Corporate Director’s Breach of Fiduciary Duty Not Dischargeable in Bankruptcy

Corporate Director’s Breach of Fiduciary Duty Not Dischargeable in Bankruptcy

      In a recent decision by Judge Fulton of the Bankruptcy Court, it was held that the damages owed by a former corporate officer arising out of the corporation’s claim against him for breach of fiduciary duty could not be discharged in his personal bankruptcy. Cornerstone Industries Corp. v. Kaufman (In re: Louis A. Kaufman), Case No. 14-34045, Adv. Proc. No. 15-03011, __B.R. __, 2015 WL 4692569 (Bankr. W.D. Ky. Aug. 6, 2015).

      Kaufman, while serving apparently as an officer/director, of Cornerstone, violated his fiduciary duties thereto in assisting a former employee to compete with Cornerstone.  In that action, a judgment in the amount of $1,831,738.00 was entered in Cornerstone’s favor, which award included punitive damages.  After Kaufman's post-trial motions were denied, Kaufman filed for bankruptcy relief under Chapter 11 and sought to have the judgment in Cornerstone’s favor discharge.  This decision was in response to Cornerstone’s application for summary judgment to the effect that Kaufman's liability is not dischargeable.  That request for summary judgment would be granted.

      In response to the allegation that the debt should be dischargeable, the Court parsed the provisions of Sections 523(a)(2)(A) and 523(a)(6) of the Bankruptcy Code, they being certain of the provisions which set forth the test as to when a debt is not subject to discharge, and compared them to the findings in the state court action, including the specific terms utilized in the jury instructions.  Ultimately, the Court determined that the judgment against Kaufman was for conduct which falls within the exceptions from dischargeability as set forth in Section 523(a)(2)((A) and 523(a)(6), and for that reason discharge would be denied.

      In dicta, the Court also reviewed the test under Section 523(a)(4), but ultimately determined it needed to make no conclusion as to the application of that provision in that summary judgment was already justified under Sections 523(a)(2) and 523(a)(6).

      This case is a good demonstration of how counsel for the plaintiff, anticipating a ruling in their favor on breach of fiduciary duty, should carefully construct the jury instructions with an eye to avoiding dischargeability in the event the judgment-debtor subsequently seeks bankruptcy protection.

LLCs Are People Too

LLCs Are People Too

            In a recent decision from the Sixth Circuit Court of Appeals, it was held that, for purposes of the Fair Debt Collection Practices Act (“FDCPA”), an LLC is a “person.”  Anarion Investments, LLC v. Carrington Mortgage Services, LLC, __ F.3d __, Nos. 14-5731, 14-5993, 2015 WL 4503588 (6^th Cir. July 23, 2015).

            The FDCPA provides, at § 1692k, that “any debt collector who fails to comply with any provision of this subchapter with respect to any person is liable to such person[.]” In this case arising out of a residential foreclosure, the sole question was whatever the LLC with an interest in the property was a “person”.  The trial court held it was not; the Sixth Circuit reversed that determination.

            Parsing the FDCPA, while acknowledging that certain provisions are restricted in application to natural persons, the Court determined that an LLC is otherwise a “person” as contemplated by § 1692k of the FDCPA.

 

Adding Insult to the Injury of a Cyber Attack? – Not When you Bring it On Yourself

Adding Insult to the Injury of a Cyber Attack? –

Not When you Bring it On Yourself

 

       My law partner Doug Brent has released an update addressing how a company, having suffered a cyber attack, may find itself in the cross-hairs of federal regulators. 

      In the case he discusses, a major hotel chain, after being targeted in a cyber attack, was targeted by the Federal Trade Commission for not having in the place reasonable protections against that sort of attack after it at least implied to its customers that it did.

      HERE IS A LINK to his update.

A Horse, a Horse, my Kingdom for a Horse

A Horse, a Horse, my Kingdom for a Horse

 

 

      Today is the anniversary of the Battle of Bosworth, the final major battle of that English civil war titled The War of the Roses (this conflict was at the time sometimes referred to as the Cousin’s War).  It was at this battle that King Richard III, variously identified as the last King from the House of Plantagenet or the House of York, fell, he being the last English King to die in battle.  Henry Tudor, the victor, then became King Henry VII.

