The passing of a giant

Today marks the anniversary of the death of Cardinal Thomas Wolsey, Archbishop of York, Lord Chancellor of England and Abbott of St. Albans.
He was in his age a force of nature in England.

Standing in Dispute Among Members of LLC

Standing in Dispute Among Members of LLC

            On November 16, the Kentucky Court of Appeals issued a decision addressing whether the member of an LLC has standing, in his own name, to bring an action asserting various claims including that the other member(s) has violated fiduciary duties.  It also addresses a claim for wrongful termination of employment of a member by an LLC.  Chou v. Chilton, 2012 WL 5626184 (Ky. App. Nov. 16, 2012). 

 

      As I was involved in this dispute I will not say more beyond recommending it to you.

 

Delaware Supreme Court Sidesteps Question of Default Fiduciary Duties in LLCs

Delaware Supreme Court Sidesteps Question of Default Fiduciary Duties in LLCs While Squarely Head-Butting Chancellor Strine

It had been hoped that the decision of the Delaware Supreme Court in Gatz Properties v. Auriga would resolve the question as to what are, if any, the default fiduciary duties imposed by the Delaware LLC Act. In the end, the Delaware Supreme Court has managed to avoid this question, finding that the contractual standards set forth in the limited liability company agreement of the LLC at issue provided a standard; consequently, the issue of a default duty in the absence of agreed contractual standard was not before the Court. At the same time, the Supreme Court, in a per curiam decision, chastised Chancellor Strine for his decision’s expansive explication of the question of what would be those default duties. Gatz Properties, LLC v. Auriga Capital Corp., ___ A.2d ___, 2012 WL 5425227, 2012 Del. LEXIS 577 (Del. Nov. 7, 2012), affirming 40 A.3d 389 (Del. Ch. 2012).

The Facts of the Dispute

Peconic Bay LLC was organized to hold a leasehold interest in certain property, to develop the property into a golf course, and to sublease the property to a golf course operator. The Gatz family and their affiliates held over 85% of the Class A and over 52% of the Class B membership interests in Peconic Bay.

      By 2004 the golf course was failing and Gatz believed that the lease operator planned to exercise its early termination rights under the sublease. Instead of attempting to identify a new lessee to operate the golf course, Gatz hatched a plan intending that he could purchase Peconic Bay at a distressed price. Among other things, Gatz discouraged a potential third-party purchaser, provided misleading information to minority members about potential buyers, including understating their interest in the property, and conducted a “sham” auction. Gatz, the only bidder at the auction, purchased Peconic Bay. The minority members of Peconic Bay, LLC (“Peconic Bay”), sued Gatz Properties, LLC (“Gatz Properties”), the manager of Peconic Bay, and William Gatz (“Gatz”), who owned and controlled Gatz Properties, arguing that Gatz Properties breached its fiduciary duties. The Court of Chancery ruled in favor of the plaintiffs on both contractual and statutory grounds, from which ruling the defendants appealed.

Where the Supreme Court and the Chancery Court Agreed

            The Delaware Supreme Court affirmed the finding that Gatz/Gatz Properties (collectively “Gatz”) violated the contracted-for fiduciary duty by refusing to negotiate with a third-party bidder and causing the company to be sold to himself at an unfair price in the flawed action. The relevant contractual provision of the LLC Agreement provided:

Neither the Manager nor any other Member shall be entitled to cause the Company to enter into any amendment of any of the Initial Affiliate Agreements which would increase the amounts paid by the Company pursuant thereto, or enter into any additional agreements with affiliates on terms and conditions which are less favorable to the Company than the terms and conditions of similar agreements which could then be entered into with arms-length third parties, without the consent of a majority of the non-affiliated Members (such majority to be deemed to be the holders of 66-2/3% of all Interests which are not held by affiliates of the person or entity that would be a party to the proposed agreement).

The Supreme Court wrote, “[v]iewed functionally, the quoted language is the contractual equivalent of the entire fairness equitable standard of conduct and judicial review.”  It further determined that Gatz had acted in bad faith, in consequence of which Gatz was not entitled to the benefit of an exculpation and indemnification provision, of the LLC Agreement, it containing a carve-out for acts of gross negligence, willful misconduct or willful misrepresentation.

