Being Bound by An Operating Agreement You Did Not Sign

Being Bound by An Operating Agreement You Did Not Sign

      In a recent decision, the Federal District Court for the Western District of Kentucky considered and rejected the assertion that a member of an LLC was not bound by its operating agreement because they had not signed it. Pure Marketing, LLC v. Got Matcha Premium Tea Co., LLC, 2020 WL 234658 (W.D. Ky. Jan. 15, 2020). 

      The back story of this decision is important. Pure Marketing, pursuant to a contribution agreement, made an investment in Got Matcha, becoming a member therein. The substantive rights of Pure Marketing were determined under the Got Motcha operating agreement. However, in connection with this suit, Pure Marketing apparently desired to avoid application of that operating agreement, or bring any claims under it, because it contained an arbitration clause. Pure Marketing asserted that it was not bound by the operating agreement because it never signed it. 

      The court first determined that any rights held by Pure Marketing were determined under the operating agreement, and not the contribution agreement; all parties had fully performed on it. Ultimately, the suit would be dismissed. In the course of doing so, the court, in reliance upon KRS § 275.275(3) and Del. Code Ann. tit. 6, § 18-101(9), would reject the assertion that a signature is necessary in an operating agreement to be bound thereby. Rather, “any member of an LLC, original or subsequently admitted, is bound by the terms of an operating agreement regardless of whether the party signed said agreement.”

LLC Act Specifically Provides Immunity from Personal Liability for an LLC’s Breach of Contract

LLC Act Specifically Provides Immunity from Personal Liability for an LLC’s Breach of Contract

In a recent decision from the Kentucky Court of Appeals, it reaffirmed the rule that the members of an LLC are not liable for its debts and obligations. In this instance, even where the member of an LLC allegedly caused it to breach an agreement to which it was a party, no personal liability attached. Pulaski Properties, Inc. v. Haney, No. 2018-CA-000341-MR, 2019 WL 5092461 (Ky. App. Oct. 11, 20).

In this case, Pulaski Properties, Inc. (“PPI”) alleged that Acton, the managing member of Lake Cumberland Investments, LLC (“LCI”) should be held personally liable for the breach of a contract between LCI and PPI. As recited in the decision of the Court of Appeals, it was alleged that “Acton effectively and legally is LCI for all purposes pertaining to the agreement with [PPI.]” (bracketed language in original) and that “[b]y failing to cause LCI to honor the agreement by the simple expedient of making the conveyance in his capacity as manager, yet personally accepting and keeping part of the consideration thereof, he should indeed be liable for breach of contract.” 2019 WL 5092461,*3. In response, the court relied upon KRS § 275.150, it affording the members, managers and other constituents and representatives of an LLC limited liability from its debts and obligations, the court ultimately holding “Thus, KRS 275.150 specifically provides immunity from personal liability for members/managers of an LLC in instances such as this.” Id., *4.

In addition, the court found that there could be no breach of contract for which Acton could be liable because the alleged agreement did not satisfy the requirements of the Statute of Frauds.

LLC Restricted to Penalty Detailed in Operating Agreement to Apply Upon Failure to Meet Capital Contribution Obligation

LLC Restricted to Penalty Detailed in Operating Agreement to Apply Upon Failure to Meet Capital Contribution Obligation

It is not at all atypical for LLC operating agreements to provide that, from time to time, that members may be required to contribute additional capital to the venture. It is likewise not atypical for one or more members to fail to satisfy those obligations. Anticipating that circumstance, it is incumbent that the operating agreement address what happens upon such a default, including how those funds may be otherwise raised and the consequences to the defaulting number. In a recent case out of the North Carolina Business Court, the court held that where the operating agreement identified either of a pair consequences to a member defaulting upon an additional capital contribution obligation, the company could not otherwise address the default. Chisum v. Compagna, 2017 NCBC 61, 2017 WL 3113414 (N.C.B.C. July 20, 2017).

