Federal District
Court Addresses Corporate and
LLC Derivative Actions, Pleading of Futility
LLC Derivative Actions, Pleading of Futility
In a decision issued last week
by the Federal District Court for the Eastern District of Kentucky (Judge Reeves),
there was addressed the requirements for bringing a direct, versus a
derivative, action in the context of both the corporation and the LLC. Also
considered in detail was the requirements for pleading demand futility. Smith v. Tarter, No. 5:17-334-DCR, 2018
WL 506227 (E.D. Ky. January 22, 2018).
Smith, along with other
individuals, filed, in the alternative, direct and derivative claims with
respect to a corporation, the Tarter Companies, identified as “the largest
manufacturer of farm gates and animal management equipment in North America,”
and certain related LLCs. It was alleged that defendants Joshua Tarter and
Thomas Gregory, including a company they organized, all were funneling assets
of the Tarter Companies to themselves. Specifically, they used a company they
organized, QMC Industry Company, Ltd. (“QMC”), as the vehicle through which
they would source products in China. However, Tarter and Gregory would cause QMC
to markup its prices vis-à-vis what it was paying the Chinese manufacturer, in
effect capturing, uniquely for themselves, some of the cost savings that would
have otherwise been enjoyed by the Tarter Companies.
In response to the complaint,
the defendants filed a motion to dismiss.
The court began its analysis
with the direct claims bought with respect to the corporation’s, beginning its
analysis by noting that the plaintiffs “have not alleged that they sustained
any personal injuries apart from the costs and a loss of cost savings allegedly
incurred by the Tarter Companies.” 2018 WL 506227,*4. Then applying the rule
that a shareholder may not bring a personal claim unless they are able to show
injury other than to the corporation, and that claims based upon the diminution
of share value are derivative in nature, the direct claims were dismissed for
lack of standing.
Turning to the direct claims
brought with respect to the LLCs, the plaintiffs asserted that they had the
standing to bring them as, inter alia,
they are parties to the operating agreement and the defendants were charged
with violating same. Judge Reeves rejected this assertion, holding rather that,
again, the alleged injuries were to the business entity, and in consequence
thereof any suit to remedy same needed to be on a derivative basis. He cited in
support KRS § 275.337. To that end, the court wrote:
The
plaintiffs have not plausibly alleged that they sustained any injury as members
of the Tartar LLCs that is not indirect or incidental to the Tartar LLCs’
expenditure of costs and loss of cost savings. As a result, they lack standing
to bring an individual capacity action to redress those injuries. Accordingly,
the plaintiffs lacked standing to maintain an individual capacity action either
as shareholders of the Tartar Corporations or as members of the Tartar LLCs, and
their individual capacity claims must be dismissed. 2018 WL 506227, *5.
Turning then to the derivative
counts, the court began by noting the “heightened pleading standards” under
Federal Rule of Civil Procedure 23.1 applicable with respect to derivative
actions, particularly the obligation that the plaintiff “state with
particularity” the efforts “made to prod the entity into bringing the action on
its own behalf, and any reason the plaintiff failed to make such an effort or
the effort was unsuccessful”. In addition to FRCP 23.1, there were cited the
equivalent provisions of the Kentucky Business Corporation and the Kentucky Limited
Liability Company Acts.
Relying upon both Kentucky and
Delaware law, the situations in which demand futility is available were
discussed. Here, it was found that the only defendant with an ownership
interest in the Tartar Companies is Joshua Tartar, owning 16.6%. The plaintiffs
own 50% of that company, and the remaining balance of 33.47% was owned by
non-parties to this action who are members of Joshua Tarter’s family. It was
determined that the plaintiffs had not plead with particularity why those other
owners could not or would not exercise legitimate business judgment with
respect to the matter. Specifically, the plaintiffs had failed to make “particularized
factual allegations” that would give rise to “a reasonable doubt” that the
siblings would “not exercise independent and disinterested business judgment.”
2018 WL 506227, *6. In this respect, the court adopted a Delaware rule as to
determining whether a director is interested in a transaction thereby unable to
exercise independent business judgment:
Under
Delaware law, a director is considered “interested” if he or she: (i) received
a personal financial benefit that was not shared by the other stockholders from
the challenged conduct; (ii) might suffer a “materially detrimental impact”
from the proposed legal action; or (iii) was incapable, due to domination and
control, of objectively evaluating a demand to assert the company’s claims.
2018 WL 506227, *7 (citations omitted).
In that the plaintiffs had not
alleged any of these disabling factors, they had not satisfied their obligation
to plead demand futility. Rather, “The plaintiffs have plead no facts
indicating that the desire to maintain control of 50% of the Tartar Companies
together with Joshua Tartar would undermine Joshua Tartar’s siblings’
independent judgment.” Id.
The complaint was dismissed
without prejudice, so subject to statute of limitations issues, presumably,
after appropriate demand, the complaint could be refiled.
I do have a quibble with the
opinion, where it provides:
Griffin [v. Jones, 170 F. Supp. 3d 956 (W.D. Ky.
2016)] and Patmon [v. Hobbs, 280 S.W. 3d 589 (Ky. App.
2009)] established that, under Kentucky law, a managing member of a limited
liability company (“LLC”) owes fiduciary duties both to the LLC and its
individual members.
Not recognized in this
decision is that after the Patmon
decision, KRS § 275.170, it defining the fiduciary obligations that are owed in
LLCs, was revised, eviscerating most of the Patmon
decision (it as well has been essentially set aside by the third opinion of the
Court of Appeals in that case) and that this case involves an alleged breach of
the duty of loyalty, which is owed only to the company (and not inter se of members). In addition,
fiduciary duties, including as to who owes them and to whom, are subject to
being altered in the operating agreement.
A reference to the default rule has validity if and only if it has been
first determined that the operating agreement did not set forth a different
formula. Maybe, in this instance the
operating agreement was silent as to whom the duties were owed, and the default
rule applied. Alternatively, the
operating agreement was never reviewed. Either way, the opinion does not say.
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