Where the Supreme Court and the Chancery Court Disagreed

Having disposed of the matter on the basis of the contract at issue and its definition of what were the manager’s fiduciary obligations, the Delaware Supreme Court held that the Court of Chancery acted improperly in addressing whether and what default fiduciary duties apply when the LLC agreement is silent on the issue. The Supreme Court characterized the Court of Chancery’s determination that default fiduciary duties exist “as dictum without any precedential value.”

The Court of Chancery had held that the “Delaware Limited Liability Company Act imposes ‘default’ fiduciary duties upon LLC managers and controllers unless the parties to the LLC Agreement contract that such duties do not apply.”  The Supreme Court found that the issue had not been properly raised below, and that in any event it need not have been reached given the explicit duties detailed in the LLC Agreement. Moreover, according to the Delaware Supreme Court, “the merits of the issue whether the LLC statute does — or does not — impose default fiduciary duties is one about which reasonable minds could differ” and one that has not previously been decided by the Delaware Supreme Court. The Supreme Court expressed its view that one could reasonably conclude the LLC statute is “consciously ambiguous” in that regard, and suggested that the “‘organs of the Bar’ . . may be well advised to consider urging the General Assembly to resolve any statutory ambiguity on this issue.”

Some Other Background

      The views of Chancellor Strine to the effect that there do exist default fiduciary duties in the Delaware LLC Act runs directly contrary to a position previously taken by Chief Justice Steele.  Rather, in Freedom of Contract and Default Contractual Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L. J. 221 (Summer 2009), he posited that there are no default fiduciary duties in limited partnerships or LLCs organized Delaware law.  Chancellor’s Strine’s opinion in Gatz is directly contrary to this view.

What This Decision Means in Kentucky

      At the broadest level, this decision has no impact upon Kentucky law.  The Delaware LLC Act is silent as to the fiduciary duties owed by a member or manager.  It is consequent to that silence that there exists a dispute as to whether fiduciary duties exist in that form, and if they do exist, what are they.  Kentucky’s LLC Act, in contrast, specifies default fiduciary duties that may then be modified in a written operating agreement.  See KRS § 275.170.  Where the written operating agreement does not provide otherwise, the statutory provisions apply.  See KRS § 275.003(8).  Hence, in Kentucky, there cannot be a questions of “what are the fiduciary duties when the operating agreement is silent”; the statute has already addressed that question. 

      On a slightly more subtle level, this decision highlights the danger of knee-jerk reference to Delaware law.  While it is indeed true that on many manners Delaware serves as the best authority when Kentucky law does not address a point, that reference presupposes that the policies of Delaware and Kentucky bear some high degree of similarity.  As to this specific point, in that Kentucky has defined what are the default fiduciary duties in an LLC, it is ultimately of no concern what Delaware may ultimately resolve to be the default fiduciary duties in LLCs organized in that jurisdiction.  Where Kentucky law has spoken to a point, the reference to foreign law as to its interpretation and application needs to be restricted to those states that have made similar determinations.  As such, an Arkansas decision as to the fiduciary duties in LLCs, the Arkansas LLC Act being, as to that point, nearly identical to that in Kentucky, would be far more availing than would be a reference to Delaware law.

      The last impact of this decision in Kentucky, and this is a bifurcated point, is upon practitioners.  Initially, with an appreciation that the Kentucky and Delaware Acts are so dissimilar from one another, there should come as well the realization that mastery of the Kentucky LLC Act does not qualify one to practice in Delaware LLCs.  Initially, the significant differences between the Kentucky and Delaware Acts often precludes skill transfer between the two forms.  Second, with Delaware’s reliance upon its own contract law as the background against which LLCs agreements are drafted, one must, in order to effectively draft and interpret Delaware LLC agreements, master not only the LLC Act but the full range of Delaware’s contract law. 

      The second arm of this bifurcated point is that practitioners who aspire to draft operating agreements in multiple jurisdictions, even if limited only to Kentucky and Delaware, need to have a careful appreciation of the background against which the operating agreement is written.  In drafting an operating agreement for a Kentucky LLC that is silent as to fiduciary duties, you in effect write into the agreement the statutory default rules.  Whether, on a normative matter, with respect to any particular venture those are the most appropriate rules is a different question, the answer to which could well land the drafter into hot water for failure to consider their implications.  In contrast, one who drafts a limited liability company agreement for a Delaware LLC that is likewise silent as to fiduciary duties has introduced a significant ambiguity into the relationship, namely what fiduciary duties, if any, apply?  The ex post resolution of that ambiguity likely will be, at minimum, expensive.  Failure to appreciate the problem created is even worse.

