Limited Liability Companies in Kentucky - Chapter Supplements

Limited Liability Companies in Kentucky

 

I have prepared and made available cumulative supplements to the following chapters of the UK/CLE treatise Limited Liability Companies in Kentucky:

 

Chapter 5        Basics of LLC Formation

Chapter 6        Foreign LLCs

Chapter 8        Statutory Transactions: Conversions, Mergers and Share Exchanges

Chapter 9        Dissolution of a Limited Liability Company

 

There has also been added a new chapter 9A, Developments on the Law of Kentucky LLCs. 

 

They can all be accessed through THIS LINK.

Pannell v. Shannon – A Cornicopia of Guidance on Contract Law, Statutory Interpretation and the Place of LLCs in the Law

Pannell v. Shannon – A Cornicopia of Guidance on Contract
Law, Statutory Interpretation and the Place of LLCs in the Law

      The Kentucky Supreme Court’s decision in Pannell v. Shannon is of great utility on a variety of fronts including identifying a test for when an agreement is executed by an agent versus by a principal, the effect of administrative dissolution/reinstatement upon an agent’s liability, rules for interpreting statutory amendments, and the importance on focusing upon the LLC Act over the common law in assessing LLCs.  Pannell v. Shannon, 425 S.W.3d 58 (Ky. March 20, 2014).

      The dispute arose out of a defaulted lease.  Shannon’s LLC was the tenant – that LLC was during the term of the lease administratively dissolved.  A replacement lease was entered into in the period between the administrative dissolution and the LLC’s reinstatement.  When the LLC ultimately defaulted the landlord sought to hold Shannon liable on the obligation.

Was the Lease with Shannon or the LLC?

      The lease agreement entered into during the period of the LLC’s administrative dissolution described the tenant as being the LLC, but the signature line did not specify that Shannon signed it in a representational capacity (e.g., “Ann Shannon, Sole Member, on behalf of Elegant Interiors, LLC”).  The Court held that level of specificity to not be necessary.  Rather, noting that it indicated “By:” and in reliance upon Fletchers Cyceopedia, the Court found this format, combined with the fact that the body of the lease identified the LLC as the tenant, to be sufficient to indicate she was not signing in an individual capacity.

[T]he simple fact is that Shannon did not have to list her title, although clearly the better practice is to include it.  425 S.W.3d at 64.

Scrivener Error?

      Pannell sought to argue that the identification of the LLC as the tenant was a “scrivener error” and that it was always intended that Shannon as an individual be the tenant.  This argument was rejected on the basis that “full, clear, and decisive evidence” of a mutual mistake was not presented.  425 S.W.3d at 67.

The Effect of Administrative Dissolution/Reinstatement

      The real crux of the decision is the impact of administrative dissolution and subsequent reinstatement upon each of (i) a member’s limited liability and (ii) the liability of an agent on a contract entered into after dissolution and before reinstatement.  425 S.W.3d at 68.  The Court recognized that these are distinct questions based upon distinct legal principles:

“[T]he liability of a director, officer, employee or agent of a limited liability entity during a period of administrative dissolution is technically a separate question from the liability of the owners of the entity.”  425 S.W.3d at 77.  

Member Limited Liability After Administrative Dissolution

      The Court could not have been more express about the continuity of a member’s limited liability after reinstatement:

This Court concludes that a member of an [LLC] enjoys statutory immunity from liability under KRS 275.150 for actions taken during a period of administrative dissolution so long as the company is reinstated before a final judgment is rendered against the member.  425 S.W.3d at 67.

      Distancing LLCs from the common law of corporations (more on that below), the Court looked to the statutes addressing a member’s limited liability (KRS § 275.150) and the retroactive effect of reinstatement (KRS § 275.295(3)(c); now KRS § 14A.7-030(3)) and determined that reinstatement wiped the slate clean.

The plain meaning of the relate-back language is that the company is deemed viable on reinstatement from the point of administrative dissolution onward, which necessarily includes the time of suspension between the date of administrative dissolution and reinstatement.

Reinstatement under the statute literally undoes the dissolution. This is why the Secretary of State was required to “cancel” the certificate of dissolution and issue a certificate of existence. See KRS 275.295(3)(a). And that certificate of existence took effect, by statute, retroactively on the date of dissolution.  425 S.W.3d at 68.

Hence Pannell’s argument that a member’s limited liability is suspended during the period between administrative dissolution and reinstatement was rejected.

Agent Limited Liability After Administrative Dissolution

      Turning to the question of Shannon’s liability as an agent for the LLC’s obligation undertaken while the LLC was administratively dissolved, the Court noted that the question divides into a pair of inquiries, namely:

First, can Shannon under the circumstances of this case be personally liable by reason of her merely being an agent?  Second, can she be personally liable because she acted as an agent without authority?

       In response to the first question, the Court referred to KRS § 275.175(1) and noted that its rule of limited liability extends to the LLC’s agent.  As the LLC’s existence had been reinstated and:

reinstatement is retroactive to the date of dissolution, and it is as if the dissolution never occurred, giving the company a seamless existence.  The limitation on the agent’s liability simply for being an agent is likewise seamless.  425 S.W.3d at 78.

