Right Outcome, but the Court of Appeals is Confused as to the Business Judgment Rule

Right Outcome, but the Court of Appeals is Confused as to the

Business Judgment Rule

 

 

            In a recent decision the Court of Appeals correctly found that it would not second guess the decisions made by a board of directors as to how corporate assets should be applied to remedy existing problems.  At the same time, however, the Court was off base as to what is the Business Judgment Rule, and was off base as to who owes and who is the beneficiary of the fiduciary obligations in a corporation.   Davis v. Innwood Condominium Property Owners Association, Inc., No. 2013-CA-001221-MR, 2014 WL 2938486 (Ky. App. June 27, 2014).

 

            Davis owned a condominium in the Ironwood development, a low and fixed income complex. The property has in recent years faced a number of challenges including the need to expend some $100,000 in brick repairs in order to remedy a code violation, significant repairs to the heating system, and an increase in insurance premiums after a fire.  A special assessment of the owners was made in order to increase reserves.

 

            Davis, who at various times has served on the board of directors, brought suit alleging that the board had failed to satisfy the terms of the master deed as to a number of issues including exterior maintenance, limitations upon occupancy of units and failing to require background checks on occupants.  In addition, he alleged that the board had failed to maintain the property as a “first-class condominium.”  Collectively, he asserted that these failures, characterized as breaches of fiduciary duty, reduced the fair market value of his unit.

 

            After discovery, the trial court dismissed the complaint as being subject to the “business judgment rule”; this appeal followed.

 

            Davis’ argument was that the Master Deed set forth requirements, that even though some issues were being address the board was not requiring full compliance with those requirements, and a breach of fiduciary duty therefore resulted.  The Court of Appeals affirmed the trial court’s determination that the Business Judgment Rule precluded court intervention, it writing:

 

The business judgment rule is “a presumption that in making a business decision, not involving self-interest, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Allied Ready Mix Co., Inc. ex. rel. Mattingly v. Allen, 994 S.W.2d 4, 8 (Ky.App.1998). The record below indicates that the Board sought guidance from its management company, Prudential Parks, and Weisberg Realtors in making decisions as to how to best address the issues raised by Davis. The record further reflected that the Board did not have all of the necessary funds at its disposal to immediately fix each of the problems raised by Davis. However, the Board, based upon the advice it received, in consideration of the financial status of the tenants and owners at Innwood, did vote to approve a Special Assessment for repairs and maintenance. By considering the economic standing of its residents and the problems at issue and making such a decision, this Court is not persuaded that the Board breached any fiduciary duty in this instance.

 

Finding there to be no assertion of fraud or conflict of interests that precludes the application of the Business Judgment Rule, the trial court’s dismissal of the complaint was upheld.

 

            That said, before the quoted language above the court misidentified the source of the Business Judgment Rule as being in the statutory formulae of the standards imposed upon corporate directors, those being KRS §§ 273.215 and 271B.8-300.  Sorry, but that is not the case.  Those cases recite the standards of performance and the standards of culpability imposed upon directors.  The Business Judgment Rule, in contrast, applies not to corporate directors but rather to the courts called upon to assess the actions taken by the directors, and creates a presumption against judicial review of decisions made by a corporate board.  In no manner is this presumption against judicial review “codified” in the the Kentucky statutes on business and nonprofit corporations.

 

            Another point, this one clearly dicta, in which the Court of Appeals was on less than a sound footing was in finding that there exists a fiduciary duty running from the corporation’s board to the individual owners thereof.  The Court of Appeals acknowledged that this determination is in contrast to that made in the then not final Ballard v. Willow Council of Co–Owners, Inc., 430 S.W.3d 229, 2013 WL 6134150 (Ky. 2013).  A motion for reconsideration in Ballard was denied on June 19, 2014, and that decision is now final. Hence the suggestion in Davis that a fiduciary duty is owed directly to the owners should be treated as moot.

