Court Addresses the Direct Versus Derivative Distinction in LLCs
In a recent decision from the Federal
District Court for the Eastern District of Kentucky (Judge Bunning), a
complaint was dismissed where it brought what were derivative claims, but in
the guise of direct claims. On that basis, the complaint was dismissed. DT Grat
Jmt, LLC v. Keeney, Civ. Act. No. 17-101-DLB-CJS, 2017 WL 5194063 (E.D.
Ky. November 9, 2017).
Keeney, the defendant herein,
served as the manager of a series of 13 limited liability companies
collectively referred to as the “Park Companies.” The plaintiffs herein were
members in the Park Companies. They alleged, in the complaint, that Keeney had
engaged in a pattern of fraudulent conduct, self-dealing and mismanagement of
the various Park Companies. In addition, Keeney owned four other business
entities (the “Kenney Business Entities”) that, in turn, provided services to
the Park Companies; the plaintiffs did not have an ownership interest in any of
those companies. It was alleged that park Companies assets were diverted to the
Keeney Business Entities.
Various of the operating
agreements of the Park Companies provided that an annual budget would be
presented to the members for consideration, and that “the budget must be
approved in writing by the Members.” It was alleged that Keeney had failed to
tender proposed budgets, but had continued to disperse assets from the Park Companies.
Also, those same operating agreements required that related party transactions have
the approval of a majority of the members. It was alleged that payments had
been made by various of the Park Companies to the Keeney Business Entities
without that approval. Based upon information that came to light once Keeney,
at the plaintiffs request, began marketing the Park Companies for sale, and
after a forensic audit, it was determined that Keeney had, without the approval
required by the operating agreement, transferred to the Keeney Business Entities
nearly $12 million. Suit was then brought against the defendants alleging
breach of contract, breach of fiduciary duty, aiding and abetting breach of
fiduciary duty, and fraud. The defendants then filed a motion to dismiss under
The defendants argued that the
proper plaintiffs in this action should be the 13 LLCs comprising,
collectively, the Park Companies, and not the individual members thereof. Specifically:
Defendants believe that those
limited-liability companies are the real parties in interest because “individual
members of LLCs may only bring claims in their individual capacity when they
have suffered a separate and distinct injury from that of the LLC.” Defendants
argue that the current Plaintiffs have not suffered an injury that is separate
and distinct from the injury allegedly suffered by the Park Companies. Thus,
defendants contend that the Plaintiffs’ claims are derivative, and under Rule
17(a), the Court must substitute the current Plaintiffs for the 13-limited
liability companies collectively referred to as the Park Companies. 2017 WL
5194063, *3 (citations omitted).
In opposition, the plaintiffs
asserted that this is it this action is direct, not derivative, they asserted:
Specifically, plaintiffs argue that
the important distinction is that the alleged misdeeds involve wrongs to certain members - not all members - of the 13
limited-liability companies that are collectively referred to as the Park
Companies. That is, because the misdeeds were to the benefit of some members of
the limited-liability companies - Defendants - and to the detriment of other
members of the limited-liability companies - Plaintiffs. Plaintiffs believe
that it is this distinction that makes plaintiffs the real parties in interest,
rather than the 13 limited-liability companies known as the Park Companies.
Thus, Plaintiffs argue that they are entitled to bring a direct claim for the
distinct harms they suffered from the Defendants’ misconduct. 2017 WL 5194063, *4
The court would agree with the
defendants in this action, holding, inter
alia, that is the various of the Park Companies that should be the
plaintiffs in this action, noting, for example, that the allegations were that
monies were transferred from the Park Companies.
At oral argument, the
plaintiffs argued that the Kentucky LLC Act, specifically KRS § 275.337(1),
allows them to bring a direct action against the defendants. The court noted,
however, that the condition of that provision is a requirement that “the member
can prevail without showing an injury or breach of duty to the company.” In
this case, it was found that the plaintiffs could not meet this burden. Rather,
finding that the crux of the claims were that assets and other funds were
misappropriated from the Park Companies, the actions complained of assert an
injury to the LLCs, not to the individual plaintiffs.
Breach of the Operating
The plaintiffs also asserted
that the defendants had violated certain of the terms of the operating
agreements, alleging that this gave rise to a direct cause of action. Noting
that the existence of the LLCs was a condition precedent to the existence of
these claims, the Court found that the claims are necessarily derivative.
“But for the limited liability
companies, those claims would not exist.” Trident-Allied
Assocs., LLC v Cypress Creek Assocs., LLC, 317 F.Sup. 2d 752, 754 (E.D.
Mich. 2004). Those “very Agreements… served as the basis for the creation of
the LLC in the first instance.” Id.
(citing Trademark Retail, Inc. v Apple
Glenn Investors, LP, 196 F.R.D. 535, 540 (N.D. Ind. 2000)). Put simply,
Plaintiffs’ claims are derivative, not direct, whether styled as breach of
contract, breach of fiduciary duty, or fraud. 2017 WL 5194063, *6.
Having determined that the various
Park companies are the real parties in interest, the court determined that
diversity jurisdiction would be lacking, and the action was dismissed.
All of that is well and good,
but in discussing the fiduciary duties of the members of an LLC, there was some
incorrect dicta presented with respect to fiduciary duties. Specifically, the
opinions provides in part:
Defendants' duty ran to both the
members of the limited-liability companies into the limited-liability companies
themselves. The liability of members and managers of limited-liability
companies is outlined in Ky. Rev. Stat. Ann. § 275.170. In Kentucky, a managing
member of a limited-liability company owes fiduciary duties to other members of
the limited-liability company and to
the limited-liability company itself. Patton
v Hobbs, 280 S.W.3d 589, 595 (Ky. Ct. App. 2009). Although it may be true
that Plaintiffs, as members of the 13 limited-liability companies that formed
the Park Companies were owed fiduciary duties by Defendant Keeney, so too were
the limited-liability companies. 2017 WL 5194063, *5.
But Still Some Problems as to Fiduciary
With respect to the reference to KRS § 275.170,
the court, in a footnote, wrote:
To summarize the statute, “a member
or manager must account to and hold as trustee for a limited liability company
any profit or benefit to right from the use of company property by that member
or manager including, but not limited to, confidential, proprietary, or other
matters entrusted to that person's status as a manger (sic manager) or member.”, quoting from Patton v Hobbs.
The problems with these statements
KRS § 275.170 does not
outline liability, but rather outlines fiduciary duties/standards of
The statute bifurcates
the fiduciary duties between those of care and loyalty;
While the duty of care
is owed, in a member-managed LLC, by each member to each other member and to
the company, the duty of loyalty is owed only to the company;
The central holdings of
Patton v Hobbs had been significantly
undercut by subsequent amendments to the LLC Act making express that the
statutory formula sets forth the only fiduciary duties of the members and
While the alleged
diversion of assets from the Park Companies implicated the duty of loyalty
(nobody would complain that they diverted the assets in a sloppy manner,
thereby implicating the duty of care), that duty of loyalty is owed only to the
LLC and not amongst the members.