      In that the LLC in question was subsequently reinstated, the Court found there to be no opportunity for imposing liability on an agent.  Rather, as the LLC Act protects agents from liability on the LLC’s debts (KRS § 275.150(1)), then: 

To the extent that any liability is claimed solely because Shannon was a manager or agent of the LLC, the analysis above for why she cannot be liable as a member applies.  The reinstatement is retroactive to the date of dissolution, and it is as if the dissolution never occurred, giving the company a seamless existence.  The limitation on the agent’s liability simply for being an agent is likewise seamless.  425 S.W.3d at 78. 

     Providing an appropriate critical eye to the question before it, the Court observed:

The immunity provided by KRS 275.150 extends only to liability by reason of her being an agent.  By alleging that Shannon acted without authority, Pannell is not claiming she is liable solely because of her status as an agent, but because she had no authority to act as an agent.  425 S.W.3d at 81. 

In reliance upon the statutory statement that a dissolved LLC continues to exist after its dissolution, the Court found that when combined with reinstatement, Shannon never lost the capacity of being the LLC’s agent.

In response to the argument that giving such a broad affect to the effect of reinstatement is improper, the Court observed:

The simple fact is that Kentucky’s corporation law and other business entity laws differ from those in other states ….  The existence of a majority rule can only be persuasive if the rule is based on statutes like those in Kentucky.  425 S.W.3d at 79, 80.

The Nature of LLCs

No end of confusion has resulted from efforts to force LLCs into the prior models of partnerships and LLCs and to them impose the supposed common law of these organizational forms onto the LLC.  The first decision of the Kentucky Court of Appeals in Patmon v. Hobbs, 280 S.W.3d 589 (Ky. App. 2009) is a classic example of a court trying to do so.  Why that does not work was been extensively reviewed.  See, e.g., Rutledge and Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 (2010). 

      In Pannell, the Supreme Court, building upon prior decisions, made the rule express – LLCs are creatures of statute divorced from the common law.

[The] common law of business entities has largely been abrogated by the adoption of the various statutes like the Kentucky Business Corporation Act and the Kentucky Limited Liability Company Act.  In fact, “limited liability companies are creatures of statute controlled by Kentucky Revised Statutes (KRS) Chapter 275,” not primarily by the common law. To the extent that common law doctrines could arguably govern limited liability companies, the Kentucky Limited Liability Company Act “is in derogation of common law,” KRS 275.003(1), and the traditional rule of statutory construction that “require[s] strict construction of statutes which are in derogation of common law shall not apply to its provisions.” Id. Thus, to the extent the statutes conflict with common law, the common law is displaced.

This Court must therefore first look at the controlling statutory law.  425 S.W.3d at 67-68.  (citations omitted).

      Consequently, in assessing matters involving LLCs the court needs to focus upon the LLC Act and the operating agreement of that particular LLC.  Whether, for example, LLC members are more like partners or more like shareholders is irrelevant to the question of whether the members have fiduciary duties and what those duties are – the LLC Act expressly addresses whether the members owe fiduciary duties, what those duties are and to whom they are owed.  See KRS §§ 275.170(1), (2), (4).  At the risk of redundancy:

[F]irst look to the controlling statutory law.

Continuity in Statutory Construction

      The Kentucky LLC Act provides that a LLC’s dissolution will not “abate or suspend” the rule of limited liability set forth in KRS § 275.150.  KRS § 275.300(4)(e).  Accord KRS § 271B.14-050(2)(i).  While this statute was adopted only in 2007, the Kentucky Supreme Court found this provision was not an alteration of the law but rather “clarified the intent of the legislature as to the effect of dissolution on the liability of … corporate shareholders.”  425 S.W.3d at 72.  This application of in pari mataria, which requires a nuanced consideration as to whether the General Assembly sought to alter versus clarify the meaning of a prior enactment, stands in contrast to the far more clumsy, and typically inapplicable, rule to the effect that by each amendment the legislature seeks to alter and depart from the prior rule.  In the area of business entity law, based as it is upon typically comprehensive statutory schemes, tweaking the words employed for the purposes of providing greater clarity and precision is far more typical than is a reversal or abandonment of a principle.  That is not to say it never happens, but it is relatively rare.

Subsequent Statutes Address Liability Absent Reinstatement

      While Pannell v. Shannon limits its application to the treatment of member and agent liability after there has been reinstatement, it does not follow that member and agent liability absent reinstatement remains unresolved.  Rather, questions of member limited liability have been addressed in statutory amendments enacted subsequent to the time the Pannell v. Shannon dispute arose. 

      First, KRS § 275.300, it addressing the effects of dissolution, now provides that dissolution does not “abate or suspend” the rule of limited liability.  In consequence, it cannot be argued that a member’s/manager’s/agent’s limited liability is lost upon dissolution.  In this respect it is important to note an important distinction between the corporate and LLC Acts.  The Business Corporation Act, at KRS § 271B.6-220, affords the shareholders limited liability from the corporation’s debts and obligations.  Hence, KRS § 271B.14-050(2)(i), in preserving limited liability upon dissolution, preserves it only for the shareholders.  Put another way, KRS § 271B.14-050(2)(i) does not speak to the liability of corporate directors, officer and agents for a corporate liability undertaken post-dissolution and absent reinstatement.  In contrast, the grant of limited liability in the LLC Act, KRS § 275.150(1), applies not only to members but also managers and agents.  Hence the preservation of limited liability after dissolution as affected by KRS § 275.300(4)(e) is broader than is the equivalent provision in the Business Corporation Act.  Now, whether after dissolution and before reinstatement one was an “agent” may be in dispute, but that is resolved under other law.