 

      Henry’s victory in battle was if anything surprising.  Richard’s forces outnumbered those of Henry.  Meanwhile, Lord Stanley (William Stanley) held his own force; if combined with that of Henry, that of Richard would have been out-numbered.  At the same time, Richard held Stanley’s son as a hostage.  As battle was about to commence, Richard sent word to Stanley that if Stanley did not join with him, he would execute Stanley’s son.  Stanley replied, “I have other sons.” 

 

William Stanley was the brother of Thomas Stanley, husband of Margaret Beaufort and mother of Henry Tudor.  Ergo, Lord Stanley was the brother in law to Henry’s mother.  Thomas Stanley had previously been married to Eleanor Neville, sister to Warwick the Kingmaker and aunt to Richard III’s recently deceased wife.

 

      Richard’s attack upon Henry’s position nearly succeeded, Henry’s standard-bearer William Brandon being killed at Henry’s side.  Polydore Virgil, a contemporary historian/chronicler, recorded that Richard fought well .  However, Richard’s fate was sealed when the Stanley family and its retainers, having until then not committed to either side, rode against Richard’s infantry as his cavalry was separately moving against Henry.

 

      William Brandon’s son Charles, ultimately Duke of Suffolk, would become the best friend of Henry VIII.

 

       In 2012, Richard’s remains were located in the course of excavations under a parking lot that now covers part of what was the Blackfriars (Dominican) Church in Leicester, England; early 2013 saw the announcement that testing had confirmed the remains were those of Richard.  In sad testimony to the modern age, litigation ensued as to whether Richard should be re-buried in Leicester Cathedral, apparently consistent with the terms of the agreement by which the archaeological work was performed and other British law, or in York where certain claimed descendants of Richard assert he would want to have been buried.  That question was resolved in favor of Leicester, and earlier this year Richard III was laid to rest in Leicester Cathedral.

 

            Notwithstanding Polydore Virgil’s positive comments as to Richard III, in proof of the adage that the winners write the history, his reputation was besmirched by various Tudor affiliates such as St. Thomas More and William Shakespeare.   He is currently being reassessed by historians who are not so indebted to supporting the legitimacy of the House of Tudor.

More on the Trustee’s Control of an LLC

More on the Trustee’s Control of an LLC

 

Following from my recent posting on the in re Lee decision, Prof. Joshua Fershee had provided comments at the Business Law Prof Blog. HERE IS A LINK to that discussion.

The Direct-Derivative Distinction in Kentucky Corporate Law

The Direct-Derivative Distinction in Kentucky Corporate Law

 

The direct/derivative distinction relates to whether or not a shareholder may bring a particular claim for their own benefit or, rather, whether the claim must be brought on a derivative basis for the benefit of the corporation. Essentially, if it is the corporation that has been injured, including by a director’s breach of fiduciary duty, the claim is derivative. It has from time to time been argued that, however, in closely held corporations, this distinction should be eliminated, and shareholders should, for their personal benefit, be able to pursue redress. Kentucky courts have carefully followed the direct versus derivative distinction, sometimes utilizing a “real party in interest” analysis. In addition, the direct versus derivative distinction has of late been applied in the context of LLCs.

 

In opposition to the direct versus derivative distinction, plaintiffs have in numerous cases argued that Section 7.01 of the ALI’s Principles of Corporate Governance should be applied to the effect that, in a closely held corporation, shareholders should be able to bring a direct action for breach of fiduciary duty. There is no published Kentucky decision in which this argument has been accepted. There are, however, at least two trial courts that have rejected this suggestion.

 

First, in Snyder v. Baumgardner, No. 09-CI-04445 (Jefferson Circuit Court, Div. 4, Cunningham, J), in an Order dated April 15, 2010, that was rejected the suggestion that pursuant to Section 7.01(d) of the Principles of Corporate Governance the plaintiff should be permitted to proceed on an individual, rather than a derivative basis, Judge Cunningham writing that the Principles had not been adopted by Kentucky courts.