Claim for Securities Fraud Dismissed for Lack of Materiality

Preliminary Acquisition Discussions Not “Material”;

Claim for Securities Fraud Dismissed

      In a recent decision, the 6^th Circuit Court Appeals dismissed, on the grounds of lack of materiality, claims for securities fraud in connection with a shareholder’s sale of shares back to the corporation and to its President/CEO.  Filing v. Phipps, 2012 WL 5200375 (6^th Cir. Oct. 23, 2012).

      Filing, an employee of White Rubber Company, acquired a significant number of shares of the corporation’s stock.  He was offered the opportunity to sell shares back to the corporation, an offer which he accepted.  Ultimately, the corporation, as well as Phipps, purchased fewer than the total number of offered shares at a price determined by a third-party valuation.  While the discussions with respect to that purchase were taking place, a third-party, Norcross, expressed an interest in acquiring White Rubber, ultimately entering into a confidentiality agreement with respect to those discussions.  The 6^th Circuit noted, however, that Norcross had executed similar confidentiality agreement, with  “dozens” of other possible acquisition targets.  Those discussions ultimately broke down when White Rubber refused to provide certain requested due diligence.  Shortly after that breakdown, the closing took place on the sale by Filing of stock to White Rubber and to Phipps.  Several months later, another set of ultimately aborted discussions regarding the acquisition by Norcross of White Rubber were initiated.  Then, a year later, after Norcross was recapitalized by its own acquisition, it acquired White Rubber for $22 million.  Although not express in the opinion, Filing sold his shares based on a company valuation of approximately $4.65 million.  Filing then brought suit against, ultimately, Phipps, the corporation and certain other directors alleging violations of § 10(b) of the ‘34 Act and Rule 10b-5 thereunder.  The trial court granted summary judgment in favor of the defendants, and appeal to the 6^th Circuit followed.

      Filing asserted that the failure to disclosed the discussions between White Rubber and Norcross violated §10(b) and Rule 10b-5, the latter of which precludes “the making of ‘any untrue statement of material fact’ or the omission of any material fact ‘necessary to make the statements made … not misleading.’”  2012 WL 5200375, *2.  A fact is material if “a reasonable shareholder would (1) consider the fact important in making an investment and (2) view the fact as having significantly altered the total mix of information available.”  Id., citing Basic Inc v. Levinson, 486 U.S. 224, 231-32 (1998).  There having been no disclosure of the potential acquisition, the question turned entirely on whether those discussions had been material.

      Ultimately, in light of the preliminary, on and off nature of the negotiations between White Rubber and Norcross, the 6^th Circuit affirmed the determination that those discussions had not been material.  The Court noted as well that it was not until Norcross was itself acquired that a transaction with White Rubber took place.  Ergo, Filing’s claims for securities fraud were unavailing.

Decision of Trial Court Reversed, Inter Alia, For Lack of Jurisdiction

Decision of Trial Court Reversed, Inter Alia, For Lack of Jurisdiction

      A recent decision of the Kentucky Court of Appeals discusses a variety of interesting topics including standing to assert a claim for breach of fiduciary duty, the effectiveness of a release given to a fiduciary with respect to undisclosed activities and whether a secret profit earned in connection with the purchase of property by an LLC constitutes a breach of fiduciary duty.  Ultimately, however, this is all dicta in that the Court of Appeals determined that the trial court lacked jurisdiction to hear the dispute, it arising out of a contract containing an exclusive venue clause referring disputes to Cincinnati, Ohio.  Ziegler v. Knock, No. 2008-CA-002160-MR, 2012 WL 5273999 (Ky. App. Oct. 26, 2012).

      David Knock and Richard Knock, members of Knock Investments, LLC and Ziegler Group, owned by Michael Ziegler, joined together by means of a Membership Interest Purchase Agreement, to form Knock/Ziegler LLC for the purpose of acquiring a strip mall in Ohio.  The Membership Interest Purchase Agreement contained a warranty from Ziegler that he was not being paid, directly or indirectly, a sales commission on the transaction.  It came to pass that Ziegler, through a wholly owned LLC, did receive a sales commission on the property acquisition.  The Knocks and Knock Investments filed suit in Boone Circuit Court alleging that the commission was improper, including as a breach of fiduciary duty.  They would largely prevail at the Boone Circuit Court, receiving a judgment roughly equivalent to their percentage interest in the LLC multiplied by the amount of the secret commission.  Cross-appeals were then filed with the Kentucky Court of Appeals.

