LLC ESOP

LLC ESOP

In what appears to be the first ruling of this nature, the Internal Revenue Service recently issued a private letter ruling to the effect that a limited liability company may adopt an employee stock ownership plan.  Doing so requires, however, that the LLC elect, for federal tax purposes, to be classified as a corporation.  As such, within the limits of this ruling (and technically it may be not be relied upon by anybody other than the party to whom it was addressed), it remains that a ESOP may not be adopted by an LLC that is taxed either as a disregarded entity or as a partnership.

PLR 201538021 (September 18, 2015).

Ambiguity in Redemption Agreement Keeps Alive Question as to Confidentiality Obligation Under Operating Agreement

Ambiguity in Redemption Agreement Keeps Alive Question as to

Confidentiality Obligation Under Operating Agreement

            A recent decision from the Delaware Chancery Court highlights how imprecise drafting can lead to disputes over what obligations are and are not owed.  UtiliSave, LLC v. Miele, C.A. No. 10729-VCP, 2015 WL 54558960 (Del. Ch. Sept. 17, 2015).

 

            The Utilisave, LLC operating agreement contained a confidentiality agreement that would “continue to be binding on a Member following the termination of its interest in the Company.”  Miele, an employee with access to Utilisave’s confidential and proprietary information, became a member of the company and in so doing became subject to the confidentiality provision.  Thereafter her interest in the company was cancelled pursuant to an Assumption and Termination of Membership Interest agreement that was silent as to the confidentiality obligation under the operating agreement.  It did, however, expressly cut off Miele’s obligation to contribute further capital to the company. 

 

For several years thereafter Miele remained an employee of UtiliSave.  After her ultimate resignation she was alleged to have taken steps to set up a competing venture, including contacting two clients of UtiliSave.  It then brought suit alleging violation of the operating agreement’s obligation of confidentiality. 

 

UtiliSave relied upon the language of the operating agreement preserving the confidentiality obligation post-termination of member status.  Miele’s defense was essentially that the Assumption and Termination agreement failed to preserve the confidentiality obligation, and that it should be read to be a waiver of all obligations including capital contribution. She also alleged that the confidentiality obligation itself is overbroad and unreasonable. 

 

Rejecting Miele’s motion to dismiss, the court began:

 

As the moving party, Miele has the burden of showing hers is the only reasonable interpretation.  Because I find both Defendant’s and Plaintiff’s interpretations are reasonable, Defendant has failed to carry this burden.

 

2015 WL 5458960, *6.

 

The failure to carefully review the limitations and obligations imposed by the operating agreement and to in turn address them in the Assumption and Termination Agreement, specifying which end and which survive, means this dispute will carry on.  Further drafting could have avoided that expense.

 

 

Massachusetts Court Applies “Neutral Principles of Law” To Resolve Dispute Over Church Trespass

Massachusetts Court Applies “Neutral Principles of Law” To Resolve Dispute

Over Church Trespass

      Recently, the Massachusetts courts were called upon to resolve a question of trespass in a Catholic Church owned by the Archdiocese of Boston. Applying “neutral principles of law,” even as there was rejected the assertion that the courts could address issues of Catholic Canon law, it was determined that the individuals were trespassing on the property. Roman Catholic Archbishop of Boston v. Rogers, No. 15-P-839, 2015 WL 5944101 (Mass. App. Ct. Oct. 14, 2015).

      In 2004, the Boston Archdiocese (the “RCAB”) determined to “suppress” (that is the technical term used in the Code of Canon Law of the Catholic Church) a number of parishes, including one in Scituate, Massachusetts. Certain former parishioners of that church thereafter maintained a 24/7 vigil in the church. Certain of those same parishioners (i) appealed the suppression to the Vatican and (ii) filed an action in civil court alleging that under Canon Law the RCAB held the church in trust for the benefit of the parishioners. In that the civil action asked a court to, in effect, apply Roman Catholic Canon Law, it was determined that the court could not hear that dispute as it is outside of its competency. That determination was affirmed by the Massachusetts Court of Appeals in 2008 (the “Prior Ruling”).

      Ultimately, all of the appeals to the Vatican seeking the reversal of the parish’s suppressions were denied. Thereafter, when various parishioners continued to maintain their vigil even after a written demand that they vacate the property, the RCAB filed an action seeking a determination that (a) those maintaining the vigil are trespassers and (b) seeking an injunction precluding them from continuing the vigil.