The Importance of Maintaining Correct Registered Office/Registered Agent Information

The Importance of Maintaining Correct Registered Office/Registered Agent Information

       A decision rendered by the Kentucky Court of Appeals last week reinforces the importance of maintaining current registered office/agent information with the Kentucky Secretary of State, as well as current principal place of business information.  In this instance, a corporation failed to satisfy each of these obligations.  Ultimately, it was saddled with a default judgment, which judgment was not set aside on the basis of “excusable neglect.”  Bradford White Corp. v. Kentucky Farm Bureau Ins. Co., No. 2013-CA-001549-MR (Ky. App. July 25, 2014) (Not to be published).

      Kentucky Farm Bureau Insurance brought a subrogation claim against Bradford White Corporation based upon a defective water heater that Bradford White had manufactured.  Bradford White is a Pennsylvania corporation qualified to transact business in Kentucky.

      Service was attempted on Bradford White not less than four times including at the registered office/agent it identified on its filings with the Pennsylvania Secretary of State and as well through the Kentucky Secretary of State via the registered office/agent identified on the Certificate of Authority.  All of these efforts were unsuccessful, the certified mail containing the summons and the complaint being in each instance returned as undeliverable.  The trial court issued a default judgment against Bradford White.  Ultimately, by some mechanism not recounted in the decision, Bradford White became aware of the default entered against it and sought to have the default judgment set aside on the basis of “excusable neglect.”

      The Court of Appeals, affirming the trial court on an abuse of discretion standard, was having none of an argument of “excusable neglect.”  Rather the Court of Appeals found that Bradford White had repeatedly failed to update its address, as well as its registered office/agent information, with the Pennsylvania and Kentucky Secretaries of State.  Ultimately:

Bradford White’s lack of actual knowledge [of the lawsuit] was not caused by the plaintiff, Secretary of State, or the post office.  Rather, it was caused by Bradford White’s willful ignorance or negligence.

       The lesson is simple – a company obligated to maintain registered office/agent information with the Secretary of State, as well as current information as to the principal place of business address, is rendering itself subject to a default judgment if it fails to do so.  The failure to keep those records current will not be a defense to the failure to receive actual notice of a suit.

      All that said, the Court of Appeals did somewhat (greatly) overstate the effect of a certain statute.  Essentially, the Court described the failure to maintain current registered office/agent and principal office address information as being “criminal,” citing KRS § 14A.2-030(2).  This is an overstatement of the statute.  That provision provides for misdemeanor treatment of the execution and delivery to the Secretary of State for filing of a document when it is known that the contents thereof are not true.  This provision applies only at the time information is filed; it is inapplicable to the obligation to keep information current.

Western District Considers Citizenship of a Donative Trust; Restricts Citizenship to that of the Trustees

Western District Considers Citizenship of a Donative Trust;

Restricts Citizenship to that of the Trustees

 

In a recent decision, the Judge Russell of the Western District considered how to assess, for purposes of diversity jurisdiction, the citizenship of a donative trust.  He determined that only the citizenship of the trustee, and not as well the citizenship of the trusts’ beneficiaries, would be pertinent.  Watkins v. Trust Under Will of William Marshall Bullitt, Civil Act. No. 3:13-CV-01113-TBR, 2014 WL 2981016 (W.D. Ky. July 1, 2014).

 

            Watkins, a beneficiary of the Bullitt Trust, brought suit on a number of grounds including breach of fiduciary duty and  against PNC Bank, the Trust’s trustee. PNC removed to federal court, and Watkins sought a remand, arguing that there should be attributed to the trust the citizenship of its Kentucky domiciled beneficiaries.  Were that done diversity would be lacking.  PNC argued that only the citizenship of the trustee should be considered in determining the trust’s citizenship.

