Wednesday, June 4, 2014

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.

      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.


      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.


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