       In a pretrial order, the trial court judge:

Limited the proof at trial to RCAB’s right of possession, stating that “[t]he trial will not concern defendants’ alleged further appeal within the ecclesiastical process regarding the closing of the parish or ownership of the [c]hurch…[or] the application or interpretation of Canon Law.” The judge also precluded evidence or argument that the defendants are equitable owners of the church, concluding that such matters had already been addressed in [the Prior Ruling].

      After a bench trial, the trial court: (a) dismissed, because it would require an interpretation of Catholic Canon Law, the defendant’s assertion of a equitable ownership in the church property; (b) determined that the former parishioners were trespassing upon the Archdiocese’s property; and (c) and enjoined those former parishioners from entering the church. This appeal followed.

      One argument made by the defendants was that the court could not rule in this matter because it would necessarily involve an interpretation of Catholic Canon Law. The trial court, affirmed by the Court of Appeals, concluded that the right to enter into the property could be resolved using “neutral principles of law” in that Massachusetts civil law determines what is required for and what are the incidents/benefits of ownership.

      In this instance, record ownership of the church in this property was vested in the RCAB, and the RCAB is entitled to determine who may use and how may be used that property. The claims brought under Canon Law, being nonjusticiable by a civil court, did not give rise to an enforceable interest in the property.

      From there, the trial court’s determination that the individuals were trespassing was easily determined in that there was no dispute that they were on the property against the express instructions of the RCAB. On that basis, the injunction against trespassing in the church was affirmed.

A Few Cases I am Following

A Few Cases I am Following

     There are number of cases pending in Jefferson County that I’m following (neither I nor Stoll Keenon Ogden are involved in any of these cases). They are:

·                     Barnes v. Oasis Computer Solutions, Inc., No. 15-CI-004778 (Jefferson Circuit Court, Division 11). In this case, Barnes, a 10% shareholder in Oasis, alleges that he was terminated as part of the scheme to reacquire his 10% ownership in the corporation and that he has been denied the opportunity to collect and review company business records so as to properly value his shares. He is asserting as well that the majority and other shareholders stood in a fiduciary relationship with one another. There is also a claim for tortious interference with economic advantage.

·                     Perkins v. Rumpke, Case 15-CI-04992 (Jefferson Circuit Court, Division 8). This complaint asserts that Rumpke, in alliance with Jones and Driveway Dumpsters, LLC, effected a scheme pursuant to which they learned the dumpster business from Perkins and then set up a competing venture, Driveway Dumpsters, LLC. No answer has yet been filed.

·                     Francis v. Francis & Company, Inc.  No. 15-CI-04112 (Jefferson Circuit Court, Division 12).  Francis, a shareholder in, and former officer and director of, Francis & Co., Inc., charges that the majority shareholder has “acted to deprive plaintiff of his right to the benefits, privileges, and responsibilities of stock ownership” by locking him out of the business and separately misusing corporate assets for personal use.  The various claims largely are alleged both individually and derivatively.  One relief sought is judicial dissolution. A counter-claim has been filed alleging that the plaintiff used company assets for personal expenses.  Curiously, the defendants assert in the answer that the corporation does not have a board of directors.

·                     Cecilia Henderson v. Spirited Holdings, LLC, Case No. 15-CI-002636 (Jefferson Circuit Court, Division 8).  This suit involves the management of Spirited Holdings, LLC, previously equally owned by Lincoln Henderson (now deceased) and his son Wesley Henderson.  Lincoln’s will left his 50% interest in the company to his wife, and Wesley’s mother, Cecilia.  She alleges, inter alia, that Wesley has cut her out of the business, depriving her of financial information, and has as well deprived her of the proceeds of the sale of Angel’s Envy (partially owned by Spirited Holdings) to Bacardi.  The defense appears to be (and this is gleaned from the answer only) that Cecilia is a mere assignee of Lincoln, as an assignee is not a member of the LLC, and has no rights vis-à-vis the LLC.

·                     Last, Edward Flint has filed a pair of new complaints, one in state court and the other in federal.