 

Second, in Fenley v. Fencroft Company, No. 10-CI-0998 (Jefferson Circuit Court, Div. 2, Shake, J.), in an Opinion and Order dated April 25, 2011, while discussing the ALI Principles of Corporate Governance § 7.01 and the suggestion that, based thereon, the individual shareholder should be allowed to proceed on an individual rather than derivative basis, it was written that:

 

“While the ALI materials are certainly reasonable and make interesting reading, they are not the law of Kentucky and there exists at this time no exception [from the derivative action rules] for closely held corporations.”

 

Court Holds that Bankruptcy Trustee Succeeded to Right to Control LLC

Court Holds that Bankruptcy Trustee Succeeded to Right to Control LLC

 

In a recent decision from the United States District Court for the Southern District of Indiana, it affirmed a determination of the Bankruptcy Court that when a member of an LLC with voting control thereof filed personal bankruptcy, that right to control the LLC became vested, as part of the bankruptcy estate, in the trustee. As such, going forward, the bankruptcy trustee has control of that LLC. In re Lester L. Lee, No. 4-15-cv-00009-RLY-WGH, Adv. Proc. No. 14-59011 (S.D. Ind. August 10, 2015).

The operating agreement of Lee Group Holding Company, LLC (“Lee Group”) identified a number of members, allocating to them certain economic and voting rights within the company. While Lester Lee did not enjoy any right to either interim or liquidating distributions from the LLC, he was afforded 51 votes therein; the balance of the members held, collectively, 50 votes. As such, Lester individually controlled a majority of the voting rights in the company.

 

Lester Lee then filed personal bankruptcy. After that filing, with the consequent entry of an automatic stay, the trustee’s counsel reviewed the Lee group operating agreement and wrote a letter providing in part that “this non-economic interest [in Lee Group] became property of the estate subject to control of the Trustee on the filing of the [bankruptcy] petition pursuant to 11 U.S.C. § 541.” Thereafter, the other members of the Lee Group executed documents purporting to accept Lee’s resignation from the Lee Group and the termination of his voting rights thereunder. These actions were taken in the face of a provision of the operating agreement which provides, inter alia, that decisions require the approval of 51% of the voting rights allocated amongst the various members. They also sought to adopt amendments to the operating agreement, again acting without consideration of the 51 voting units held by Lester Lee. After these actions were challenged by the trustee, the bankruptcy court “concluded that the Debtor’s voting rights were property of the estate as of the filing of the Petition and that the [actions of the other members of Lee Group] purporting to terminate his voting rights violated the automatic stay imposed by 11 U.S.C. § 362 and, therefore, had no legal effect.” In re Lester L. Lee, 524 B.R. 798 (Bankr. S.D. Ind. 2014).

 

It was from that ruling that this appeal to the District Court was taken. On appeal, the Court’s primary focus was upon whether the right to vote in an LLC constitutes “property of the estate,” defined by section 541(a)(1) of the Bankruptcy Code as “all legal or equitable interest of the Debtor in property as of the commencement of the case. After finding that Lee could be a “member” of the LLC notwithstanding the absence of any share in the company’s profits and losses or the distributions it should make, the Court was able to determine that Lee was a member. In a belt and suspenders analysis, the Court determined also that the voting rights themselves could constitute “economic rights in the company” affording him the opportunity to, for example, “ensure his continued employment as manager” thereof.

 

On that basis, the determination of the trial court to the effect that any effort to strip Lee of his right to control the LLC through the exercise of the 51 voting rights was invalid as a violation of the automatic stay. HERE IS A LINK to this decision.

 

Curiously not addressed by this opinion (it was not addressed by the trial court below) is Section 23-18-6-5(a)(3)(B) of the Indiana LLC Act, which provides that “a person ceases to be a member of a [LLC] upon the occurrence of any of the following events:… (3) the person is removed as a member:… (B)… By the affirmative vote, approval or consent of a majority in interest of the members after the member has assigned the member’s entire interest in the [LLC].” By this omission, the Court may be saying that, in effect, the assumption by the bankruptcy trustee of the voting rights within the estate is not an “assignment” as contemplated by this provision. Whether that is the Court’s thinking is, however, still unknown.

