Waiver of the Right to Bring a Derivative Action?
In an
August 15 decision, the Kentucky Court of Appeals reversed a decision of the
trial court finding that a participant in the deal was not acting as an attorney
for other members. J&B Energy, Inc. v. Caldwell, 2014 WL 3973966 (Ky App. 2014)
My concern
with the decision relates to a point not appealed, namely the trial court’s
determination that certain language in the operating agreement effected a
waiver by the member’s right to bring a derivative action. That language (which
appears in footnote 9) is:
The Members shall have no
power to participate in the management of the Company except as expressly
authorized by this Agreement or the Articles of Organization and except as may
be expressly required by the LLC Act. Unless expressly and duly authorized in
writing to do so by a manager, no member shall have any power or authority to
bind the Company in any way, to pledge its credit, to act on its behalf, or to
render it liable for any purpose.
The Court of Appeals wrote:
Based on this language in
the operating agreement, the court below found that the PBP members have no
authority to act on behalf of PBP without the express and duly authorized
approval of the managers in writing. The court reasoned that this included
derivative actions, and found that J & B had no authority to institute same
because it was not a manager and did not have authorization from a manager to
do so.
While
clearly dicta, it is potentially dangerous dicta, and therefore it deserves
attention.
The Ky LLC
Act does not specifically address derivative actions, so in Ky LLCs they are
brought under common law. See section [7.24] of Limited Liability Company Operations
(2014-1 supp.), Limited Liability Companies in Kentucky (UKCLE) (forthcoming).
I’m rather
concerned that the language from the operating agreement was interpreted to
preclude the members (the ultimate beneficiaries of the duties of care and
loyalty owed the managers) from policing their actions through a derivative
action.
A
derivative action is an important tool by which the participants in a venture
may initiate the policing of the conduct of those in control of the
venture. Cases from around the county
and in Kentucky make clear that the duties owed to the LLC may be enforced only
by and for the benefit of the LLC. See, e.g.,
Chow v. Chilton (reviewed HERE); Chow v. Chilton (reviewed HERE); and Turner v. Andrew (reviewed HERE).
Absent the
ability of the members to bring a derivation action on the LLC’s behalf,
conduct involving, for example, personal exploitation of company business
opportunities, self-dealing transactions and personal use of company assets may
go unexamined and unremedied.
To
that end, initiating a derivation action is not participation in the LLC’s
management. Rather, a derivation action
puts the court in control. As long ago
observed in Denicke v. Anglo California
Nat. Bank of San Francisco, 141 F.2d 285 (9th Cir.
1944), it was observed that the task of the shareholder initiating a derivative
action is to “set in motion the judicial machinery of the court” to the effect
that:
His position in the litigation is
assimilated to that of a guardian ad litem with power in the court, not in the
stockholders, to compromise the rights of the real party in interest, which is
the corporation itself. Id. at 288,
quoting Whitten v. Dabney, 154 P.
312, 316, it quoting 3 Pomeroy’s Equity
(3rd ed.) § 1095 (citations omitted).
Predating
this decision by almost forty years is a Kentucky decision utilizing similar
language. In Louisville Bridge Co. v. Dodd, 27 Ky. L. Rep. 454, 85 S.W. 683 (Ky.
1905), the Court addressed the respective roles of the plaintiff minority
shareholders and the court:
[The
plaintiff shareholders are] always subject to the control of the court. It is at last the judgment of the latter, in
the application of principles of equity, that obtains in lieu of the discretion
of the board of directors. The minority
stockholder merely sets in motion the action, and present facts upon which the
court can act.
In only
the most strained reading is insisting that those who have undertaken a
fiduciary role show that they have discharged their obligations somehow
managing or acting on behalf of the LLC.
There is
as well the point of inconsistency between an agreement which defines fiduciary
obligations owed and then by implication eliminates the mechanism by which the
discharge of those duties may be enforced (my thanks to Prof. Hemingway for
identifying this point). As she
observed:
Those actions
exist to ensure that there is a watchdog able to engage in that enforcement,
since the managers of the firm may not be willing to bring legal action against
themselves for the breach of duty.
Having a right without the ability to enforce it is tantamount to having
no right at all.
If the
axiom of equity “for every wrong there is or remedy” is otherwise correct, how
can it have currency if there is no mechanism through which to pursue a remedy?
Another
path of inquiring that deserves attention is whether the parties to a contract
may eliminate a court’s equitable power to investigate and as necessary remedy
violations of duties that are themselves typically equitable in nature?
Conceptually,
it may be possible for the members to waive the right to initiate a derivation
action, although I would almost always counsel against doing so. That said, any waiver of this right should be
required to be clear and unambiguous. I
submit the language determined by the trial court to be a waiver of the right
to initiate a derivation action does not rise to that threshold.