      Second, it has been made express that upon reinstatement following administrative dissolution, the liability of an agent for actions undertaken during the period of dissolution “shall be determined as of the administrative dissolution or revocation had never occurred.”  KRS § 14A.7-030(3)(b).  See also 425 S.W.3d at 81, note 20.

      Third and last, in response to Martin v. Pack, the acts now provide that an agent may after dissolution enter into contracts appropriate for the entity’s winding up and liquidation.  See KRS § 275.300(2)(a); id. § 271B.14-050(1)(c).

More on Member Limited Liability

      Building upon the earlier decision in Racing Investment Fund 2000, LLC, the Court highlighted the centrality of limited liability to the LLC and imposed a high bar for setting it aside.  425 S.W.3d at 66.  As such, where it is questionable whether an agent enjoys limited liability, the presumption will be that it is available.  It remains to be seen whether and how this attitude will impact upon whether and how is developed a distinct theory for piercing LLCs.

More on the Nature of Administrative Dissolution

      In Pannell, the Kentucky Supreme Court considered the purpose of administrative dissolution and rejected an effort by a third-party to impose liability upon a dissolved LLC’s agent for an LLC obligation based upon “the temporary faltering of the relationship between the LLC and the state to [the third-parties’] advantage when [the third-party] has no interest in that relationship.”  425 S.W.3d at 84.  Administration dissolution to be little more than a speed-bump in the bilateral relationship between the Commonwealth and an entity created under the laws thereof.

More on the Source of Duties in LLCs

      The Supreme Court has directed that the first source of LLC law is the LLC Act and recognized that LLCs are strangers to the common law.  In Patmon v. Hobbs, the Court of Appeals imposed fiduciary obligations upon the “officers and members” of an LLC based upon the determination that LLCs are “similar to Kentucky partnerships and corporations.” 280 S.W.3d at 594-95.  The Pannell decision significantly undercuts (if not more) this analytic path, and directs that rather than relying upon analogy to other organizational forms the focus needs to be upon the language of the LLC Act.  In that the LLC Act defines who owes fiduciary duties, to whom they are owed and what are those duties (KRS § 275.170), there the question should end.

A Small Footfault on Member – versus – Manager-Managed

      It bears noting that the Court made a small misstep in its consideration of agency and the application of KRS § 275.135.  This statute provides, inter alia, that in a member-managed LLC each member as a member is an agent of the LLC while if the LLC is manager-managed the managers are agents and the members are not by reason of that status agents.  The Court suggested that the determination of whether the LLC is member or manager managed is determined by a factual assessment of the management employed.  See 425 S.W.3d at 76, fn. 17.  In fact, whether an LLC is member or managed is a positive law question determined by reference to the election made in the articles of organization.  See also KRS § 275.025(1)(d).  As set forth in the comment to Prototype section 401, “Irrespective of the provisions in the operating agreement, whether a LLC is ‘manager managed,’ as that phrase is used in the Act, depends on whether the articles of organization so provide.”

 

Landlord Not Protected by Exclusive Remedy of Workers Compensation

For Every Action there is an Equal and Opposite Reaction,

and What is it With Funeral Homes?

        A recent case from the Nebraska Supreme Court highlights a perhaps negative consequence of a common structure employed in closely held businesses.  The structure at issue is as follows:  a group of owners organize a business corporation or LLC to be the operating company.  They as well organize, typically in the form of a partnership or LLC, a parallel company that will own the real estate and facility in which the operating company operates.  Lease payments from the operating company cover the real estate company’s borrowing costs and, assuming that piercing is not an issue, protect the accumulated value in the real estate company from claims by the creditors of the operating company.

        It was this structure that was employed in the case under review in Nebraska.  Howsden v. Roper’s Real Estate Company, 2011 WL 5105810 (Neb. Oct. 28, 2011).  Howsden was an employee of Roper & Sons, Inc., a funeral home.  That funeral home operated from a facility owned by Roper’s Real Estate Company, Inc.; both Roper & Sons and Roper’s Real Estate had the same ownership.  Howsden, an employee of the funeral home company, was injured on the property, falling down a seldom-used elevator shaft.  In connection therewith, she received workers’ compensation benefits pursuant to the policy of the operating company.  From there, she brought as well a negligence action against the real estate company based upon improper maintenance of the elevator.

        The real estate company defended on the basis that Howsden’s rights under workers’ compensation coverage were the sole and exclusive remedy available to her, in effect arguing for consolidation of the operating and real estate companies.  This effort was unsuccessful.  The Court recognized that setting up separate business structures for different parts of an operation is entirely legitimate.  At the same time, the Court noted that doing so has consequences.  One of the consequences is, necessarily, that the different business ventures, absent circumstances justifying piercing, will be treated as distinct from one another.  Under Nebraska, law, piercing is not available absent fraud or a significant equitable basis, and the Court here found that there was neither fraud in the structuring nor an equitable basis for ignoring the legal distinctiveness of the different operation, stating that it would be at best near impossible for one to structure different operations in difference corporations and then argue, on an equitable basis, that they should be consolidated.  Ergo, Howsden’s suit against the real estate company could proceed, in not being barred by the exclusivity provision of Nebraska’s workers’ compensation statute; the real estate company was not her employer.