 

There have been a long series of cases that have addressed the question of whether the bankruptcy estate succeeds to a member’s right to participate in the management and affairs of an LLC. Famously, in In re Ashley Albright, it was determined that the bankruptcy court did succeed to the management rights. See also Thomas E. Rutledge and Thomas Earl Geu, The Albright Decision - Why a SMLLC is Not an Appropriate Asset Protection Vehicle, 5 Business Entities 16 (Sept./Oct., 2003).  That, however, was in the context of a single member LLC; Lee Group was a multiple-member LLC in which different concerns were present. This decision is yet another in which it was held, inter alia, that multiple-member versus single-member is not of itself a distinguishing factor (although certainly those fact changes may impact upon the executor contract analysis).  See, e.g., Matter of H&W Food Mart, LLC, 461 B.R. 904 (Bankr..N.D.Ga., 2011); Norberg v. Hawks Prairie Casino, LLC (In re McSwain), 2011 WL 4706982 (Bankr. W.D.Wa., 2011); In re Alameda Investments, LLC, 2013 WL 3216129 (Bankr.C.D.Cal., 2013).

 

 

Essentially, the members of the Lee Group vested control in Lester Lee. Now, for all effects and purposes, control of the LLC has been vested in Lester Lee’s bankruptcy trustee, and it appears there is little the members may do about that. While they may be trapped in that situation, counsel drafting LLC operating agreements (similar issues can arise under limited partnership agreements) need to carefully consider how voting control is allocated and address mechanisms by which, subject to the limitations of the automatic stay, operational control of the business venture may be properly removed from a bankruptcy trustee should that eventuality arise.

In response to a cross-posting of this review, Professor Carter Bishop observed:

The opinion is clear that for bankruptcy purposes BRC 541 sweeps into the debtor member’s bankruptcy estate “property” that includes the LLC interest and voting rights pertaining to that LLC interest, even if the member was a noneconomic member. The other members devoted their entire argument to BRC 541. They never addressed BRC 365. As long as 541 applies, any action to terminate those rights violates the automatic stay and are void and infective. The court so held.

The court did not state the trustee could exercise those voting rights.  The next step is crucial. If the operating agreement is an executory contract of a multi-member LLC, BRC 365 will normally respect LLC state law restrictions as “applicable law” and deny the trustee the right to exercise the debtor’s voting rights (similar outcome to a non-delegable personal service contract).This was a managing member of a multi-member LLC, so I assume BRC 365 blocks the trustee’s exercise.

 

So, I don’t think the opinion is quite as broad as Tom’s title suggests. It merely holds that BRC 541 requires the voting rights to be included in the estate. That does not conclude the matter which next shifts to BRC 365.

 

To which I respond:

The point you identify, namely the capacity to vote (as contrasted with hold) the voting interests is, well, interesting.

Neither this nor the prior decisions discuss the operating agreement as or not as an executory agreement - 365 has not been identified (based upon the pleadings I have reviewed) as an issue.

In In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr. E.D. Va. 2000), and I'm here working from memory, it was found that the voting rights were part of the estate, but that the estate was dissociated from the LLC; I think you are making the point that a similar outcome could follow if and when there is a later challenge to the estate's exercise of its voting control.  I would not be surprised if a court were to find “I’ve already said the voting rights are part of the estate, and (a) its too late for you to argue section 365 and/or (b) when I said the voting rights were in the estate I necessarily meant as well that the estate could exercise the voting rights.”

Whether the point has been already raised and rejected, or it simply has not been raised, is unknown.  I’ll see what more I can learn.

  

Developments in Same-Sex Marriage in Kentucky: Courts Holds that County ClerkMay Not Refuse to Issue Marriage Licenses Based on Personal Objection to Same- Sex Marriage

Developments in Same-Sex Marriage in Kentucky: Courts Holds that County Clerk May Not Refuse to Issue Marriage Licenses Based on Personal Objection to Same-Sex Marriage

 

      Yesterday Judge Bunning (E.D. Ky.) issued his ruling to the effect that a county clerk may not, based upon her personal objection to same-sex marriage, refuse to issue any marriage licenses.