►In the state action Flint v. Gannett Co., Inc., No. 15-CI-05156 (Jeff. Cir. Ct. Div. 7), a variety of allegations sounding in fraud and breach of fiduciary duty are made against Gannett (i.e., the Courier-Journal) and various of its officers for failure to publish stories about alleged malfeasance by various Kentucky judges and Governor Beshear.  Certain of the allegations are based upon the Courier-Journal not informing the public about the petition for impeachment of Governor Beshear that Plaintiff Flint separately filed with the Kentucky General Assembly.

►In the federal action, Flint v. Beshear, Case No. 3:15-CV-777-DJH (W.D. Ky), Governor Beshear is charged with a number of improprieties including letting MetLife Insurance Company raise premiums without official approval while he has been Governor and that he bribed members of the General Assembly to not hold an impeachment trial.

Okay, That I Did Not Anticipate

Okay, That I Did Not Anticipate

     I was somewhat surprised that my article A Corporation Has No Soul - The Business Entity Law Response to Challenges to the PPACA Contraceptive Mandate, 5 William & Mary Business Law Review 1 (2014), was cited by the Texas Court of Appeals in a case focused upon whether a forcible detainer action could be sworn to by the bank’s attorney rather than by the bank itself.  

      On the other hand, I cannot complain about a citation.  Norvelle v. PNC Mortgage, No. 02-14-00322-CV, 2015 WL 4965295 (Aug. 20, 2015).

Illinois Supreme Court Addresses Legal Malpractice, Direct Versus Derivative Distinction (But Why Does it Keep Describing an LLC as a “Corporation”?)

Illinois Supreme Court Addresses Legal Malpractice, Direct Versus Derivative Distinction (But Why Does it Keep Describing an LLC as a “Corporation”?)

In a recent decision, the Illinois Supreme Court addressed the standard for a successful claim for legal malpractice, here in the context of the direct versus derivative distinction. Unfortunately, in the course of an otherwise analytically sound decision, that same court repeatedly utilized the nomenclature of corporations in discussing the legally distinct limited liability company (“LLC”). Stevens v. McGuireWoods LLP, Docket No. 118652, 2015 IL 118652, 2015 WL 5608264 (Ill. Sept. 24, 2015).

The named plaintiffs had been members of Breeland Management LLC (“Breeland”). They hired McGuireWoods LLP to bring suit against Breeland’s managers and majority owner, Rogers, on claims based upon misappropriation of trademarks and intellectual property.  These claims were brought both individually and derivatively on behalf of Breeland.  Many of those counts were dismissed.

After that dismissal, the named plaintiffs retained new counsel, who filed an amended complaint restating the original claims against the managers and the majority owner, as well as adding seven counts against Breeland’s counsel, Sidley Austin LLP.  Sidley moved to dismiss those claims based upon a variety of bases including failure to state a claim but, most importantly for this dispute, statutes of limitation and repose. The trial court would dismiss all the claims against Sidley with prejudice based upon the statute of limitations/repose.

Ultimately the named plaintiffs would settle with Rogers, the majority owner of Breeland, and be cashed out.

After having been cashed out, the named plaintiffs filed a legal malpractice action against McGuireWoods, seeking not less than $10,000,000, primarily on the basis that the initial lawsuit had not included the claims against Sidley within the applicable statute of limitations/repose. The action was again both individual and derivative.  The trial court dismissed the suit.

On appeal to the intermediate court, the determination that the individual claims against McGuireWoods would be dismissed was affirmed. The intermediate Court of Appeals, however, noted that the trial court had never expressly addressed the named plaintiffs’ capacity to, on a derivative basis, bring a claim against Sidley. The Illinois Supreme Court accepted review of that question.

The Illinois Supreme Court began its analysis by noting the rules as to what is required for a successful legal malpractice claim. Essentially, the plaintiff bears the burden of demonstrating that, as a direct and proximate result of the attorneys poor performance, the plaintiff suffered actual monetary damages i.e., that they would have prevailed absent the alleged malpractice.