        Curiously, the Kentucky courts have considered a strikingly similar factual situation and came to a similar conclusion.  Jessie v. Dermitt, No. 2005-CA-0011961-MR (Ky. App. Dec. 8, 2006) (Not To Be Published).  Therein, the plaintiff fell through a hole in the floor of a funeral home that was being remodeled.  The operations of the funeral home venture were structured as an LLC; the real property was owned separately by the LLC’s members.  The real property owners defended on the basis of the exclusivity provision of the workers’ compensation law.  For essentially the same reasons as those applied in the Howsden decision, that effort was in Kentucky was rejected.  “[The owners] have cited no legal authority to this Court that permits the exclusive remedy provisions of the Workers’ Compensation Act to be extended to a landlord who owns the premises where the employer’s business is operated.”  Jessie v. Dermitt, slip op. at 7.

An Unincorporated Syndicate is Not Governed by Corporate Law

An Unincorporated Syndicate is Not Governed by Corporate Law

            In a recent decision, the Federal District Court for the Eastern District of Kentucky confirmed that an unincorporated syndicate is not, as a default matter, governed by the rules set forth in the Kentucky Business Corporation Act. KNC Investments, LLC v. Lane’s End Stallions, Inc., 2011 WL 5507395 (E.D. Ky. 2011).  In this instance, in a suit arising out of the interpretation of a stallion syndicate agreement, the plaintiff argued that the provisions of the Kentucky Business Corporation Act governing the inspection of corporate books and records should be referenced with respect to the interpretation of the books and records inspection right that existed under a syndicate agreement.  The court dismissed this argument, noting that:

No justification exists to extend Kentucky law that by its own terms is strictly limited to corporations to non-corporate entities such as the LDK Syndicate.  Id. at *4.

Vampires and Business Organizations

Vampires and Business Organizations

        The November/December 2011 issue of The Journal of Passthrough Entities includes my article Vampires and the Law of Business Organizations: The Fruitless Search for Authenticity.  This piece compares the various constructs used for the vampire in various books and movies, analogizing that to the various laws governing business organizations.  What is a vampire in a particular book or movie is determined by the author.  In the same way, what are the rights, duties and responsibilities of individuals within a particular organization are determined by the controlling statute and the governing documents.  Ultimately, each must be assessed on its individual terms, and assumptions that one characteristic applies in other contexts are often erroneous.

The article can be accessed HERE

Wisconsin Court Misses the Point of Choice of Entity

Wisconsin Court Misses the Point of Choice of Entity

            In a recent decision interpreting and applying the Wisconsin LLC Act, the Court, sadly, missed the point of choice of entity, suggesting that the fiduciary obligations amongst all businesses or organizations not only are but should be the same.  Executive Center III LLC v. Meieran, 2011 WL 4704274 (E.D. Wisc. Oct. 4, 2011).

            Meieran bought a 12.5% interest in BRIC Executive, LLC (“BRIC”) for $250,000 pursuant to an agreement under which that 12.5% interest would be redeemed by a date certain with penalties and additional expenses incurred for any delayed redemption.  A year and one-half after that agreement was entered into, and when the repurchase obligation was already in default, the Plaintiff entered into an agreement with BRIC for the sale/leaseback of a BRIC-owned building.  BRIC received approximately $1.3 million from that transaction and entered into a 3-year lease for one unit in the building.  BRIC distributed the $1.3 million it received to pay off various debts, including its redemption obligation to Meieran.  The redemption price had by then swelled to $425,000 – Meieran accepted $400,000 in full satisfaction thereon.  At that point, BRIC had no other assets, and immediately defaulted on its lease obligation to the Plaintiff.  They brought suit against Meieran, alleging a number of counts including fraudulent conveyance of the $400,000 paid to the Defendants, breach of fiduciary duty owed to the Plaintiff and receiving an improper inequitable distribution from BRIC. 

      My concern is with the statements made as to fiduciary duties. 

      After engaging in an effort to distinguish Gottsacker v. Monnier, 697 N.W.2d 436 (Wis. 2005), the Court discussed whether or not common law fiduciary duties exist in addition to those imposed by statute.  Apparently working from the positions that fiduciary duties amongst business owners are normative and that the fiduciary duties that are owed are equivalent amongst business organizations, the Court wrote:

In fact, there is growing consensus that common law fiduciary duties should apply to the operations of LLCs….  Logic dictates the same. Fiduciary duties exist to protect people who are affected by the actions of those who control businesses.  Therefore, it would not make any sense if the expectation for a business to act fairly were to be different simply due to the business owners’ choice of form – an LLC in this case.  If that were so, every dishonest owner could simply elect to operate its business as an LLC and claim that no fiduciary duties applied to its actions. 

For these reasons, the Court finds that common law fiduciary duties apply to LLCs.  2011 WL 4704274, *8-9. 