Chisum was a member in Judges Road Industrial Park, LLC (“Judges Road”), the other members being Rocco Compagna and Richard Compagna (collectively “Compagna”). The operating agreement for Judges Road provided that, from time to time, the members would make additional capital contributions when determined that such were needed by the Managers. That determination by the Managers required, in effect, approval of a majority in interest of the members. Initially, Chisum held 35% of the interest in Judges Road. Over time, there were certain reassignments in the ownership of the company, ultimately reducing, it would seem, Chisum’s interest in the company to 16.66%. The operating agreement went on to detail the consequences of any failure to contribute additional capital, pursuant to which the other members were allowed to contribute the missing funds to the company or, in the alternative, loan them to the company.  If treated as a capital contribution, the contributing members pro rata portion of the company would increase.  It came to pass that an additional capital contribution of $100,000 was to be made, of which Chisum was to pay $16,666.66. When Chisum did not meet this capital contribution, Compagna satisfied it in full, and asserted that in consequence Chisum’s interest in the company was reduced to zero. Chisum objected, asserting that, under the operating agreement, he was at most subject to dilution, but not termination as a member.

Parsing the operating agreement, particularly section 8.1(b) thereof, and as well considering the method of valuation to be applied upon the proposed transfer of a membership interest, the court concluded:

This Court has thoroughly considered the language of section 8.1(b) of the Operating Agreement and concludes that it is unambiguous and does not permit a member’s Membership Interest to be diluted to zero, or extinguished, by his failure to contribute capital in response to a capital call. The unambiguous language of the Operating Agreement provides that a contributing member making a Capital Contribution for a non-contributing member is credited with one additional Capital Unit for each $1,000,000 of “Additional Capital” contributed. Each member’s Membership Interest is then adjusted by dividing the member’s aggregate Capital Units by the new total aggregate number of Capital Units held by all members. As a result, the contributing member’s Membership Interest proportionally increases, the non-contributing member’s Membership Interest proportionally decreases. Since the non-contributing member is not required to sell his Capital Units to the contributing member, the non-contributing member’s Membership Interest can be proportionally reduced in relation to the total number of Capital Units outstanding, but can never be reduced to 0.

With respect to the ability, in a Kentucky organized LLC, to define the consequences of any failure to contribute additional capital or otherwise satisfy obligation undertaken in the operating agreements, see KRS § 275.003(2).

 

The “President” of LLC Is Not Personally Liable on the LLC's Promissory Note

The “President” of LLC Is Not Personally Liable on the LLC's Promissory Note

      In a recent decision from the Federal District Court for the Western District of Kentucky (Judge Stivers), it was held that an officer of an LLC who on its behalf executed a promissory note did not undertake personal liability on that obligation. Haynes v. Lankford, Civ. Act. No. 1:17-CV-00091-GNS, 2017 WL 4322434 (W.D. Ky. September 28, 2017).

      Lankford, as President of Rural Physician Partners, LLC, executed a pair of promissory notes. The notes were not satisfied, and the holders thereof brought suit against Rural Physician Partners, LLC and, as well, Lankford in his individual capacity. Lankford defended, filing a motion to dismiss on the basis that he, as an individual, is not personally liable on those notes. Reasoning as follows, the Court granted the motion to dismiss:

The Kentucky Supreme Court has held “that if the body of the contract states that the agreement is with a corporation or other entity, then the officer or agent signing the agreement has not signed in her individual capacity and cannot be held personally liable solely because of her signature.” Pannell v. Shannon, 425 S.W.3d 58, 65 (Ky. 2014). See also Griffin v. Jones, 170 F. Supp. 3d 956, 968 n.6 (W.D. Ky. 2016) (“Jones did sign the SE Book operating agreement and the management agreement between CA Jones Management and College Book Rental. However, Jones signed these agreements in his representative capacity as an officer of one of the signatories, not in his individual capacity, and therefore cannot enforce these agreements in his individual capacity.” (citing Pannell, 425 S.W.3d at 65)). Thus, execution of a document on behalf a limited liability company does not render a member or its officers liable for a promissory note executed on behalf of the company unless expressly contemplated by the terms of the contract.

It is uncontroverted that Lankford signed the promissory note in his capacity as President of Rural Physician Partners, LLC, which is reflected by the notation below his signature on the document. (Verified Compl. Ex. A, at 5, 10, DN 1-2). In addition, Plaintiffs have specifically alleged that “[a] secured Promissory Note was executed by Monty J. Lankford in the name of Rural Physicians [sic] Partners, LLC, as its President....” (Verified Compl. ¶ 5 (emphasis added)). Accordingly, Plaintiffs have failed to state a claim against Lankford in his individual capacity.

