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.