       Initially, there is a significant question, not addressed by the Court, as to why fiduciary duties are even being contemplated in this situation.  The suit here is filed by the purchaser of a commercial building who is, no doubt justifiably, upset that the seller has, in the capacity of a tenant, breached their obligations.  This appears to be, and the Court does not indicate anything to the contrary, an arms-length transaction.  Buyer is not a member of BRIC.  Setting aside the question of what are the fiduciary duties, there is no indication of a relationship from which the Plaintiff could assert there to have arisen a fiduciary obligation that was violated.  The opinion recites that the payment to Meieran rendered BRIC insolvent.  If the basis of the claim is a fiduciary shift on insolvency to the benefit of the creditors, that would be nice to know.

       Returning to the mindset issue, the dual suggestions by the Court that (a) as a normative matter fiduciary duties exist in business organizations and (b) that fiduciary duties do not change between organizations, are both demonstratively incorrect and indeed misleading. 

       The first proposition, namely that fiduciary duties are normative, is disproven by the fact that many statues expressly permit either the restriction or the elimination of fiduciary duties and/or permit the elimination of culpability for the breach of a fiduciary obligation.  See, e.g., Del. Code Ann. tit. 6, § 18-1101(c) (permitting an operating agreement to eliminate all fiduciary duties); KRS § 275.170 (permitting the statutory default fiduciary duties of care and loyalty to be altered in a written operating agreement); and id. § 275.185 (permitting a written operating agreement to eliminate culpability for breach of fiduciary duties of care and loyalty).  Ergo, the premise that all business organizations must impose upon their constituents fiduciary obligations is manifestly incorrect.

          Perhaps even more troubling is the Court’s suggestion that fiduciary duties are a constant across business organizations.  This is simply not the case.  As the U.S. Supreme Court stated so eloquently in SEC v. Cheney Corp., 318 U.S. 80, 85-86 (1945):

But to say that a man is a fiduciary only begins analysis; it gives direction to further inquiry.  To whom is he a fiduciary?  What obligations does he owe as a fiduciary?  In what respect has he failed to discharge these obligations?  And what are the consequences of his deviation from duty?

       Different expectations and limits are placed upon different fiduciaries.  Simple paid agents are held to a care standard of simple negligence.  See Restatement (Third) of Agency § 8.08 (2006).  In contrast, corporate directors are held to a wanton or reckless standard.  See, e.g., KRS § 271B.8-300(5)(b).  Members of a Wisconsin LLC are held to a “willfull misconduct” standard.  Wisc. Code § 183.0402(1)(d). 

       Turning to the obligation of loyalty, partners, trustees and members of a member-managed are precluded from benefitting from a self-dealing transaction with the trust/partnership/LLC or the use of its assets.  See Restatement (Second) of Trusts § 203 (1959); Wisc. Code § 183.0402(2); KRS § 275.170(2); UPA § 21(1).  In contrast, corporate directors are permitted to enter into conflict of interest transactions and to utilize corporate assets for personal benefit provided the terms of the transaction are “fair” to the corporation.  See, e.g., KRS § 271B.8-310(1)(c).  Some jurisdictions even go so far as to remove from that director the burden of proving fairness, requiring, rather, that the complaining shareholder prove lack of fairness. 

         Clearly not every “fiduciary” is held to the same standard.  The failure to recognize this crucial aspect of business organization law generally and the entire point of the choice of entity calculus is the fundamental failure of Executive Center III LLC v. Meieran.

Rednour Properties, LLC v. Spangler Roof Services, LLC - A Rant in Three Parts (Part III)

Rednour Properties, LLC v. Spangler Roof Services, LLC –

A Rant in Three Parts (Part III)

What Next?

A Motion for Discretionary Review has been filed with the Kentucky Supreme Court. In the judicial sphere, there seem to be four possible outcomes to the Rednour dispute, namely:

• The Supreme Court does not grant discretionary review, leaving Rednour an unreviewed and published decision;

• The Supreme Court does not grant discretionary review, but does direct the Court of Appeal’s decision not be published;

• The Supreme Court grants discretionary review and overturns the troubling aspects of the Rednour decision; or

• The Supreme Court grants discretionary review and affirms the troubling aspects of the Rednour decision.

All of these options carry a significant aspect of uncertainty. Assuming the Kentucky Supreme Court does grant discretionary review (and we likely will not have a decision on that for many months), there will be a significant delay thereafter in the release of the final decision. Assuming it to be the fastest possible course, even a denial of review but a de-publishing of the Court of Appeals’ ruling would not entirely resolve our issues as Rednour, being the only decision on this point in Kentucky, may continue to be cited as authority.

A Legislative Response?

Unlike states such as Texas that have sought to reduce the rule of piercing the veil to statute, Kentucky has relied exclusively on common law save and except for a provision in the LLC Act providing that the failure to maintain the required records is not a basis for setting aside the otherwise applicable rule of limited liability. While it should remain under consideration, attempting a legislative fix would involve a number of issues including the decision as to whether to only respond to the problems raised by the Rednour decision or, alternatively, to adopt an entirely statutory formula for piercing (a middle point may as well be possible) and the need to amend multiple statutes so that a consistent rule can be adopted. There is as well the risk that certain members of the bar would object to either or both of the reversal of Rednour and/or any effort to reduce to statute the piercing rules.