Finally, Some Clear Direction On Diversion Of Business Opportunity: Patmon v. Hobbs III

Finally, Some Clear Direction On Diversion Of Business Opportunity:
Patmon v. Hobbs III

Last Friday, the Kentucky Court of Appeals issued its third decision in the Patmon v. Hobbs, No. 2014-CA-001411-MR, 2016 WL 3886831 (Ky. App. July 15, 2016). This third opinion acknowledges certain of the errors made in Patmon v. Hobbs I, clarifies the measure of damages upon the diversion of an opportunity and perhaps most importantly adopts a strict test as to the defense that a venture was financially unable to act upon the opportunity. In doing so, the Court of Appeal cited the article I wrote with Professor (now Dean) Tom Geu on Patmon I, namely The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 (2010).

      Grossly oversimplifying the dispute, Hobbs, purporting to act as the managing member of an LLC, unilaterally transferred for no consideration certain contract rights and other assets of the LLC. Hobbs was a co-owner of that transferee company. Patmon, another member of the original LLC, brought an action charging Hobbs with having breached his fiduciary duties to the LLC. In the first Patmon v. Hobbs decision, Patmon v. Hobbs, 280 S.W.3d 589 (Ky. App. 2009), it was ultimately held that he might have done so, but that Patmon would have the burden, on remand, showing that the LLC could have performed on the transferred contracts. While the ultimate conclusion that Hobbs was bound by fiduciary obligations was (and is) normatively correct, the analytic path used in the decision was hopelessly flawed. Those errors were reviewed in the Analytic Protocol article; HERE IS ALINK to that article. The decision has as well been parsed, including against subsequent amendments to the LLC Act, via its annotation; HERE IS A LINK to that annotation (see Exhibit 7.7.2). Also, since Patmon I was decided, the LLC Act has been amended to cut off further misinterpretation of the Act as to both the statutory definition of the fiduciary duties in LLCs and the availability of a “fairness” defense to the appropriation of company assets. See KRS §§ 275.170(1), (2), as amended by 2010 Ky. Acts, ch. 133, § 32 (expressing labeling the various provisions is the duty of care and the duty of loyalty owed in LLCs); KRS 275.170(2) as amended by 2012 Ky. Acts, ch. 81, § 106.

      After remand and another appeal, the Court of Appeals considered the further actions of the trial court.  See Patmon v. Hobbs, 2014 WL 97464 (Ky. App. Jan. 10, 2014.) inding that the trial court did not resolve necessary issues, the Court of Appeals criticized the measure of damages it had employed. HERE IS A LINK to my review of that decision.

      After that remand and another appeal, now this case comes to the Court of Appeals for a third time. Cutting to the chase, it continues to be unhappy with the work done by the trial court, and the case has for the third time been remanded.

      The first substantive portion of the opinion calls the trial court to task for not providing, as it had been previously directed to do so, specific findings of fact and conclusions of law. On that basis the reversal and remand was granted. Slip op. at 11. “Nevertheless, we find it helpful to further explain the trial court’s on remand as described in Patmon I. Id.

      From there, the Court of Appeals (Judges Dixon, Lambert and Thompson) first addressed who had the burden of proof on the question whether the LLC had the financial wherewithal to perform on the leases that had been transferred. Hobbs had defended on the basis that the LLC could not perform, so it was in effect deprived of nothing by the transfer of the leases. “Hobbs defended his actions opining that American Leasing did not have the financial ability to take advantage of the O’Reilly.” Slip op. at 4. Patmon asserted that the burden should be upon Hobbs to prove the absence of the ability to perform, while Hobbs responded that Patmon I had allocated that burden to Patmon and that under the “law-of-the-case” that allocation could not be revisited. Over several pages the Court all but said that this allocation of the burden should have been upon Hobbs, but under the law-of-the-case rule it must in this case be as set forth in Patmon I. “There is some appealing logic to the reasoning that the inability of the Corporation (sic - this case involves an LLC) to undertake the diverted opportunity as an affirmative defense to be proven by the defendant.” (slip op. at 14), but:

[W]e agree with Hobbs that the law-of-the-case doctrine applies to the holding in Patmon I that Patmon had some burden to demonstrate that American Leasing had the financial ability to take advantage of the O’Reilly leases to prevail under the doctrine of diversion of business opportunity.