Ultimately, the futility of the malpractice action came down to a question of standing. The various allegations, asserted by the named plaintiffs individually, were deficient in that they were based upon injuries suffered by Breeland Management. As such, the claims are derivative in nature, and the named plaintiffs had no expectation of an individual recovery thereon. As to the claims, now characterized as derivative, any recovery would be to Breeland Management; the named plaintiffs could not have received any of the fruits of the lawsuit, even had it been successful. While Breeland, directly, or the remaining minority members of Breeland, derivatively, still might have a valid claim against McGuireWoods, these named plaintiffs did not. Rather:

That said, plaintiffs have an insurmountable problem even as to their derivative claims. In the insurmountable problem is that, even assuming that McGuirewoods had successfully prosecuted plaintiffs’ derivative claims against Sidley, plaintiffs would not have recovered anything from the resulting judgment in their individual capacities.

Slip op. at ¶ 15.

All that said, this opinion suffers from a failure to utilize the appropriate nomenclature. In fact, the first substantive sentence of the decision refers to the “shareholders” of an LLC.  LLCs have members not shareholders. In ¶ 4 of the decision, it is stated that “as Breeland’s corporate counsel, Sidley’s duty ran solely to the corporation and not to its individual shareholders.” (emphasis added). Of course, Breeland was a LLC, not a corporation, so Sidley was the LLC’s counsel with a duty to the LLC and not its members. Later, at ¶ 20 of the opinion, it is stated that “in Illinois, shareholders cannot recover personally on LLC derivative claims.” (emphasis added) Again, LLCs do not have shareholders.  At ¶ 23 of the decision, even while citing the Illinois Limited Liability Company Act, it is recited that in order to have standing “to bring a derivative claim, the plaintiff must have been a shareholder at the time of the transaction at which he complains and must maintain his status as shareholder throughout the entire pendency of the action.” (emphasis added, italics in original). Of course, the cited provision of the Illinois Limited Liability Company Act does not say anything about shareholders, but only about members.

Thanks to Bob Keatinge for the laad on the decision.

LLPs and Diversity Jurisdiction

LLPs and Diversity Jurisdiction

      While the discussion may ultimately be dicta, a recent decision out of Indiana reinforces the rule as to assessing, for purposes of diversity jurisdiction, a limited liability partnership. Scholastic Services, Inc. v First Midwest Bancorp, Inc., No. 2:15-CV-211, 2015 WL 5772526 (N. D. Ind. Sept. 30, 2015).

      Scholastic Services fell behind on its loan obligations to First Midwest Bancorp. Negotiations were commenced as to a re-amortization of the loans.  While Scholastic apparently believed an agreement as to re-amortization was in place, the bank declared the note to be in default.  When Scholastic challenge that determination, the bank's counsel, Krieg DeVault, LLP, contacted scholastic and its principles, reaffirming the alleged default and seeking a forbearance agreement Scholastic brought suit against the bank on a variety of state law claims, and alleged as well that Krieg DeVault (“KN”) had violated the Federal Fair Debt Collection Practices Act (“FDCPA”).  The suit, filed in state court, was then removed to the Federal District Court.  That removal was allegedly on the basis of federal question jurisdiction over the FDCPA claim against KN, with supplemental jurisdiction over the state law claims against the bank.  The removal asserted as well diversity jurisdiction over the claims brought against the bank.

       While, ultimately, this may all be dicta, the court noted that the assertion of diversity jurisdiction was flawed.  Initially, with respect to the point the diversity jurisdiction existed over the state law claims, looking at that aspect of the lawsuit is simply being between Scholastic and First Midwest, the court explained that diversity jurisdiction must exist as between all defendants and all plaintiffs; diversity jurisdiction is not assessed on a claim by claim basis, but rather must exist over the entire case.  2015 WL 5772526, *1, n. 2.  Rather:

The parties’ briefs with respect to diversity jurisdiction overlook a key component.  Both parties omit the simple fact that even if the Plaintiffs are citizens of Indiana and the Defendants have shown by competent proof that the bank is not a citizen of Indiana (which it is not), then nonetheless, KG can destroy diversity if any of its members are a citizen of Indiana.  In other words, because Plaintiffs named KD as a defendant (even if with respect to only the federal claim alleged), then absent severance KD cannot be a citizen of Indiana in order to maintain diversity.  ….  Therefore, to properly allege citizenship, Defendants must identify every partner of KD, and must further allege the citizenship of every one of those partners.  If any of the partners are themselves LLCs or partnerships, the Defendants must do likewise for them.  Because the amended notice of removal fails to properly plead the citizenship of all of the parties named as Defendants, it fails to invoke this Courts subject matter jurisdiction over the entire case based on diversity of citizenship.  