What to do Now?

Assuming we have a year until these issues can be resolved, we must decide what we are going to do in the meantime. With respect to newly organized entities, are we still going to organize single member LLCs and single shareholder corporations in Kentucky, and what are going to do with respect to those SMLLCs and single shareholder corporations that are already our clients?

New Organizations

If someone walks into our office today and requests a SMLLC or single shareholder corporation, are you going to still organize them in Kentucky (presumably with appropriate disclosure as to the risk) or are you automatically going to organize them in another state?

Existing SMLLCs and Single-Shareholder Corporations

Similar to the question above, but in this instance restricted presumably to those clients with whom we have an ongoing relationship, a decision needs to be made whether you will advise them of these developments in the law and lay out their options, namely remain organized in Kentucky or reorganize in another jurisdiction.

The Internal Affairs Doctrine

Of course, domiciling these ventures in Delaware or another jurisdiction assumes, when the question of piercing a foreign corporation or LLC arises, that the court will apply the proper law, that being the law of the jurisdiction of organization. In the case of a corporation this rule is recited in the Restatement (2nd) of Conflicts § 307 and in Kentucky law at KRS § 271B.15-050(3). It is embodied well in our LLC Act. KRS § 275.405(2). See also United States v. Daugherty, 599 F. Supp. 671, 673 (E.D.Tenn. 1984) (applying Kentucky law to determine whether corporate veil should be pierced because corporation was incorporated in Kentucky); Soviet Pan Am Travel Effort v. Travel Committee, Inc., 756 F. Supp. 126, 131 (S.D.N.Y.1991) (“Because a corporation is a creature of state law whose primary purpose is to insulate shareholders from legal liability, the state of incorporation has the greater interest in determining when and if that insulation is to be stripped away.”).

Why Are We Even Needing to Consider These Issues?

I appreciate that some believe it inappropriate to challenge the Bench by suggesting that a ruling was not well reasoned and insightful. I am not one of those persons, and those who are of that viewpoint should not read the balance of this column.

The public and the practicing bar have every right to expect that the decisions of all of our courts, but especially those at the appellate level, are complete and well grounded. Decisions like Rednour that entirely depart from the statutory law, the case law and the extensive scholarly commentary, impose a significant burden upon Kentucky’s business community and our too fragile economy. Untold hours are now going to be spent redomesticating existing business to other jurisdictions in an effort to avoid the application of this decision. For the same reason, newly organized businesses are more likely to be organized outside of Kentucky, and they will now bear the cost of foreign qualification and of additional tax filing. These costs are a tax on business that have directly come about by at best weak and even non-existent analysis. Kentucky cannot and should not have to bear these costs.

Rednour Properties, LLC v. Spangler Roof Services, LLC – A Rant in Three Parts (Parts II)

Rednour Properties, LLC v. Spangler Roof Services, LLC –

A Rant in Three Parts (Part II)

Substantive Failures

On the facts of this case, piercing could well have been proper.  What is more important, however, is the fact that the opinions rendered do not of themselves justify piercing.  Rather, to suggest that the Rednour decision is unsupported by either the facts recited or the law applied would be generous.  Without intending to address every issue:

·                    Selecting a form that provides limited liability is not only entirely permissible but intended – did the General Assembly adopt numerous statutes for organizational forms that provide limited liability expecting they would never be utilized?;

·                    Electing to be organized as a corporation (or other form that affords limited liability) for the purpose of achieving limited liability is entirely permitted.  Anderson v. Abbott, 321 U.S. 349, 361 (1944);

·                    Corporate law has long recognized the permissibility of a single-shareholder corporation.  As the Court of Appeals recently observed in Thomas v. Brooks, 2007 WL 1378510 (Ky. App. May 11, 2007), “it is perfectly legal for a corporation to be owned by a single shareholder”;

·                    Were the 1998 Amendments to the LLC Act affirmatively providing for a single-member LLC intended by the General Assembly to be a trap for the unwary?;

·                    In that the role of the registered agent is defined as being to accept legal process and notices tendered to the entity and to retain information as to the entity’s communications contact (KRS § 14A.4-050), there is no basis for the argument that the sole owner being the registered agent justifies piercing the entity;

·                    There exist models, each employing various elements, for piercing the veil of a business corporation, a path of analysis exemplified in Kentucky in White v. Winchester Land Development, 584 S.W.2d 56 (Ky. App. 1979).  That model applies to a corporation.  An LLC is not a corporation.  See, e.g., Cook v. Patient EDU, LLC, 2011 WL 3276679 (Mass. Super. 2011).  A court that is considering piercing an LLC must first articulate a model for when piercing an LLC is appropriate.  That an independently justified analytic framework is needed for LLCs, as contrasted with corporations, has been recognized by the Court of Appeals.  See Welty v. Sexton, No. 2000-CA-002847-MR (Ky. App. 2002), slip op. at 6-7;

·                    In the context of an analytic model, an explanation of the facts of the case that do and do not justify piercing needs to be set forth – that was not done in Rednour;

·                    It is and has been the law of Kentucky that piercing may not take place absent “a showing of fraud or injustice separate and apart from the corporation’s failure to pay its debt.”  Scarbrough v. Perez, 870 F.2d 1079, 1084 (6^th Cir. 1989).  See also, e.g., Sudamax Industria e Comercio de Cigarros, LTDA v. Buttes & Ashes, Inc., 516 F. Supp.2d 841, 849 (W.D. Ky. 2007) – that was not done in Rednour; and

·                    A failure to identify the capacity, as a principal or as an agent, on a document goes at best to the question of whether “corporate” formalities have been maintained, but more importantly goes to the question of the disclosed or undisclosed principal.  Agency law has its own protocols for when an agent may be held liable on an obligation, and those protocols should not be mixed with those for piercing.

