Friday, May 16, 2014

Patmon v. Hobbs - Round Two

Patmon v. Hobbs – Round Two

      The Patmon v. Hobbs dispute, it involving a breach of the duty of loyalty by the managing member of an LLC in appropriating for his own benefit a business opportunity and company assets, has again returned to the Kentucky Court of Appeals.  Patmon v. Hobbs, 2014 WL 97464 (Ky. App. Jan. 10, 2014).
      Briefly, Hobbs was the managing member of American Leasing and Management, LLC, a company in which Patmon was as well a member (Hobbs 51%, Patmon 44% and other 5%).  The primary business of the LLC was the build and lease of various retail establishments.  On the alleged basis that the LLC was not able to perform on and thereby exploit certain existing contracts, Hobbs unilaterally transferred them to another LLC in which he was a member.  Patmon brought suit to challenge Hobbs’ breach of duty.  By a circuitous (and flawed) path, the Court of Appeals determined that Hobbs violated his fiduciary duties (a normatively correct conclusion) in unilaterally assigning to the second LLC the build and lease agreements.   See Patmon v. Hobbs, 280 S.W.3d 589 (Ky. App. 2009).  That first decision was reviewed in Rutledge & Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Ark. L. Rev. 473 (2010).  Here is a LINK to that article. 
      The case was then remanded to the trial court for the consideration of what damages were owed by Hobbs. 
      In a ruling dated September 6, 2012, the trial court ordered Hobbs to remit to Patmon $37,400, that being 44% of the proceeds from the sale of his portion of the LLC to which the contracts were transferred. 
Patmon submitted damages request based on the total contract price of the contracts at issue, but Patmon is only entitled to the percentage of profit she would have received if the contracts were executed by American Leasing instead of American Development.  After the projects were complete, Hobbs sold his interest to a third party for $115,000 minus $25,000 for attorney fees.  Hobbs made a total profit of $85,000 on the projects in question.  Since, Patmon owns 44% of American Leasing, the Court finds that her damages are 44% of $85,000, or $37,400.  Accordingly, the Court sets Patmon’s damages for Hobb’s common-law breach of fiduciary duty and failure to follow statutory guidelines of KRS § 275.170 at $37,400.

      This second trip to the Court of Appeals then followed. 
      Ultimately, this ruling of the Court of Appeals is dicta.  The order from which Patmon appealed was not final and therefore the Court of Appeals lack jurisdiction to hear the appeal.  On that basis it was dismissed.  Still, the Court of Appeals was at pains to discuss what should be the proper measure of damages in the suit.  Hence, while it may ultimately be dicta, it is compelling dicta.  As to those points:

The Duty of Loyalty
            The Court of Appeals recited that in the prior decision:
[w]e noted the existence of a common law duty of loyalty owed to members of a limited liability company as well as the existence of statutory duty set forth in KRS 275.170, that requires a member to “account to and hold as trustee for a [LLC] any profit or benefit derived from transaction involving the use of a [LLC’s] property by that member or manager without [adequate] consent.”  2014 WL 97464, *1 (the [adequate] being added by the Court of Appeals).

      The “owed to members of the LLC” is curious in that later in the decision the Court noted that a member’s duty of loyalty is owed to the company.  2014 WL 97464, *2, note 7.  It is the latter statement that is correct.  The LLC Act is clear – the duty of loyalty is owed to the LLC – that is what the statute says.  See KRS § 275.170(2) (“account to the [LLC] and hold for it”); see also Ballard v. 1400 Willow Council of Co-Owners, Inc. __ S.W.3d __, ___; 2013 WL 6134150, *10 (Ky. 2013) (directors owe their duties “to the corporation.”, citing KRS § 273.215).
      From there the Court of Appeals:
Reversed and remanded with instructions for the trial court to determine whether American Leasing was able to take advantage of the opportunity diverted by Hobbs, which is a prerequisite to recovery.

