North Carolina Court Addresses a Poorly Drafted Complaint, But Makes a Few Errors of its Own

North Carolina Court Addresses a Poorly Drafted Complaint,

But Makes a Few Errors of its Own

 

       In a recent decision from the North Carolina business Court, it considered (and rejected) a poorly researched and crafted complaint.  Largely on lack of jurisdiction grounds.  However, in doing so, the court made some suggestions as to the application of derivative action law that are not clearly the law.  Azure Dolphin, LLC v. Barton, 2017 NCBC 88, 2017 WL 4400223 (N.C.B.C. Oct. 2, 2017).

      Jean-Pierre Boespflug (“Boespflug”) and Justin Baron (“Barton”) had over the years accumulated a significant real estate portfolio held in a variety of formats and business vehicles.  Typically Barton contributed management efforts and Boespflug contributed capital.  Azure Dolphin was a vehicle through which Boespflug held interest in various ventures.

      In April 2011, Boespflug communicated to Barton that he could no longer personally guarantee loans on the various properties.  In response, as alleged in the lawsuit, Barton took action to remove Boespflug/Azure Dolphin from the various properties, converted the equity to promissory notes, treated Boespflug’s interest as no longer having voting rights, and unilaterally amended the operating agreements controlling the individual properties to be “considerably more favorable to” Barton. Opinion, ¶ 12.

      Significant portions of the complaint were dismissed because the North Carolina court did not have personal jurisdiction over the named defendant; these defendants were business entities organized and having principal places of business outside of North Carolina.

      With respect to one defendant, JPB Holdings, while its incorporation in California had been contemplated, it was never completed.  Under North Carolina law it could not be sued as it did not exist as a corporation.

      Claims for the judicial dissolution of entities created outside of North Carolina on the basis that:

This Court has held that “[j]udicial dissolution of entities created under, and granted substantial contractual freedom by, the laws of one state should be accomplished by a decree of a court of that state.” Camacho v. McCallum, 2016 NCBC LEXIS 81, at *13–14 (N.C. Super. Ct. Oct. 25, 2016). Courts in other jurisdictions have consistently reached the same conclusion. See, e.g., In re Raharney Capital, LLC v. Capital Stack LLC, 25 N.Y.S.3d 217, 217–18 (N.Y. App. Div. 2016) (holding that New York courts lack jurisdiction to dissolve Delaware LLC); Young v. JCR Petroleum, Inc., 423 S.E.2d 889, 892 (W.Va. 1992) (“The existence of a corporation cannot be terminated except by some act of the sovereign power by which it was created.”); Mills v. Anderson, 214 N.W. 221, 223 (Mich. 1927) (“It is textbook law that the courts of one State cannot dissolve a corporation created by another State.”).  Opinion ¶ 37

      As for two North Carolina organized LLCs, Boespflug’s application for judicial dissolution was denied for lack of standing.  While he had been a member of each, he pledged those interests to his attorneys.  When they foreclosed on the pledge he ceased to be a member.  Under the North Carolina LLC Act, only a member has standing to move for judicial dissolution.  As to this point the Court cited N.C. § 57D-3-02; a reference to § 57D-3-02(a)(3) might have been more on point.

      With respect to Boespflug’s efforts to have Barton removed as the manager of the entities over whom the court had jurisdiction, the court found (on questionable reasoning expanded upon below) that removal of a manager may be granted only in a derivative, and not in a direct, action.

      Efforts to have the Barton-amended operating agreements set aside were dismissed as not all parties thereto were not before the court

The Court concludes that the absent members of the Investment Entities are necessary parties under section 1–260. The purpose of Plaintiffs’ claim is to invalidate the Investment Entities’ operating agreements and to alter their memberships. Yet each of the Investment Entities has one or more members or owners who are parties to its operating agreement but are not parties to this litigation. Any declaration invalidating an operating agreement or altering the LLC’s membership under the operating agreement would, “as a practical matter,” adversely affect the rights of these members. N.C. Monroe Constr. Co. v. Guilford County Bd. of Educ., 278 N.C. 633, 640, 180 S.E.2d 818, 822 (1971) (holding that a contracting party “is a necessary party in a proceeding to declare its contract ... invalid”). Accordingly, this Court cannot “properly determine the validity of” the operating agreements without making each member “a party to the proceeding.” Id.; see also Window World of St. Louis, Inc. v. Window World, Inc., 2015 NCBC LEXIS 79, at *15 (N.C. Super. Ct. Aug. 10, 2015). Opinion ¶ 53, citations to record deleted.

      Last, claims for breach of fiduciary duty were sismissed because, under the North Carolina LLC Act, a manager’s fiduciary duties were for the benefit of the company and not for each individual member.