Rednour Properties, LLC v. Spangler Roof Services, LLC – A Rant in Three Parts (Part I)

Rednour Properties, LLC v. Spangler Roof Services, LLC –

A Rant in Three Parts (Part I)

      A recent decision of the Kentucky Court of Appeals has thrown into doubt whether a single-member LLC (SMLLC) is effective in providing limited liability to its sole member, a decision equally applicable to single shareholder corporations.

       Rednour Properties, LLC v. Spangler Roof Services, LLC, No. 2009-CA-001159-MR, 2011 WL 2535330 (Ky. App. June 10, 2011, modified July 8, 2011) (“To Be Published”) involved a dispute over payment for roofing and related refurbishment work on an apartment complex.  Ritchie Rednour was the sole member and registered agent at Rednour Properties, LLC and Rednour Blake, LLC, both Kentucky LLCs.  On June 6, 2007 Rednour Blake, LLC purchased an apartment complex.  Rednour Properties, LLC managed the apartment complex.  On July 12, 2007 Rednour, signing as the “general/owner,” entered into a contract between Rednour Properties, LLC and Spangler Roof Services, LLC (“Spangler”) whereunder Spangler agreed to perform certain repairs to the apartment complex.  Thereafter, three change orders dated August 12, 2007, August 20, 2007 and January 2, 2008 were agreed upon.  On September 20, 2007, Rednour Blake, LLC transferred title to the apartment complex to

250 Oxford Drive

, LLC, a Kentucky LLC.  A judgment for $48,531.83 plus $15,000 in attorney fees was entered.  Although the opinion does not address whether the judgment against Rednour Properties, LLC was or was not collectable, the Court of Appeals affirmed the trial court’s refusal to dismiss Rednour, an individual and the sole member of Rednour Properties, LLC, from the action and holding him personally liable on the judgments.

       In affirming the trial court’s determination that the separate existence of Rednour Properties, LLC would be ignored and that Rednour, an individual, would be held liable on the LLC’s debts, the Court of Appeals recited the following facts:

·                    That one of the LLCs at issue transferred the apartment complex to its own wholly-owned subsidiary;

·                    Trial court testimony (the nature of this testimony is not recited in the trial court’s opinion, order and judgment of May 20, 2009) “showing a lack of distinction between the various LLCs which Rednour owned, and Ritchie Rednour, the individual”;

·                    The identification in the contract for repair work of one LLC as the owner of the property when in fact it was owned by the other LLC (the contract was prepared by Spangler); and

·                    All three of the LLCs were owned by Rednour and he signed the contract with Spangler “without specifying that he was acting in a corporate capacity.”

The Court of Appeals noted Rednour’s argument that Spangler had not established “any evidence of fraud or injustice,” but said nothing more beyond that.

In its holding, the Court of Appeals wrote:

[W]e hold that there is substantial evidence to support the Circuit Court’s decision to pierce the corporate veil in this action.  While the record establishes the corporate existence of the entities at issue (Rednour Blake and Rednour Properties, which both list Rednour as the registered agent), it is obvious that these entities were “dummy” corporations [throughout, the Court of Appeals refers to LLCs as “corporations”] designed to protect Rednour from personal liability.  Rednour is the sole member and agent of these companies as well as several others, at least one of which is a subsidiary of another LLC, and Rednour admits to having set up the LLCs for tax purposes.  Under these circumstances, we aren’t able to discern any difference between Rednour and his various LLCs.  Accordingly, we must hold that the Circuit Court did not commit any error when it held Ritchie Rednour individually liable for the corporate debts and declined to dismiss him as a defendant.

      Needless to say, if this decision stands, it is a body blow to single-member LLCs as well as single-shareholder corporations in Kentucky; it may be extended as well to multiple owner entities.  Without here reciting the myriad analytic failures of this decision, it must be recognized that:

·                    Every choice of entity decision is going to have a tax component, and if having engaged in tax planning is a reason for setting aside a limited liability entity, then every limited liability entity should be pierced because its election was at least in part for tax purposes; and

·                    It is unclear whether the court is referring to Rednour being the registered agent or rather the apparent agent (see KRS § 275.135(1)) of the LLCs, but it appears more likely that the reference is to the position of registered agent.  If that is the case, the sole owner may never be the registered agent of a business organization without thereby supporting an argument that the veil should be pierced; and

·                    The fact that one elected a limited liability entity with the intention of reducing one’s personal liability (and is there any other reason for doing so?) will be a basis for setting aside that limited liability shield.