       In what is ultimately dicta, the Court of Appeals upheld the rulings of the Boone Circuit Court with respect to: (1) the capacity of the Knocks as individuals, as proper parties to the litigation (I believe I am in disagreement, on a normative matter, with that determination; more on it below); (2) that a release entered into between the parties was not enforceable; (3) that Ziegler did breach his fiduciary duty in taking the sales commission; and (4) a claim by Ziegler for reimbursement for tax work performed on behalf of the LLC. 

      Ultimately, however, none of it mattered.  The Membership Interest Purchase Agreement at issue provided an exclusive venue provision calling for any litigation to take place in Cincinnati, Ohio.  Finding that, inter alia, this provision stripped the Boone Circuit Court of jurisdiction to hear this dispute, its decision was reversed.

Choice of Venue Upheld an Appeal

      It is curious that the Court of Appeals was able to determine that the choice of venue clause is valid and enforceable.  In Midnight Terror Productions, LLC v. Winterland, Inc., 2012 WL 5457530 (Ky. App. Nov. 9, 2012) (reviewed here in November 14), in response to a challenge to the legitimacy of a venue clause, the Court of Appeals directed that that determination needed to be made by the trial court and on that basis remanded for a decision on the merits.  While the court wrote that “Nothing in the record demonstrates that Prudential Resources Corporation (v. Plunkett, 583 S.W.2d 97 (Ky. App. 1979)) should operate to void the application of the choice of venue clause in the Membership Interest Purchase Agreement,” neither does it recite that the various factors set forth therein have been considered by either the trial court or the Court of Appeals.

Standing

            This opinion gives far too few facts to come any binding conclusions as to the standing, but further understanding would be helpful.  It appears that the Knocks held their entire interest in the LLC that was the acquirer of the property through an LLC.  Normally, to the extent there was any breach of fiduciary duty, that duty would have been owed to the LLC that was itself a member of the purchaser LLC; the Knocks as individuals, would not have individual standing to object.  The opinion does not specify, however, whether the Knocks individually or their LLC were the signatories to the Membership Interest Purchase Agreement. 

Breach of Fiduciary Duty

            It is unfortunate that the decision of the Boone Circuit Court’s as supported (in dicta) by this holding of the Court of Appeals must ultimately be ignored.  Clearly, the earning of an undisclosed commission on the LLC’s acquisition of property, unless specifically disclosed and approved by the disinterested members (see KRS § 275.170), is a breach of fiduciary duty.  See also Thomas E. Rutledge and Thomas Earl Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 (2010).  At the same time it is not clear that recourse to fiduciary duty law was necessary.  Ziegler warranted that he was not to receive a commission when in fact he was.  Clearly he violated his warranty, a matter that can be resolved as a straight-forward breach of contract action.

So Begins Gloriana

So Begins Gloriana

 

       On this day in 1558 Mary Tudor, who would later have foisted upon her the moniker "Bloody," died, leaving the English throne to her half-sister Elizabeth. Where Mary's reign of just over 5 years was one of tumult at the highest political levels, for at least a significant and perhaps a majority of the population it was a return to the preferred old ways, a view put forth expertly by Professor Scarisbrick in his The Reformation and the English People. Elizabeth's reign would by contrast be seen as one of peace and growth, later dubbed the Gloriana. Elizabeth would rule until 1603.

Using the Corporation as Your Personal Piggybank

When You Use the Corporation as Your Personal Piggybank,

Don’t Be Surprised When Your Creditors Do So As Well

      It axiomatic, all else being equal, the assets of a corporation are not the property of corporation’s shareholders.  A concept identified under a number of labels including “asset partitioning,” while the shareholder may own 100% of the corporation, that ownership does not translate into an ownership interest in the corporation assets.  Sometimes, however, all else is not equal, and shareholders treat the corporation assets as their own.  As reviewed in a recent decision by the Kentucky Court of Appeals, when a shareholder acts in that manner, they should not be surprised when their creditors are permitted to do so as well.  Caswell v. Richardson, 2012 WL 5457402 (Ky. App. Nov. 9, 2012).

