiated an appeal of the trial court’s ruling.  Pformer, in addition to arguing on appeal that the decision of the trial court was substantively accurate, as well argued that O’Reilly lacked standing to bring the appeal, and that it should be dismissed for lack of jurisdiction.

       Notwithstanding that O’Reilly was the sole member of the LLC, the Connecticut Court of Appeals held that a “member or manager … may not sue in an individual capacity to recover for an injury based on a wrong to the limited liability company.”  Id. at 587.  On that basis the appeal was dismissed.

      The principles identified in this decision are equally applicable in Kentucky as evidenced by the recent decision of the Court of Appeals in Chou v. Chilton.  Other cases rendering the same result include:

·                     Zipp v. Florian, 2006 WL 3719373 (Conn. Super. Nov. 13, 2006) (member of an LLC lacked standing to bring suit based upon damage to property owned by LLC);

·                     Finley v. Takisaki, 2006 WL 1169794 (W.D. Wash. April 28, 2006) (members of an LLC lacked standing to assert a claim for injury to the LLC);

·                     Carey v. Howard, 950 So.2d 1131 (Ala. 2006) (members of LLC lacked standing to sue for declaratory relief with respect to option agreement between LLC and third-party);

·                     Northeast Realty, LLC. v. Misty Bayou, L.L.C., 920 So.2d 938 (La. App. 2006) (members of an LLC lacked standing to intervene in an action against an LLC to quiet the tax title because claim of ownership of property in dispute belonged to the LLC); and

·                     Cortellesso v. Town of Smithfield Zoning Board of Review, 888 A.2d 979 (R.I. 2005) (sole member of LLC lacked standing to appeal zoning decision on property that the sole member had conveyed to the LLC).

Court Rejects Notion That LLC is a “Nominal Party” to the Suit Over Its Assets

Court Rejects Notion That LLC is a “Nominal Party” to the Suit Over Its Assets

      In a recent decision, Judge Simpson of the Western District of Kentucky resoundingly rejected the notion that an LLC is only a nominal party to a lawsuit between its members as to its assets.  R.C. Tway Co. v. High Tech Performance Trailers, LLC, Civ. Act. No. 3:12-CV-122, 2013 WL 842577 (W.D. Ky. Mar. 6, 2013).

      This action was filed in federal court pursuant to its diversity jurisdiction.  As such, it was necessary that none of the plaintiffs have the same citizenship as any of the defendants.  At the time the complaint was filed, defendant High Tech Performance Trailers, LLC (“High Tech”) had as its sole member Bruce Hanusosky, an Ohio citizen.  As such, High Tech was a citizen of Ohio.  It bears noting that, after the time the complaint was filed, High Tech converted from an Ohio LLC to an Ohio corporation.  Under the rule of Grupo Dataflux v. Atlas Global Group, L.P., 541 U.S. 567, 570-71 (2004), the citizenship test applicable to LLCs rather than that of corporations was applied to High Tech.

      On the plaintiffs’ side, R.C. Tway Co. is a Kentucky corporation with its principal place of business in Kentucky.  Ergo, it is a citizen of Kentucky.  Kentucky High Tech Performance Trailers, LLC (“Performance Trailers”) had as its members Tway and High Tech.  As such, Performance Trailers is a citizen of both Kentucky, attributed to it through Tway, and Ohio, attributed to it through High Tech.  At this point of the analysis, diversity jurisdiction is lacking in that Ohio citizenship is shared by both a plaintiff and a defendant.  In response thereto, the plaintiffs asked the court to disregard Performance Trailers’ citizenship on the basis that it is but a nominal party to the action.  This suggestion was ultimately rejected by Judge Simpson, and the action was dismissed without prejudice for lack of subject matter jurisdiction.

      As an aside, where the Court utilized “High Tech” and “Ky. High Tech,” which I found confusing, I here utilize “High Tech” for the Ohio LLC (a defendant) and “Performance Trailers” for the Kentucky LLC (a plaintiff).

      Performance Trailers was organized as a joint venture vehicle between Tway and High Tech for the manufacture of custom trailers.  Under Performance Trailers’ operating agreement, Tway had day-to-day operational control, including the right to accept deposit of company funds.  The complaint alleged that High Tech and Hanusosky received at least $330,000 of Performance Trailers’ funds but did not surrender them to the LLC care of Tway.  There were additional allegations of various breaches of the operating agreement, intellectual property infringement and breach of a non-compete provision in the operating agreement.

