Wednesday, January 31, 2018

Federal District Court Addresses Corporate and LLC Derivative Actions, Pleading of Futility

Federal District Court Addresses Corporate and
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.




Friday, January 5, 2018

Free Advice – Don’t Die While a Member of an LLC

Free Advice – Don’t Die While a Member of an LLC

      LLC law provides for often surprising results upon a member’s death. Essentially, unless different rules are set forth in the operating agreement, the decedent’s rights as a member in the LLC evaporate, and the estate has only a limited rights against the LLC and the other members. Oftentimes the estate has no right to inspect the LLC’s books and records, and absent a contrary provision in the operating agreement the estate will be owed no fiduciary duties.
      In a recent decision out of New York, the court applying an operating agreement and Delaware law that are not dissimilar from the laws of Kentucky, it was confirmed that the estate of what had been the majority owner of a company operating a chain of luxury hotels was not entitled to inspect the LLC’s books and records and was not owed fiduciary duties. Estate of Calderwood v. ACE Group Intl. LLC, 2017 NY Slip Op 08750 (App. Div. 1st Dept. Dec. 14, 2017).
      This decision has been reviewed in the New York Business Law Divorce; HERE IS A LINK to that review.

Thursday, January 4, 2018

Florida Court Addresses Priority of Charging Orders

Florida Court Addresses Priority of Charging Orders
      In a pair of recent decisions, the Court of Appeals for the First District in the State of Florida has provided guidance with respect to the priority of the lien created by a charging order.  This being a point seldom addressed, the prior guidance largely being restricted to the McClure decision from Colorado, these new decisions provide important guidance.  Capstone Bank v. WinSouth Credit Union, Case No. 01D-16-1484 (Nov. 30, 2017); Capstone Bank v. Perry-Clifton Enterprises, LLC, Case No. 01D-16-1094 (Nov. 30, 2017).
      In the WinSouth Credit Union case, while the facts recited in the opinion are rather sparse, WinSouth applied for a charging order against the interest of John Richards and Christopher Richards, each in an unnamed Florida limited liability company.  Likewise, Capstone Bank had applied for a charging order against the same interest, the question was the priority of the orders.  The charging order issued in favor of WinSouth was based upon a judgment entered by an Alabama court.  Over a dissent, it was determined that the Alabama judgment had not been properly domesticated in Florida before the charging order was issued.  On scanty analysis, the court went on to determine that the WinSouth charging order should not have been issued, leaving that of Capstone with priority.
      While the dissent would challenge the determination that the judgments against John Richards and Christopher Richards were not sufficiently domesticated in Florida, it explained why Capstone would still prevail, that based upon the timing of the application for and receipt of the charging order. 
      In the Perry-Clifton case the dispute again began with an Alabama judgment, this being a divorce decree.  The question was whether a Alabama divorce judgment in favor of Christy Richards constituted a charging order in favor of Christopher Richards’ interest in Perry-Clifton Enterprises, LLC.  The divorce decree awarded to her all of Christopher’s interest in Perry-Clifton Enterprises.  While the divorce decree was filed in Florida, no charging order was at that time requested.
      Thereafter, Capstone requested and received from a Florida court a charging order against Christopher Richards’ interest in Perry-Clifton.  Christy Richards, some six weeks later, sought to intervene in that action and filed a motion to stay the issued charging order.  The trial court determined that the Alabama divorce decree “itself constituted a charging order” and had priority over that issued to Capstone Bank.  That determination would, in this appeal, be reversed.
      On the basis that a charging order, issued by a court on motion, is the “sole and exclusive remedy” against an interest in a Florida LLC, the court concluded that the charging order issued in favor of Capstone Bank would have priority. 

Wednesday, January 3, 2018

LLCs Are Even More So Where Is The Action

LLCs Are Even More So Where Is The Action

      Based on statistics released for the entirety of 2017 by the Kentucky Secretary of State’s office, LLCs remained the dominant entity of choice. In 2017, some 23,550 LLCs were organized in Kentucky. In turn, 2,070 for-profit corporations were organized. Essentially, more than 11 LLCs were organized for every corporation created in Kentucky.

Tuesday, January 2, 2018

A Bishop of Rome By Any Other Name

A Bishop of Rome By Any Other Name

            Today marks an interesting anniversary of an event that took place in the year 533 ad.  On this day, a man named Mercurius was elected Pope (the Bishop of Rome).  He adopted as his papal name John II, believing that he should not as Pope be known by his birth name, it being that of the Roman (pagan) god Mercury.  He was the first Pope to adopt a  papal name different from his own name.

      More popes have been “John” than any other name, most recently John XXIII. The last Pope to not adopt a regnal name was Marcellus II, elected in 1555.