 

            The Court began by reviewing the competing rulings of Carden v. Arkoma Associates, 494 US 185 (1990) (citizenship of an unincorporated association determined by reference to the citizenship of all of the members therein) and Navarro Savings Association v. Lee, 446 US 458 (1980) (in suit brought by trustees in their individual capacities, only the citizenship of the trustees would be relevant in determining citizenship) and noted that the subject trust was a traditional donative (and not a business trust).  From there Judge Russell determined that as the Bullitt Trusts lacks independence but is “dependent upon PNC to own and manage its property for the benefit of the beneficiaries,” only the citizenship of the trustees would be relevant.

 

            This holding is consistent with certain rulings of other courts while it is at the same time in opposition of other rulings – it does not appear that a majority rule has yet emerged.  Reviews of those other rules can be found HERE and HERE. 

Court of Appeals Refuses to Adopt Outsider Reverse Piercing

Court of Appeals Refuses to Adopt Outsider Reverse Piercing

      In a recent decision, the Court of Appeals rejected an effort by a judgment creditor to effect an outsider reverse pierce of a corporation in order to secure assets that would be applied to satisfy a debt of the sole shareholder. Williams Estate v. William C. Oates Estate, No. 2012-CA-000327-MR, 2014 WL 2937773 (Ky. App. June 27, 2014).

      Cecil Williams, in August, 1990, loaned $62,500 to William Oates. While the loan was unsecured, apparently Oates told Williams that he owned a piece of residential real estate. No mortgage was filed, however against that real estate. In actuality, Oates did not own the house; rather, it was owned by William C. Oates Realty Co., Inc., of which Oates was the sole shareholder. Oates never repaid Williams the borrowed $62,500. Ultimately, when Williams brought suit, he was awarded a default judgment. However, he was never able to collect thereon. That judgment was subsequently renewed so that it would not become subject to the 15 year statute of limitations of KRS § 413.090. Ultimately the corporation was administratively dissolved after Oates' death, and its assets were distributed to Oates’ heirs. In turn, Williams sought to recover those assets from the heirs in order to satisfy the debt.  In addition, Williams sought to have the corporate existence set aside ab initio, thereby treating the corporation's assets as those of Oates individually.

      Both of these arguments were rejected.

      With respect to the suggestion that the corporation had never really existed, the court relied upon KRS § 271B.2-030(1), which provides that the existence of the corporation begins when the articles of incorporation are filed with the Secretary of State. The court noted as well that the corporation had filed, for several years, the necessary annual reports with the Secretary of State, and tax returns had been filed.  From this the court determined that the corporation had “established its corporate existence.”

      Turning to the effort to pierce the veil, the court noted that the plaintiff was attempting to do a “reverse pierce.” Citing Turner v. Andrew, 413 S.W.3d 272, 277 (Ky. 2013), “reverse piercing” was described as “a theory in which the creditor of an individual who was the sole member of the corporation seeks to pierce the veil to obtain corporate assets to satisfy the member’s personal debt.” It was notes as well that the Turner court had stated that it is unclear whether Kentucky recognizes reverse piercing.  In this decision, the Court observed that the plaintiff had failed “to provide any thoughtful insights were compelling arguments as to why this concept should be adopted in the Commonwealth.”

       Last, and perhaps alluding to the rule of White v. Winchester Land Development that contractual creditors are in the position to protect themselves by contract, it was observed that “a loan for the sum of money at issue should have been secured when it was originally made.”

Kentucky Ban on Same-Sex Marriage Held Unconstitutional

Kentucky Ban on Same-Sex Marriage Held Unconstitutional

      By statute and Constitution, Kentucky has laws providing, inter alia, that it will not recognize same-sex marriages performed in other states and that same-sex marriages may not be performed in Kentucky.  Earlier this year, Judge Heyburn declared unconstitutional that aspect of Kentucky law providing that Kentucky will not recognize same-sex marriages performed in other jurisdictions.  That decision is currently being appealed to the Sixth Circuit Court of Appeals in concert with similar rulings from other states throughout the Sixth Circuit. 