      Richardson held a judgment against Caswell and sought to enforce it by a garnishment action served against C. Caswell, Inc., a corporation wholly owned by Caswell.  The corporation made no response to that garnishment order, and Richardson filed a motion to hold both Caswell and the corporation in contempt.  Following a hearing on the contempt motion (the decision does not recite whether or not either Caswell or the corporation appears thereat), the corporation was found to be in possession of Caswell’s property, that it had failed to file a timely affidavit, and that civil sanctions in the amount of $25,000 were appropriate.  The corporation was afforded the opportunity to purge the contempt by answering the garnishment order.

      The corporation did finally respond through an affidavit from Caswell denying that the corporation held any of his property.  That affidavit denied that the corporation had any net assets, whereupon Richardson was granted the opportunity to subpoena the corporation’s bank records.

      The inspection of the bank records demonstrated that corporation assets were being dispersed for Caswell’s personal expenses:

In her motion, Richardson alleged that Caswell had been untruthful in his affidavit.  She contended that the corporation’s bank statements showed that the business had made substantial withdrawals to pay Caswell’s expenses of a purely personal nature soon after its receipt of the garnishment order in May.

The trial court held an evidentiary hearing whereupon it found that: 

Caswell regularly deposited money in the corporate bank account and freely accessed any and all funds held by the corporation.  The court determined that Christopher Caswell’s affidavit filed in answer to the order of garnishment was intended merely to thwart Richardson’s efforts to collect on the judgment.

      In light of his actions, Caswell was fined $14,853.18 payable to Richardson, was sentenced to 24 days of jail, was ordered to pay Richardson’s attorney’s fees; there was as well assessed against the corporation a contempt penalty in the amount of $1,482.00.  On appeal, Caswell argued that the trial court was in error in concluding that the corporation held assets belonging to him.  Based upon his own testimony to the effect that he used the corporation as his personal piggybank, the Court of Appeals rejected that assertion:

In support of his argument, Caswell relies on the affidavit and testimony of Belinda Pinotti, accountant for Caswell and his corporation.  Pinotti indicated to the court that as of the day on which the garnishment was served, there was no money to which Caswell was entitled. In light of this testimony, Caswell objects to the court’s conclusion that the corporation was, in fact, holding money that belonged to him.

At the hearing, Caswell indicated to the court that he had routinely paid personal expenses from the corporate bank account and that he “knew it was my business’s money, but ... if I did not have the money in my personal account, yes, I used it at my leisure.” From an abundance of testimony in a similar vein, the trial court concluded that the corporation was a mere instrumentality and that all the funds held in the corporate account on the day the garnishment was served “was for all intents and purposes being held for Mr. Caswell to do with as he pleased.” Opinion and Order at 5. The trial court did not err by concluding from the evidence presented that the corporation held money belonging to Caswell.

      In response to the defense that in fact he had not lied on his affidavit, again the Court of Appeals was able to reject his argument based upon his own testimony:

While Caswell indicated in his affidavit that the funds in the corporate bank account were all tagged for disbursement to contractors and suppliers, he admitted that he wrote checks from the corporate account in May 2009 to pay off the loan on his Mercedes-Benz and to pay his home mortgage and that he otherwise generally used the corporate account as his own. Although he denied that he had lied or willfully refused to obey the court's garnishment order, the trial court concluded from his testimony that Caswell's affidavit was patently false and that he had intended by this falsehood to avoid the order of garnishment by perpetrating this deception. The record contains ample proof to refute any claim of an abuse of discretion.

       The Court of Appeals was able to summarily dispose of assertion that the trial court was prejudiced against Caswell and that somehow Richardson was acting in bad faith in seeking to enforce the judgment.

      Limited liability, the rule that the shareholders are not, by reasons of that status, liable for the debts and obligations of the corporation, is oft (incorrectly) cited as the sine qua non of the corporation.  Just as important as that rule is its flip side, namely that the corporation is a legal entity distinct from the shareholders and that the corporation’s assets are not available to satisfy the shareholders’ debts and obligations.  These rules, however, assume that the corporate form is being appropriately utilized.  The rule of shareholder limited liability from the debts and obligations of the corporation may be, in appropriate circumstances, set aside under doctrines including piercing the veil.  As demonstrated by this case, efforts to rely upon the asset segregation aspects of the corporation can similarly be set aside when the corporate form is abused.