 

      Howard Friedman at the Religion Clause Blog has provided an excellent summary of the decision, with links to the pleadings.  HERE IS A LINK TO THAT POST.

More Warning from the IRS on Tax Scams

More Warning from the IRS on Tax Scams

 

      The efforts of some of the more undesirable elements of our society continue to apply their ingenuity to efforts at defrauding people through schemes linked to the IRS and the federal tax code. The IRS has again warned about how these schemes are perpetrated and what taxpayers can do to reduce their risk.

      The text of the most recent notice from the IRS is as follows:

******

 

 

Scam Phone Calls Continue; IRS Identifies Five Easy Ways to Spot Suspicious Calls

IR-2014-84, Aug. 28, 2014

WASHINGTON — The Internal Revenue Service issued a consumer alert today providing taxpayers with additional tips to protect themselves from telephone scam artists calling and pretending to be with the IRS.

These callers may demand money or may say you have a refund due and try to trick you into sharing private information. These con artists can sound convincing when they call. They may know a lot about you, and they usually alter the caller ID to make it look like the IRS is calling. They use fake names and bogus IRS identification badge numbers. If you don’t answer, they often leave an “urgent” callback request.

“These telephone scams are being seen in every part of the country, and we urge people not to be deceived by these threatening phone calls,” IRS Commissioner John Koskinen said. “We have formal processes in place for people with tax issues. The IRS respects taxpayer rights, and these angry, shake-down calls are not how we do business.”

The IRS reminds people that they can know pretty easily when a supposed IRS caller is a fake. Here are five things the scammers often do but the IRS will not do. Any one of these five things is a tell-tale sign of a scam. The IRS will never:

1.     Call to demand immediate payment, nor will we call about taxes owed without first having mailed you a bill..

2.     Demand that you pay taxes without giving you the opportunity to question or appeal the amount they say you owe.

3.     Require you to use a specific payment method for your taxes, such as a prepaid debit card.

4.     Ask for credit or debit card numbers over the phone.

5.     Threaten to bring in local police or other law-enforcement groups to have you arrested for not paying.

If you get a phone call from someone claiming to be from the IRS and asking for money, here’s what you should do:

·         If you know you owe taxes or think you might owe, call the IRS at 1.800.829.1040. The IRS workers can help you with a payment issue.

·         If you know you don’t owe taxes or have no reason to believe that you do, report the incident to the Treasury Inspector General for Tax Administration (TIGTA) at 1.800.366.4484 or at www.tigta.gov.

·         You can file a complaint using the FTC Complaint Assistant; choose “Other” and then “Imposter Scams.” If the complaint involves someone impersonating the IRS, include the words “IRS Telephone Scam” in the notes.

Remember, too, the IRS does not use unsolicited email, text messages or any social media to discuss your personal tax issue. For more information on reporting tax scams, go to www.irs.gov and type “scam” in the search box.

Additional information about tax scams are available on IRS social media sites, including YouTube and Tumblr where people can search “scam” to find all the scam-related posts.

 

Diversity Jurisdiction and Tax Classification

Diversity Jurisdiction and Tax Classification

      In a recent decision, the court rejected the suggestion that the election by a particular LLC, for purposes of the Federal Internal Revenue Code, to be classified as a corporation should impact upon the mechanism by which the citizenship of the LLC is assessed for diversity purposes.  In effect, the LLC argued that, having elected to be taxed as a corporation, it should be assessed for diversity purposes as a corporation.  This argument was unsuccessful. Fairfield Castings, LLC v Hofmeister, No. 4:15-cv-00059, 2015 WL 4105027 (S.D. Iowa July 2, 2015).

      In rejecting the invitation to treat the LLC as a corporation for purposes of diversity jurisdiction, the District Court wrote:

Similarly, Spara’s elective decision to be treated as a corporation for tax purposes does not somehow transform its LLC status for purposes of evaluating diversity jurisdiction. The motivations behind a business entity’s choice to be taxed in a certain manner have no bearing on the rationale for evaluating the citizenship of each member of an LLC.