      Since Judge Heyburn’s initial decision, additional Plaintiffs have joined the case.  Specifically, these new Plaintiffs desire to be married in Kentucky; they are not married under the laws of any foreign jurisdiction.  Yesterday, Judge Heyburn held that those aspects of Kentucky law precluding a same-sex marriage are unconstitutional.  Ergo, Kentucky has no legitimate basis for denying marriage licenses to same-sex couples.  The issuances of those marriage licenses will not, however, commence immediately; Judge Heyburn has stayed his ruling until the Sixth Circuit can consider the issue.

       Of concern primarily to attorneys involved in due process analysis, Judge Heyburn did not find that sexual orientation creates a protected class.  Rather, it was not ultimately necessary to engage in that analysis as under even the highly differential rational basis analysis, the prohibition of marriage licenses to same-sex couples failed: “Kentucky’s laws banning same-sex marriage cannot withstand Constitutional review regardless of the standard.  The Court will demonstrate this by analyzing Plaintiffs’ challenge under rational basis review.” Slip op. at 14.

      Before Judge Heyburn (and as well argued to the Sixth Circuit), the state of Kentucky has argued that restricting marriage to heterosexual couples insures a balanced birthrate, that being necessary for Kentucky’s long term economic viability.  This argument has been widely lampooned, including HERE. 

      In response, the Court wrote:

This Court will begin with Defendant’s only asserted justification for Kentucky’s laws prohibiting same-sex marriage: “encouraging, promoting, and supporting the formulation of relationships that have the natural ability to procreate.”  Perhaps recognizing that procreation-based arguments have not succeeded in this Court, nor any other Court post-Windsor, Defendant adds a disingenuous twist to the argument:  traditional marriages contribute to a stable birth rate which, in turn, ensures the state’s long-term economic stability. 

These arguments are not those of serious people.  Though it seems almost unnecessary to explain, here are the reasons why.  Even assuming the state has a legitimate interest in promoting procreation, the Court fails to see, and the Defendant never explains, how the exclusion of same-sex couples from marriage has any affect whatsoever on procreation among heterosexual spouses.  Excluding same-sex couples from marriage does not change the number of heterosexual couples who choose to get married, the number who choose to have children, or the number of children they have.  The Court finds no rational relation between the exclusion of same-sex couples from marriage and the Commonwealth’s asserted interest in promoting naturally procreative marriages.  Slip op. at 15.

He went on to observe “that Kentucky’s laws do not deny licenses to other non-procreative couples reveals the true hypocrisy of the procreation-based argument.” Slip op. at 16.

      Responding to the likely suggestion by some that allowing same-sex marriage in some manner impinges upon their rights, Judge Heyburn wrote:

Sometimes, by upholding equal rights for a few, Courts necessarily must require others to forebear some prior conduct or restrain some personal instinct.  Here, that would not seem to be the case.  Assuring equal protection for same-sex couples does not diminish the freedom of others to any degree.  Thus, same-sex couples’ right to marry seems to be a uniquely “free” constitutional right.  Hopefully, even those opposed to or uncertain about same-sex marriage will see it that way in the future.  Slip. op at 19.

      From there Judge Heyburn delivered the punch line, namely:

IT IS HEREBY ORDERED THAT to the extent Ky. Rev. Stat. §§ 402.005 and .020(1)(d) and Section 233A of the Kentucky Constitution denies same-sex couples the right to marry in Kentucky, they violate the Equal Protection Clause of the Fourteenth Amendment to the United States Constitution, and they are void and unenforceable. 

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.”

 

A Pair of Recent Equine Dispute Decisions Illuminate Principles of Contract, Agency and Fiduciary Duty Law

A Pair of Recent Equine Dispute Decisions Illuminate Principles
of Contract,  Agency and Fiduciary Duty Law

      A pair of May, 2014 decisions, while themselves not inter-related, provide a litany of useful direction on numerous points of contract, agency and fiduciary duty law.  Crestwood Farm Bloodstock v. Everest Stables, Inc., __ F.3d __, 2014 WL 1856697 (6^th Cir. May 9, 2014); James T. Scatuorchio Racing Stable, LLC v. Walmac Stud Management, LLC, 2014 WL 2116096 (E.D. Ky. May 20, 2014).  As a concession to the brevity of life, this review will focus upon the legal rules explicated in the decisions and skip their tortured factual background.

