Monday, October 6, 2014

Waiver of the Right to Bring a Derivative Action?

Waiver of the Right to Bring a Derivative Action?

In an August 15 decision, the Kentucky Court of Appeals reversed a decision of the trial court finding that a participant in the deal was not acting as an attorney for other members.  J&B Energy, Inc. v. Caldwell, 2014 WL 3973966 (Ky App. 2014)
My concern with the decision relates to a point not appealed, namely the trial court’s determination that certain language in the operating agreement effected a waiver by the member’s right to bring a derivative action. That language (which appears in footnote 9) is:
The Members shall have no power to participate in the management of the Company except as expressly authorized by this Agreement or the Articles of Organization and except as may be expressly required by the LLC Act. Unless expressly and duly authorized in writing to do so by a manager, no member shall have any power or authority to bind the Company in any way, to pledge its credit, to act on its behalf, or to render it liable for any purpose.

The Court of Appeals wrote:
Based on this language in the operating agreement, the court below found that the PBP members have no authority to act on behalf of PBP without the express and duly authorized approval of the managers in writing. The court reasoned that this included derivative actions, and found that J & B had no authority to institute same because it was not a manager and did not have authorization from a manager to do so.
While clearly dicta, it is potentially dangerous dicta, and therefore it deserves attention.
The Ky LLC Act does not specifically address derivative actions, so in Ky LLCs they are brought under common law.  See section [7.24] of Limited Liability Company Operations (2014-1 supp.), Limited Liability Companies in Kentucky (UKCLE) (forthcoming).
I’m rather concerned that the language from the operating agreement was interpreted to preclude the members (the ultimate beneficiaries of the duties of care and loyalty owed the managers) from policing their actions through a derivative action. 

A derivative action is an important tool by which the participants in a venture may initiate the policing of the conduct of those in control of the venture.  Cases from around the county and in Kentucky make clear that the duties owed to the LLC may be enforced only by and for the benefit of the LLC.  See, e.g., Chow v. Chilton (reviewed HERE); Chow v. Chilton (reviewed HERE); and Turner v. Andrew (reviewed HERE).
Absent the ability of the members to bring a derivation action on the LLC’s behalf, conduct involving, for example, personal exploitation of company business opportunities, self-dealing transactions and personal use of company assets may go unexamined and unremedied.
To that end, initiating a derivation action is not participation in the LLC’s management.  Rather, a derivation action puts the court in control.  As long ago observed in Denicke v. Anglo California Nat. Bank of San Francisco, 141 F.2d 285 (9th Cir. 1944), it was observed that the task of the shareholder initiating a derivative action is to “set in motion the judicial machinery of the court” to the effect that:
His position in the litigation is assimilated to that of a guardian ad litem with power in the court, not in the stockholders, to compromise the rights of the real party in interest, which is the corporation itself. Id. at 288, quoting Whitten v. Dabney, 154 P. 312, 316, it quoting 3 Pomeroy’s Equity (3rd ed.) § 1095 (citations omitted).
Predating this decision by almost forty years is a Kentucky decision utilizing similar language.  In Louisville Bridge Co. v. Dodd, 27 Ky. L. Rep. 454, 85 S.W. 683 (Ky. 1905), the Court addressed the respective roles of the plaintiff minority shareholders and the court:

[The plaintiff shareholders are] always subject to the control of the court.  It is at last the judgment of the latter, in the application of principles of equity, that obtains in lieu of the discretion of the board of directors.  The minority stockholder merely sets in motion the action, and present facts upon which the court can act.
In only the most strained reading is insisting that those who have undertaken a fiduciary role show that they have discharged their obligations somehow managing or acting on behalf of the LLC.
There is as well the point of inconsistency between an agreement which defines fiduciary obligations owed and then by implication eliminates the mechanism by which the discharge of those duties may be enforced (my thanks to Prof. Hemingway for identifying this point).  As she observed:
Those actions exist to ensure that there is a watchdog able to engage in that enforcement, since the managers of the firm may not be willing to bring legal action against themselves for the breach of duty.  Having a right without the ability to enforce it is tantamount to having no right at all.
If the axiom of equity “for every wrong there is or remedy” is otherwise correct, how can it have currency if there is no mechanism through which to pursue a remedy?
Another path of inquiring that deserves attention is whether the parties to a contract may eliminate a court’s equitable power to investigate and as necessary remedy violations of duties that are themselves typically equitable in nature?
Conceptually, it may be possible for the members to waive the right to initiate a derivation action, although I would almost always counsel against doing so.  That said, any waiver of this right should be required to be clear and unambiguous.  I submit the language determined by the trial court to be a waiver of the right to initiate a derivation action does not rise to that threshold.


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