As mentioned above, the decisions reference to corporate law vis-à-vis the removal of a director is at minimum questionable.  Specifically:

“Managers of limited liability companies are similar to directors of a corporation.” Kaplan v. O.K. Techs., L.L.C., 196 N.C. App. 469, 474, 675 S.E.2d 133, 137 (2009). [How are managers of an LLC similar to corporate directors?  The former derive their authority from the statute and often are in place before the corporation has shareholders. The manager of an LLC comes into that position by contract and has the authority determined by contract.]  North Carolina law is clear that a corporate director owes a fiduciary duty to the company [Why is this relevant to LLC? The LLC act defines the obligations of a manager, so why not use the LLC statute as the basis of your legal argument? The business corporation act is not applicable to LLCs, and it does not serve as a “gap-filler” for the LLC Act.  See N.C. § 57D-2-30(e). More importantly, the applicable provision in the LLC statute is only a default provision, requiring the judge to determine what the operating agreement says about manager duties, what they are and to whom they are owed and who may bring a claim for their violation], and an action to remove a director for mismanagement is properly raised by the corporation, not by individual shareholders. See, e.g., Gwaltney v. Gwaltney, 2017 NCBC LEXIS 11, at *17 (N.C. Super. Ct. Feb. 8, 2017); Greene v. Shoemaker, 1998 NCBC LEXIS 4, at *5, 8, 13–16 (N.C. Super. Ct. Sept. 24, 1998). [Perhaps true in the context of a corporation, but this is an action involving an LLC.] For the same reason [application of corporate law to LLCs is unsupported (and unsupportable?)] an action to remove a manager of an LLC is derivative in nature and must be asserted by or on behalf of the LLC, rather than by an individual member. See, e.g., Kroupa v. Garbus, 583 F. Supp. 2d 949, 953 (N.D. Ill. 2008) (applying Delaware law); Mich II Holdings LLC v. Schron, 2011 N.Y. Misc. LEXIS 7182, at *11 (N.Y. Sup. Ct. June 16, 2011) (under New York law, claim for removal of manager is “a claim of the corporation”); see also Freeman v. Premium Natural Beef, LLC, 2013 U.S. Dist. LEXIS 138797, at *17 (W.D. Okla. Sept. 27, 2013).  [No, an action to remove a manager is not governed by corporate law, it is governed by the LLC statute that defers to the LLC’s operating agreement.  N.C. § 57D-2-30(a). Therefore, such a blanket statement is dead wrong.  Who has the right to remove the Manager is determined by the operating agreement.]

            “Corporification” is the term oft-employed to describe the incorporation (pun intended) of concepts of corporate law into LLCs.  The topic is considered generally at Borden, Hurt and Rutledge, It’s a Bird, It’s a Plane, No, It’s a Board-Managed LLC!, Business Law Today (March 2017); SteveFrost and Kelley Bender, Adopting Corporate Terms in an LLC Agreement, or “Be Careful What You Ask For: You Might Get It!!”, J. Passthrough Entities, Jan-Feb. 2017 at 17 and Steven G. Frost, Things You Thought You Knew About Delaware Law, But Maybe Don’t … Recent Delaware Partnership and LLC Case Law, J. Passthrough Entities, May-June 2013 at 25. To date, “corporification” seems to come in two flavors.  In the first, having examined an operating agreement and found that it utilized “corporate” concepts such as a “board” or a “president,” the court utilizes related concepts of corporate law in order to apply those provisions.  This is the analytic path employed in Obeid v. Hogan, No. 11900-V CL, 2016 BL 185285 (Del. Ch. June 10, 2016) and Richardson v. Kellar, 2016 NCBC 60, 2016 WL 4165887 (Sup. Ct. N.C. Aug. 2, 2016).  Cases such as these caution against the inclusion of corporate concepts and terms absent careful consideration of what additional law may follow from doing so and either knowingly accept that possibility or in the alternative the careful limitation of the application of that additional law.

      This Azure Dolphin case is of the second flavor, one which is likely more destructive to the development of LLC law. In this case the judge in effect treated the law of business corporations as being normative.  Then, drawing various analogies between LLCs and corporations (e.g., managers of an LLC are like corporate directors), applied corporate law to the dispute.  There are several flaws built into this system.  First, it assumes the analogies are accurate.  In fact often then are not.  Looking specifically at Azure Dolphin, the managers of an LLC are not equivalent to the directors of a corporation.  The former derive their authority from the terms of the unique operating agreement of a particular LLC.  It is no more possible to say “managers have the authority to do x, y and z” than it is to say that “the price of widgets ranges from a to b.”  Under most LLC acts the only mandatory effect of electing that the LLC have managers is that the members, qua members, cease to have apparent agency authority to act on the LLC’s behalf. See, e.g.., KRS § 275.135(2)(a).  In contrast, directors of a corporation derive their authority not from a contract or a delegation from the shareholders (directors are not the shareholders’ agents) but rather from the corporate statute.  See generally Rutledge, Let’s Stop Describing LLCs as “Hybrids,” J. Passthrough Entities  (Sept./Oct. 2014)  at 29.

      The Azure Dolphin court, in analogizing to corporate law to determine the path by which a manager could be removed, failed to apply either the LLC’s operating agreement or the North Carolina LLC Act (which would have directed the court to the operating agreement). Other courts should not make the same error.