2015 WL 5772526, *2 (footnote omitted, citation to record omitted).

      The court would go on to acknowledge that the claim under the FDCPA gives rise to federal question jurisdiction (28 USC § 1331), and the counts against the bank are based upon a common nucleus of operative facts, giving rise to supplemental jurisdiction.

Enforcing an Operating Agreement Against a Member Who Didn’t Sign?

Enforcing an Operating Agreement Against a Member Who Didn’t Sign?

      It is quite troubling when someone finds out that, after having joined an LLC, they can be bound to an operating agreement that they have never agreed to. That is, however, the manner in which many of the LLC statutes operate. Persons who agree to be minority members of an LLC are on notice of the need to consider this eventuality and, if possible, negotiate protections against it.  Otherwise, they need to accept that this is a possible outcome.

      In a recent decision from New York, Shapiro v Ettenson, 2015 N.Y. Slip Op 31670 (U) (Aug. 16, 2016), three individuals came together and formed a member-managed LLC, equally owned by the three of them.  They did not, however, adopt a written operating agreement.  Nearly 2 years after the LLCs organization, two of the members executed a written consent pursuant to which the articles of organization were amended to change the LLC from being member-managed to manager-managed and they also adopted a written operating agreement.  In addition to addressing the management of the company, it provided that a majority of the members could determine to make a capital call upon all of the members and, upon a member’s failure to satisfy a capital call, their interest in the company would be diluted.  After a capital call was made, one of the members, Shapiro, filed a lawsuit challenging the adoption of the written operating agreement and the capital calls.

      Cutting to the chase, Shapiro lost, primarily because the New York LLC Act provides a default rule that a majority of the members can adopt or amend the articles of organization or operating agreement.  A detailed analysis of this decision, prepared by Peter Mahler and posted on his (highly recommended) blog, New York Business Divorce, is available at Can LLC Agreement Be Enforced Against Member Who Doesn’t Sign It? (CLICK HERE to link to the posting).

      Having reviewed Peter’s description of this ruling and as well the numerous additional questions he identified, it is important to consider whether a similar outcome could happen in Kentucky.  In a word, “Yes.”  

      If the members never adopt an operating agreement per se, then the articles of organization and the LLC Act are the operating agreement.  KRS § 275.003(8).  Initially, the Kentucky LLC Act provides a default rule that the members vote in proportion to their capital contributions, and goes on to provide a default rule that a majority-in-interest of the members may pass on most points, including amendment of the operating agreement. See KRS § 275.175(1); id. § 275.175(2)(a).  While the LLC Act does not allow a capital contribution obligation to be imposed upon a member absent their written consent thereto (KRS § 275.200(1)), it is open to question whether a majority of the members, over the objection of a particular member, could impose a capital contribution obligation that, even while not specifically enforceable against the objecting member, can still have any of the consequences for lack of performance or otherwise allowed to be set forth in an operating agreement.  See KRS §§ 275.003(2)(a)-(g).

      Another mechanism by which the same effect can come about is a merger.  Under Kentucky law, absent a contrary provision in a written operating agreement, a majority-in-interest of the members can approve a merger.  Utilizing this provision (i) a majority of the members set up a new company and with it a new operating agreement and then (ii) cause the existing LLC to be merged with and into the new LLC with the new LLCs operating agreement binding all of its members.  See also KRS § 275.350(1).  Upon the effective time and date of the merger, all of the members of the former LLC are bound by that new operating agreement.  See KRS § 275.365(11); see also Rutledge The 2010 Amendments to Kentucky’s Business Entity Laws, 33 N. Ky. L. Rev. 383, 397-99 (2011).  Again, while members who vote against the merger may not be subject to capital contribution obligations to the new company (KRS § 275.365(11)), they may be subject to various penalties, detailed in the new LLCs operating agreement, if they do not participate in additional capital raises (KRS §§ 275.003(2)(a)-(g)).

      Depending upon the underlying state law, being a minority member in an LLC can be a precarious position.  Some of those risks and some thoughts on how they maybe militated are addressed in Rutledge, Minority Members and Operating Agreements, 10 J. Passthrough Entities 21 (Nov./Dec. 2007).   HERE IS A LINK to that article.