Although we must apply the legal principles pronounced in Patmon I to the facts as stated in that opinion, the law-of-the-case doctrine applies only to the extent that an issue was actually resolved….  Although Patmon I placed the burden of proof on Patmon on remand to demonstrate American Leasing had the financial ability to perform the O’Reilly leases, Patmon I did not address the proof necessary to meet that burden. We now do so. Slip op. at 14.

      The Court would require that Patmon demonstrate (presumably in further disputes this burden will be upon the defendant) that the LLC was able to utilize the opportunities. Crucially, at this juncture the Court would also define what is the standard for insolvency such that it will release a fiduciary from the charge of having diverted an opportunity.

       The Court began by reviewing foreign law to the effect that only actual insolvency as a defense to the diversion of what is otherwise a company opportunity. Slip op. at 14-15. Quoting Klinicki v. Lundgren, 678 P.2d 1250 at 1253-54 (Or. App. 1984), the Patmon III Court wrote:

To allow a corporate fiduciary to take advantage of a business opportunity when the fiduciary determines the corporation to be unable to avail itself of it would create the worst sort of temptation for the fiduciary to rationalize an inaccurate and self-serving assessment of the corporation’s financial ability and thereby compromise the duty of loyalty to the corporation if a corporate fiduciary’s duty of loyalty conflicts with his personal interest, the latter must give way. Unless a corporation is technically or de facto insolvent, a determination whether a business opportunity is corporate or personal does not depend on the corporation’s relative financial ability to undertake the opportunity. Slip op. at 15.

It went on to state:

We hold that unless American Leasing was insolvent or legally prevented from performing the O’Reilly leases, Hobbs must compensate it for his diversion of the O’Reilly leases. The trial court is instructed to make the requisite finding. Slip op. at 16-17 (emphasis added).

      The Court then turned to how damages are to be measured. Previously the trial court had in effect awarded Patmon a percentage interest in the net proceeds realized by Hobbs from the disposition of the leases transferred from the LLC. That measure was rejected. Rather, first Hobbs is liable to the LLC for the full measure of the benefits and the gains generated from the use of those assets. “KRS 275.170 requires that Hobbs completely disgorged himself of any benefits received.” Slip op. at 18. Those benefits are to go to the LLC, rather than directly to Patmon. Further, “in addition to statutory damages, if the trial court finds on remand the American Leasing is not financially insolvent, the measure of damages is the lost profits the corporation (sic - LLC) would have received had the opportunity not been diverted.” Slip op. at 18-19. The Court noted as well that pre-judgment interest may be in order. Slip op. at 19.

      Then, returning to Patmon I and Patmon II, the LLC is to be dissolved, and in the course thereof the trial court may reset the sharing ratios between the members. Slip op. at 9.

This decision is important for a variety of reasons including:

·         Recognition of the separation of LLCs from the common law of corporations and partnerships (Slip op. at 13);

·         Recognition of the prior error in the allocation of the burden of demonstrating inability to perform, strongly hinting that in the future the burden is upon the person alleging the inability to perform;

·         Defining actual insolvency as the threshold for an inability to perform;

·         Giving teeth to the statutory directive that, in the event of the diversion of company assets from an LLC, the person effecting the diversion is obligated to remit to the LLC all gains and benefits derived therefrom;

·         Specifying, on remand, that the trial court is not to accept the price at which Hobbs ultimately transferred the LLCs assets, but rather to independently determine their fair market value;

·         Affirmation of the rule that, upon dissolution of the LLC, sharing ratios may be reset in order to, on an equitable basis, account for Hobbs’ a breach of duty; and

·         Raising, with respect to the award of damages to the LLC, the possibility of an award of prejudgment interest.

      For myself, I have been far from reticent in criticizing the decision rendered in Patmon I. This Patmon III decision goes a long way to bringing Kentucky’s law on fiduciary duties in LLCs into compliance with the LLC Act and more generally principles of fiduciary duty law.

Enforcing an Operating Agreement Against a Member Who Didn’t Sign?