Kentucky versus Delaware

Kentucky versus Delaware –

Amending the Operating Agreement

I always enjoy hearing that businesses are organized in Delaware because the law there (as contrasted with that in Kentucky) is so settled.  While it is true that the Delaware Courts have given us a deep body of case law, it does not follow that the Delaware law has resolved questions that Kentucky has not.

Take, for example, the fundamental question of amending an LLC’s operating agreement.  Under Kentucky law since 1998, unless otherwise provided in writing, the agreement may be amended by a majority-in-interest of the members.  KRS § 275.175(2)(a).

Surely, if this point is so well settled in a “fly over” state like Kentucky, it must be equally as well resolved in Delaware.  That is not, however, the case.

It was only in 2011 that Delaware adopted a statutory default rule of the unanimous approach of the members in order to amend the operating agreement.  Further, this rule is applicable only to those LLCs whose certificate of formation is filed on or after January 1, 2012.   Delaware first adopted its LLC Act in 1992.  For all LLCs formed from that date through the end of this year, there is no statutory default rule as to the requirement to amend the operating agreement.  The Delaware Bar is in disagreement as to what is today the rule, namely all members or all parties.  Assume a non-member manager of a Delaware LLC.  Some argue that the manager’s approval is required to amend the operating agreement; others say the manager’s consent is not necessary.  The Delaware courts have not addressed the question.

Things are not always more clear in Delaware.



Choice of Entity Matters: Daywear and Eveningwear

Choice of Entity Matters:  Daywear and Eveningwear

Electing to be organized in a particular form is effectively an election of what standard form agreement will govern the internal relations between the venture and its constituents.  Depending upon your position and circumstances, whether that election is, at a particular time and place, advantageous or disadvantageous to your objectives is simply a fact of life.  In Beatty v. Melody Lake Ranch Club, Inc., No. 2003-CA-001652-MR (Ky. App. Apr. 15, 1005) (Not to be Published), an unsuccessful effort was made to rewrite the history of the choice of entity.

Melody Lake Ranch Club, Inc. was in 1967 incorporated under then KRS ch. 271.  Persons owning land within the boundaries of the club became shareholders, receiving one share of stock for each $100 of investment made.  Fast forward 22 years to 1999, when several shareholders sought dissolution of the corporation, citing its “poor financial conditions” and failure to provide certain of the recreational facilities that it was chartered to provide.  On this basis, the plaintiffs asserted that the corporation was “insolvent” and should be dissolved and liquidated under Section 273.330 of the Kentucky Nonprofit Corporations Act.  KRS § 273.330(1)(a)5 provides that a nonprofit corporation may be liquidated upon a showing “that the corporation is unable to carry out its purposes.”

In response, the corporation argued that not only was it not insolvent, but that KRS § 273.330 is not applicable, it being a business corporation, and therefore any dissolution proceeding must come about under KRS ch. 271B.

The trial court found that the corporation’s dissolution would be governed by the business, and not the nonprofit, corporation act in that the latter act applies only to nonstock corporations, evidence from the Secretary of State indicated that the corporation was organized under the business corporation statute, and because of federal income tax returns, presumably on the form for a business corporation, had been filed for each year.

Affirming the trial court’s determination, the Court of Appeals found that the election to be organized as a business corporation was conclusive.  The plaintiffs asserted that had the nonprofit corporation statute existed at the time of the club’s incorporation (in fact, the nonprofit corporation statute was enacted a year and a half after the corporation’s formation), they would have organized under that statute.  The Court said, in effect, “Yeah, but you didn’t.”  Rather, the Court found that the corporation was clearly formed under the business corporation act, and that being the case, any dissolution is to be governed by that statute, not the nonprofit corporation statute.

As has oft been noted, different forms of business organization provide different rules for different factual situations.  That the outcome in a particular circumstance in one form of organization is different from what would be the outcome were those facts applied in a different form of organization in no manner indicates that one form or the other is deficient.  Recall (and for those of you too young to recall, it is on YouTube) the Wendy’s commercial featuring the Soviet fashion show and the great distinctions between “daywear” and “eveningwear.”  That is not where we are and it is not where we want to be.  Different outcomes are the intended consequence of a robust menu of organizational forms; if that were not the case then we would have no need for alternative forms.  Appreciating those distinctions is what is important in the choice of entity election, in the drafting of organizational documents and, crucially, when the courts come to resolve disputes in business entities.

Choice of Entity Matters

The Delaware Courts have again addressed the simple fact that Choice of Entity Matters. 

In CML V, LLC v. Bax, 6 A.3d 238, 249 (Del. Ch. 2010), the Chancery Court wrote:

 “[T]here is nothing absurd about different legal principles applying to corporations and LLCs.”

Affirming the Chancery Court, the Delaware Supreme Court wrote:

 “[I]t is hardly absurd for the General Assembly to design a system promoting maximum business entity diversity.  Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.”

__ A.3d __, __, 2011 WL 3863132, at *4 (Del. 2011).

            Analogy is a dangerous tool as it can often lead to incorrect conclusions.  The fact that in one form of organization there may be Rule A does not mean that in another form of organization there should be Rule A; in fact that other form may use Rule B.  Each form of organization as modified by its organic documents needs to be understood as its own construct.