The Business Opportunity Doctrine and the Capacity to Perform

      As to the requirement that Patmon demonstrate that the LLC had the wherewithal to perform on the build-to-lease agreements there are a pair of failings, namely the allocation of the burden and the assumption that one exists.
      As to requiring Patmon to show that the LLC could have performed on the contract, this relieves the fiduciary of the obligation of showing that they satisfied his or her obligations.  Hobbs unilaterally and for no consideration assigned an LLC asset to the company he controlled.  Those facts are uncontested.  Any burden should be exclusively upon Hobbs to demonstrate the propriety of his actions.  Yes, Kentucky’s Business Corporation Act places the burden on the plaintiff to show the director violated his or her duties; KRS § 271B.8-300(6), but that is a rule that reverses the burden as traditionally imposed.  The LLC Act has no such reversal of the burden.
      As to the question of the LLC’s capacity to perform, Hobbs, who controlled the LLC, should not be permitted to raise inability to perform as a defense.  Second, even if the LLC could not perform, it does not follow that the transferred contracts were without value.  For example, the LLC could have sold the right to build out the stores, thereby realizing value.
      While the capacity to perform may be an element of whether or not there was an opportunity as to a corporation (see, e.g., Urban J. Alexander v. Trinkle, 224 S.W.2d 923 (Ky. 1943)), that reasoning is inapplicable in LLCs and was never applicable to the LLC out of which arose this suit.  At to the second point, American Leasing and Management, LLC, the company owned by Patmon and Hobbs, had signed the contract that was subsequently transferred.  This was not a business opportunity floating in the breeze but rather an asset in hand.  As to the former point, LLCs are statutory constructs that are strangers to the common law.  As recently observed by the Supreme Court in Pannell v. Shannon:

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. The obvious place to start, then, is the source of limited liability in the LLC context, KRS 275.150.  Pannell v. Shannon, __ S.W.3d __, 2014 WL 1101472, *7 (Ky. 2014).

      The application of the business opportunity doctrine cases to LLCs based upon their supposed similarity to corporations and with it the “ability to perform” defense to expropriation was inappropriate ab initio. 
      Further, it must be recognized that KRS § 275.170, in direct response to the first Patmon v. Hobbs decision, has been amended.  Initially, KRS § 275.170(2) has been defined as the exclusive formula of the duty of loyalty applicable in an LLC with respect to the actions of the members or managers (“The duty of loyalty applicable to each member and manager shall be….”).   Second, with respect to any suggestion that the utilization of a company opportunity or asset may be approved ex ante on the basis that the transaction was “fair,” the LLC Act has been amended to preclude that argument (“That a transaction was fair to the [LLC] shall not constitute a defense to the failure to request and receive the required consent of the disinterested managers or members.”).  See also Rutledge, The 2012 Amendments to Kentucky’s Business Entity Statutes, 101 Ky. Law J. Online 1 (p. 13-14) (2012).  Hobbs should never have been permitted to assert, and prospectively nobody may assert, “the LLC could not perform, therefore the contract had no value, and therefor I took nothing from the LLC, and certainly that is fair.”

The Measure of Damages

      The Court of Appeals criticized the trial court for its method of calculating damages.  For example, Hobbs sold his interest in the company to which the build-to-suit contracts were transferred for $115,000.  After certain reductions for assumed third-party expenses, Hobbs was awarded 44% of the net proceeds.  As identified by the Court of Appeals, this was incorrect.  Rather, Hobbs is obligated to hold all of the benefit of the transferred assets in trust for the LLC.   KRS § 275.170(2) says exactly that. 

      By way of example, if Hobbs transferred the build-to-suit contracts to an LLC in which he was a 40% owner, and the transferee LLC realized $100,000 on the asset, Hobbs’ liability back to the original LLC is not $40,000 but rather $100,000.  Remember that when the embezzler steals $100,000 but then donates $60,000 to the church, the embezzler’s liability is not reduced to $40,000.  Rather, the embezzler is liable for the full amount taken.  On the other side of the coin, if the embezzler invests the $100,000 and it grows to $120,000, the entire $120,000 is owed to the employer – the embezzler cannot claim the gain on the misappropriated funds.

      Further, upon dissolution, Hobbs’ sharing ratio in any net proceeds of the company will need to be adjusted in order to account for his misconduct.  Ultimately, that needs to be accomplished as part of the LLC’s dissolution as the settling of accounts is not a separate matter therefrom.  2014 WL 97464, *2.

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