Enforcing an Operating Agreement Against a Member Who Didn’t Sign?

      It is quite troubling when someone finds out that, after having joined an LLC, they can be bound to an operating agreement that they have never agreed to. That is, however, the manner in which many of the LLC statutes operate. Persons who agree to be minority members of an LLC are on notice of the need to consider this eventuality and, if possible, negotiate protections against it.  Otherwise, they need to accept that this is a possible outcome.

      In a recent decision from New York, Shapiro v Ettenson, 2015 N.Y. Slip Op 31670 (U) (Aug. 16, 2016), three individuals came together and formed a member-managed LLC, equally owned by the three of them.  They did not, however, adopt a written operating agreement.  Nearly 2 years after the LLCs organization, two of the members executed a written consent pursuant to which the articles of organization were amended to change the LLC from being member-managed to manager-managed and they also adopted a written operating agreement.  In addition to addressing the management of the company, it provided that a majority of the members could determine to make a capital call upon all of the members and, upon a member’s failure to satisfy a capital call, their interest in the company would be diluted.  After a capital call was made, one of the members, Shapiro, filed a lawsuit challenging the adoption of the written operating agreement and the capital calls.

      Cutting to the chase, Shapiro lost, primarily because the New York LLC Act provides a default rule that a majority of the members can adopt or amend the articles of organization or operating agreement.  A detailed analysis of this decision, prepared by Peter Mahler and posted on his (highly recommended) blog, New York Business Divorce, is available at Can LLC Agreement Be Enforced Against Member Who Doesn’t Sign It? (CLICK HERE to link to the posting).

      Having reviewed Peter’s description of this ruling and as well the numerous additional questions he identified, it is important to consider whether a similar outcome could happen in Kentucky.  In a word, “Yes.”  

      If the members never adopt an operating agreement per se, then the articles of organization and the LLC Act are the operating agreement.  KRS § 275.003(8).  Initially, the Kentucky LLC Act provides a default rule that the members vote in proportion to their capital contributions, and goes on to provide a default rule that a majority-in-interest of the members may pass on most points, including amendment of the operating agreement. See KRS § 275.175(1); id. § 275.175(2)(a).  While the LLC Act does not allow a capital contribution obligation to be imposed upon a member absent their written consent thereto (KRS § 275.200(1)), it is open to question whether a majority of the members, over the objection of a particular member, could impose a capital contribution obligation that, even while not specifically enforceable against the objecting member, can still have any of the consequences for lack of performance or otherwise allowed to be set forth in an operating agreement.  See KRS §§ 275.003(2)(a)-(g).

      Another mechanism by which the same effect can come about is a merger.  Under Kentucky law, absent a contrary provision in a written operating agreement, a majority-in-interest of the members can approve a merger.  Utilizing this provision (i) a majority of the members set up a new company and with it a new operating agreement and then (ii) cause the existing LLC to be merged with and into the new LLC with the new LLCs operating agreement binding all of its members.  See also KRS § 275.350(1).  Upon the effective time and date of the merger, all of the members of the former LLC are bound by that new operating agreement.  See KRS § 275.365(11); see also Rutledge The 2010 Amendments to Kentucky’s Business Entity Laws, 33 N. Ky. L. Rev. 383, 397-99 (2011).  Again, while members who vote against the merger may not be subject to capital contribution obligations to the new company (KRS § 275.365(11)), they may be subject to various penalties, detailed in the new LLCs operating agreement, if they do not participate in additional capital raises (KRS §§ 275.003(2)(a)-(g)).

      Depending upon the underlying state law, being a minority member in an LLC can be a precarious position.  Some of those risks and some thoughts on how they maybe militated are addressed in Rutledge, Minority Members and Operating Agreements, 10 J. Passthrough Entities 21 (Nov./Dec. 2007).   HERE IS A LINK to that article.

On Further Reflection, “No”

On Further Reflection, “No”

 

            At the UKCLE/KBA Section of Business Law Business Associations Institute I mentioned that the General Assembly had just passed an amendment to the Kentucky LLC Act providing by statute for derivative actions in LLCs (2015 Ky. Acts, ch. 34, § 50).  Jim Seiffert, also on the panel on fiduciary duties, asked whether the operating agreement could limit or eliminate the ability of a member to bring a derivative action?  I think I told him I don’t think so, but I can’t swear that was my response.