      By means of complaint filed in January, 2012, Tway notified High Tech of Performance Trailers’ dissolution; Articles of Dissolution were subsequently filed with the Kentucky Secretary of State.  In the sixteen-count complaint, there were several allegations in favor of Performance Trailers, including those for High Tech’s failure to perform obligations owed Performance Trailers under the operating agreement, breaches of fiduciary duties owed to Performance Trailers, claims for defamation of Performance Trailers consequent to a press release issued by High Tech and claims for theft of the company funds received and not remitted.

      Based upon these facts, the Court determined that:

Each of the claims identified above clearly alleges that High Tech or Hanusosky violated some duty it owed directly to [Performance Trailers], thus causing [Performance Trailers] injury.  As [Performance Trailers] is the allegedly injured party for each of those claims, it is the one that is entitled to enforce the rights granted by substantive law.  Accordingly, [Performance Trailers] is not a nominal party, but instead is a real party in interest as to those claims.  2013 WL 842577, *3.

      While not cited therein, this statement from Judge Simpson is consistent with the ruling of the Kentucky Court of Appeals in Chou v. Chilton, No. 2009-CA-002198-MR, 2009-CA-00-2284-MR, 2012 WL 6526184 (Ky. App. Nov. 16, 2012), wherein the court, analyzing the issues in the terms real party in interest, dismissed for lack of standing claims brought by a member of an LLC on his own behalf (the LLC itself was not a party to the action) seeking damages for breach of the operating agreement, fraud, misappropriation, breach of fiduciary and gain taken by the defendant members.  See also, e.g., Pinnacle Fitness and Recreation Management, LLC v. The Jerry and Vickie Moyes Family Trust, 844 F.Supp.2d 1078 (S.D. Ca. 2012) (dismissing claims brought by member for breach of fiduciary duties owed the LLC and for tortious interference with LLC’s prospective business advantage).

      Against this the plaintiffs argued that Performance Trailers “has no real interest in the outcome of this case” consequent to its dissolution and the plan to marshal its assets, satisfy its debts and distribute the remaining assets amongst the members.  Rejecting this analysis, the Court wrote:

However, the court disagrees that the filing of Articles of Dissolution and the request for a distribution of assets renders [Performance Trailers] a nominal or formal party to this action.  First, Kentucky law makes clear that even after the filing of Articles of Dissolution, a limited liability company remains an existing entity.  KRS § 275.300(2).  Indeed, after dissolution, a limited liability company is empowered to take actions necessary for winding up its affairs, including inter alia, collecting assets and suing or being sued.  KRS § 275.300(2)(a) and (4)(a).  As a limited liability company retains the power under state law to enforce its rights in court until the company has finished winding up, there is no basis for disregarding it entity status and holding it to be merely a nominal party to an action simply because it has been dissolved.

Nor does the fact that the parties request that this court effect an orderly distribution of [Performance Trailers’] assets change the analysis.  Questions regarding diversity of citizenship are assessed based upon “the state of facts that existed at the time of filing – whether the challenge be brought shortly after filing, after the trial, or even for the first time on appeal,” Grupo Dataflux, 541 U.S. at 571.  In other words, that the party contemplate that at the end of this action, [Performance Trailers] will no longer be an existing entity is meaningless to the diversity analysis.  The question is whether, at the outset of the action, [Performance Trailers] was entitled to enforce the rights it was asserting against High Tech and Hanusosky.  The answer to that question is plainly yes.

       On that basis the suit was dismissed.

       An LLC is not, on behalf of its members, a nominee holder of title to various assets.  Rather, an LLC is a legal entity distinct from its members that for itself holds title to assets.  See, e.g., KRS § 275.010(2) (“A [LLC] is a legal entity distinct from its members.”); id. § 275.150(1) (limited liability of members from LLC’s debts and obligations); id. § 275.155 (member not a proper party to an action against the LLC); id. § 275.240(1) (property of LLC is not that of its members); and id. § 275.246(2) (title to LLC’s property vests in the LLC and not in the members).  As such, the LLC cannot be ignored, and its rights, distinct from those of the members or a member, must be both respected and preserved.

Standing in Dispute Among Members of LLC

Standing in Dispute Among Members of LLC

            On November 16, the Kentucky Court of Appeals issued a decision addressing whether the member of an LLC has standing, in his own name, to bring an action asserting various claims including that the other member(s) has violated fiduciary duties.  It also addresses a claim for wrongful termination of employment of a member by an LLC.  Chou v. Chilton, 2012 WL 5626184 (Ky. App. Nov. 16, 2012). 

 

      As I was involved in this dispute I will not say more beyond recommending it to you.