The Covenant of Good Faith and Fair Dealing

      Every contract includes an implied covenant of good faith and fair dealing, it imposing an affirmative obligation “to do everything necessary to carry [the agreement] out.”, Ranier v. Mt. Sterling Nat. Bank, 812 S.W.2d 154, 156 (Ky. 1991); Ram Eng’g & Constr., Inc. v. Uni. of Louisville, 127 S.W.3d 579, 585 (Ky. 2003), and a negative burden to not act to “prevent [ ] the creation of the condition under which payment would be due.”  Oden Realty Co. v. Dyer, 45 S.W.2d 838, 840 (Ky. 1932). Crestwood Farm, 2014 WL 1856697, *8; Scatuorchio, 2014 WL 2113096, *8.

      In the Crestwood case, Everest directed Crestwood to sell certain horses at auction with no reserve.  Crestwood did so.  Everest “planted a separate agent at the auction (without Crestwood’s knowledge)” who sought to raise the price by bidding against the unrelated bidders.  Effectively, Everest set a reserve on the auction.  Crestwood 2014 WL 1856697, *1.  Everest argued that it did not violate the agreement in that it was Crestwood who was barred from setting a reserve.  Id. at *8.  The Court found this conduct to violate the obligation of good faith and fair dealing, consequent to which Crestwood was entitled to $219,513.89, that being what would have been its share of the sale proceeds of the failed high bid.

      At the same time the implied covenant will not supersede the express terms of the agreement.

But the “implied covenant of good faith and fair dealing does not prevent a party from exercising its contractual rights.”  Farmers Bank & Trust Co. v. Willmott Hardwoods, Inc., 171 S.W.3d 4, 11 (Ky. 2005); see also Hunt Enters. v. John Deere Indus. Equip. Co., 18 F.Supp.2d 697, 700 (W.D. Ky. 1997) (the covenant of good faith and fair dealing, “does not preclude a party from enforcing the terms of the contract….  It is not ‘inequitable’ or a breach of good faith and fair dealing in a commercial setting for one party to act according to the express terms of a contract for which it bargained”).  Put another way, “a party’s acting according to the express terms of a contract cannot be considered a breach of the duties of good faith and fair dealing.”  Big Yank Corp. v. Liberty Mut. Fire Ins. Co., 125 F.3d 308, 313 (6^th Cir. 1997). 

Scatuorchio, 2014 WL 21113096, *8.

      On that basis, the claim that a fee determined in accordance with a formula in the subject agreement could not be challenged a violating the implied covenant.  Rather, “the plaintiffs may not at this time re-write the unambiguous, agreed-upon language of the SHLA under the guise of the implied covenant of good faith and fair dealing.”  Scatuorchio, 2014 WL 211096, *9.

      Another important point is that the implied covenant does not serve to preclude self-dealing conduct, but rather only police it at the margins by protecting the express contracted terms.

As to allegations that “constitute self dealing,” a party may act in its own interest and not breach the covenant of good faith and fair dealing, as long as its discretion is not used in a way that is contrary to the spirit of the agreement. 

Scaturochio, 2014 WL 2113096, *9.

      Where, as in this case, the plaintiff was unable to show the defendant “acted in bad faith, or in an arbitrary, capricious, or unreasonable manner,” the use of contractually afforded discretion would not be second-guessed. 