 

            That said, on further reflection, and after considering the decision of the Delaware Supreme Court in In re Carlisle Etcetera, LLC, C.A. No. 10280-VCL, 2015 WL 1947027 (April 30, 2015), I’ve come to the view that the operating agreement cannot modify the capacity of a member to initiate on the LLC’s behalf a derivative action.

 

            Still, that leaves open the question as to whether an “all disputes” arbitration clause would under the Federal or Kentucky Arbitration Act require the court to refer the derivative action to arbitration. 

Derivative Actions in Kentucky LLCs

Derivative Actions in Kentucky LLCs

 

In its current form, the Kentucky LLC Act is silent as to derivative actions.  That silence does not equate, however, to a determination that there are not derivative actions in Kentucky organized LLCs. Rather, as derivative actions are a question of equitable standing, they exist independent of an enabling statute. See also Carter G. Bishop and Daniel S. Kleinberger, Bishop & Kleinberger on Limited Liability Companies ¶ 10.07[2] (2012 and 2014-2 cum. supp.)  (“Many LLC statutes expressly authorize derivative actions, but some do not. This distinction should make little difference. Derivative litigation began in the corporate context over 150 years ago without the benefit of statutes, and remains essentially equitable in nature.”)

           

Numerous courts, with respect to LLCs organized in Kentucky, have entertained actions that are either expressly characterized as derivative or in which the rules applicable to derivative actions, including the direct versus derivative distinction, have been applied.   For example:

 

·         Pixler v. Huff, Civ. Act. No. 3:11-CF-000207-JHM, 2012 WL 3109492 (W.D. Ky. July 31, 2012) (in the context of an LLC, applied the test traditionally applied in corporations as to the direct versus derivative distinction and determined whether certain claims brought by a member could be brought only on a derivative basis);

 

·         id., 2012 WL 3109492, *3 (“Therefore, Plaintiff may maintain her claims against the Defendants only where she has suffered an injury that is separate and distinct from that which would be suffered by other members or the LLC as an entity.”);

 

·         R.C. Tway Co. v. High Tech Performance Trailers, LLC, No. 3:2012-CV-00122, 2013 WL 842577, *3 (W.D. Ky. Mar. 5, 2013) (“Each of the claims identified above clearly alleges that High Tech or Hanusosky violated some duty it owed directly to [Performance Trailers], thus causing [Performance Trailers] injury.  As [Performance Trailers] is the allegedly injured party for each of these claims, it is the one that is entitled to enforce the rights granted by substantive law.  Accordingly, [Performance Trailers] is not a nominal party, but instead is a real party in interest as to those claims.”);

 

·         Chou v. Chilton, __ S.W.3d ___, Nos. 2009-CA-002198-MR, 2009-CA-002284-MR, 2014 WL 2154087 Ky. App. May 23, 2014) (“[The LLC] and not Chou himself would benefit from any recovery for breach of the operating agreement, fraud, misappropriation, breach of fiduciary duty or gains taken by the defendants.  While Chou may or may not receive funds from [the LLC] on dissolution of that company, any wrongs for breach of the operating agreement, fraud, misappropriate, breach of fiduciary duty or gains taken by the defendants perpetrated by any of the [defendants] or possibly [a separate LLC controlled by the defendants] would be wrongs against [the LLC] and not Chou individually.”); and

 

·         Turner v. Andrews, 413 S.W.3d 272 (Ky. 2013) (rejecting effort by the sole member of an LLC to bring on his own behalf (rather than on behalf of the LLC), a claim for lost profits.).

 

It bears noting that the Kentucky LLC act is atypical in not expressly addressing derivative actions in LLCs. The vast majority of the states, including Delaware, have an express derivative action statute. See Del. Code Ann. tit. 6, §§ 18-1001 through 18-1004.  See also Revised Prototype LLC Act, 67 Bus. Law. 117, 194-198 (Nov. 2011) (providing for LLC derivative actions at §§ 901-908); 1 Ribstein & Keatinge on Limited Liability Companies, appendix 10-2 (listing derivative action and related provisions of the various LLC Acts).