Fiduciary Relationships

      Both Courts highlighted the necessary and high thresholds for the creation of a fiduciary relationship, essentially the agreement by the fiduciary to act for the benefit of the other even if doing so is to the detriment of the fiduciaries’ interest.  In Crestwood the plaintiffs sought to leverage facts including the principal’s failing health and a long course of business into a fiduciary relationship.  The Court disagreed, holding that: 

That the two were friends, even close friends, may well explain why they did business together.  But that does not establish a fiduciary relationship – that Crestwood was charged with putting Everest’s interests above its own.  Many friends do business together.  But not all friends are fiduciaries, and in the world of arms-length commercial negotiations few are.  See, e.g., Sallee, 286 F.3d at 891-92 (“[T]he fact that the relationship has been a cordial one, of long duration, [is not] evidence of a [fiduciary] relationship.”  (internal quotation marks omitted)); 90 C.J.S. Trusts § 197 (“The mere existence of mutual respect and confidence does not make a business relationship fiduciary.”)

Crestwood, 2014 WL 1856697, *5. 

      Setting forth a tour-de-force recitation of the elements of a fiduciary relationship, the Scatuorchio Court, at 2014 WL 2113096, *12, wrote:

            Under Kentucky law, to establish the existence of a fiduciary duty, a party must demonstrate that: (i) the parties’ relationship existed prior to the transaction that is subject of the claim; (ii) the reliance was not merely subjective but reasonable; and (iii) the nature of the relationship imposed a duty upon the fiduciary to act in the principal’s interest, even if such action were to the detriment of the fiduriary.  In re Salle, 286 F.3d at 892; Ballard v. 1400 Willow Council of Co-Owners, Inc., No. 2010-SC-533-DG, 2013 Ky. LEXIS 579, at *33-35 (Ky. Nov. 21, 2013).  A fiduciary duty requires more than the generalized business obligation of good faith and fair dealing.  See In re Salle, 286 F.3d at 891; see also Gresh v. Waste Servs. of Am., 311 F. App’x 766, 771 (6^th Cir. 2009); Quadrille Bus. Sys. v. Ky. Cattlemen’s Ass’n, 242 S.W.3d 359, 365 (Ky. Ct. App. 2007) (“An ordinary business relationship or an agreement reached through arm’s length transactions cannot be turned into a fiduciary one absent factors of mutual knowledge of confidentiality or the undue exercise of power or influence.”  (quotation marks and citation omitted)).  “Only in rare commercial cases is it reasonable to believe the other party will put your interests ahead of their own.”  In re Salle, 286 F.3d at 892.  Rather, “extraordinary facts are necessary” to support such a believe.  Id.; see also Crestwood Farm Bloodstock v. Everest Stables, Nos. 13-5688/13-5689, 2014 U.S. App. LEXIS 8751, at * 14-15 (6^th Cir. May 9, 2014). 

      Where “commercially sophisticated parties enter into arm’s-length business agreements” that do not “expressly or impliedly contain any provision supporting the creation of a fiduciary relationship” or indicate that one party has agreed to act primarily in the interest of others to its own detriment,” no fiduciary relationship will be found. 

The Principal-Agent Contract Controls

            Everest alleged that Crestwood had violated certain duties imposed by agency law by not maximizing the value of the horses sold, including by not setting reserves.  In that Crestwood was barred by the written agreement from setting reserves, the Court found Everest’s objection to be without merit. 

            Where a contract exists defining the scope of the principal-agent relationship ...  the existence and extent of the agent’s duties are determined by the agreement between the parties.”  Monumental Life Ins. Co. v. Nationwide Retirement Solutions, Inc., 242 F.Supp.2d 438, 449 (W.D.Ky.2003) (applying Kentucky law); Restatement (Second) of Agency § 376. 

Crestwood, 2014 WL 1856697, *6. 

Takeaways

            A few takeaways:

·         the implied covenant of good faith and fair dealing with not alter express contractual obligations;

·         the obligations of an agent to a principal are determined first by reference to their express agreement and only thereafter by reference to general agency law; and

·         commercial relationships will almost never be fiduciary in nature.