April 2006 — Issue 3

Douzinas v. American Bureau of Shipping, Inc.,

888 A.2d 1146, C.A. No. 1496-N (Del. Ch. 2006)

The minority members of a Delaware LLC sued the majority member and its affiliates for diverting assets of the LLC to the majority member’s affiliates without compensation to the LLC. The defendants sought to compel the minority members to arbitrate their claims pursuant to a broad arbitration clause in the LLC agreement, and the court found the arbitration clause encompassed the minority members’ claims. The court first observed that a Texas choice of law clause in the operating agreement created “the odd situation where the parties to an LLC domiciled in Delaware chose to have their LLC Agreement governed by another state’s law, except when the Delaware LLC Act requires the application of Delaware law.” The court concluded the choice of law provision was valid because Delaware respects choice of law provisions when the chosen law has a material relationship to the matter at issue, a requirement that was satisfied because the LLC operated out of Texas. The court did not attempt to parse the differences between Texas and Delaware law because the parties agreed there was no material difference between the two states’ laws regarding the issues before the court. The court relied upon the Delaware Supreme Court’s decision in Elf Atochem North America, Inc. v. Jaffari in concluding the arbitration clause encompassed the minority members’ claims. In that case, the court held that a broad arbitration clause in an LLC agreement could encompass breach of fiduciary duty claims. The court distinguished Delaware case law from the corporate context and noted that it is frequently impossible to decide fiduciary duty claims in alternative entity cases without close examination and interpretation of the governing instrument because the Delaware alternative entity statutes permit the contracting parties to expand or restrict fiduciary duties. The LLC agreement in the instant case contained a provision stating that the relationship was strictly contractual and that no member owed the LLC or any other member a fiduciary duty. The minority member argued the clause was not relevant to its claims against the majority member acting as manager, but the court disagreed. The court looked at the governance provisions to determine that provisions of the LLC agreement would need to be carefully considered and interpreted in connection with the minority members’ claims. The court also pointed out provisions addressing confidentiality of information and proscriptions on competition. The minority members’ claims were thus within the scope of the arbitration clause, which encompassed “any dispute arising under or related to” the LLC agreement. The court held the non-signatory affiliates of the majority member were entitled to enforce the arbitration clause under an equitable estoppel theory.

DeLucca v. KKAT Management, L.L.C.

No. Civ.A. 1384-N, 2006 WL 224058 Del. Ch.(Jan. 23, 2006)

The court determined that the broadly worded advancement provisions contained in the operating agreements of several Delaware LLCs (the “KKAT Companies”) required advancement of DeLucca’s expenses in litigation brought against DeLucca by affililates of the KKAT Companies. DeLucca was a former employee and principal of an LLC (“Katonah”) that acted as investment manager of structured investment funds (the “Katonah Funds”) in which the KKAT Companies invested. The controlling owner of Katonah was yet another LLC (“Kohlberg”). In the KKAT Companies’ operating agreements, the KKAT Companies agreed to indemnify affiliates of Kohlberg for any loss “in connection with or arising out of or related to” the operating agreement, the operations or affairs of a KKAT Company or Katonah Fund, or the operations or affairs of Kohlberg if the loss was attributable to a KKAT Company or Katonah Fund so long as the affiliate did not act with fraud or gross negligence or willfully violate the law. The KKAT Companies promised advancement as to any claim that might give rise to indemnification. In a lengthy opinion that analyzes the provisions of the operating agreements in detail, the court rejected the arguments of the KKAT Companies that they were not obligated to advance expenses to DeLucca. The court characterized the dispute over advancement as “yet another case in which defendants in an advancement case seek to escape the consequences of their own contractual freedom.” The complaint against DeLucca alleged that she engaged in various acts of misconduct in pursuit of a scheme to seize control of Katonah’s assets for her own benefit. The court noted that the provisions of the operating agreements differed from the typical advancement clause in the corporate context because the corporate provisions typically track the corporate statutes, which provide for advancement where the corporate official is being sued by reason of the fact that he or she took action in an official capacity. The provisions in the operating agreements in this case did not contain language limiting advancement to cases in which the indemnified person is sued by reason of having acted in an official capacity. The court analyzed the terms of the operating agreements to determine whether DeLucca was an “Indemnified Person” and found that she clearly fell within the scope of that term as defined in the operating agreements. The court next concluded DeLucca was incurring legal expenses and that her losses were being incurred in connection with claims for which advancement was owed. The right to advancement extended to any matter that may result in indemnification, and indemnification was broadly provided for losses “in connection with or arising out of or related to” the operating agreements. The court rejected the argument that the scope of the indemnification clause was limited by an exculpation clause in the operating agreements. The court also rejected the argument that a broad interpretation of the indemnification and advancement provision was absurd and could not have been intended by the KKAT Companies. The court discussed why a rational controller of an investment fund complex might find such a broad indemnification and advancement clause prudent and noted that DeLucca would, under the terms of the operating agreements, be obligated to return the advanced funds if a court determined in a final decision that her losses were the result of fraud, gross negligence, or willful violation of law. The court also addressed language that required an indemnified person to first seek indemnification from the Katonah Funds and concluded that DeLucca was not required to assert the discrete right of advancement against the Katonah Funds when there was no explicit requirement to that effect or any indication that DeLucca had any right of advancement from the Katonah Funds. Finally, the court concluded that DeLucca was entitled to an award of fees on fees incurred in enforcing her right to advancement.

In re Delta Star Broadcasting, L.L.C.

No. Civ.A. 05-2783, 2006 WL 285974 (E.D. La. Feb. 6, 2006)

Three individuals each owned a 1/3 membership interest in a Lousiana LLC, and one of the members (Bruno) filed a voluntary Chapter 11 bankruptcy petition on behalf of the LLC. Bruno argued he was authorized to file the petition because his action was approved by two of the three members (Bruno and Treen). Treen’s approval was evidenced by a consent signed by Treen the day before the bankruptcy filing. The third member (Starr) argued that Treen had transferred his membership interest to an entity controlled by Starr eleven days prior to the filing of the bankruptcy and that Treen’s consent to the bankruptcy filing was thus ineffective. Starr further argued that the bankruptcy filing was ineffective even if Treen remained a member after the transfer of his interest because the bankruptcy filing was not approved at a properly-noticed meeting of the LLC’s members. The bankruptcy court held that the filing was not authorized because it was not approved by a formal resolution at a meeting of the members. The district court held that the bankruptcy judge erred in finding the bankruptcy filing was not properly authorized. The court first discussed the effect of the transfer of Treen’s membership interest and concluded that Treen retained his right to vote as a member after the transfer of his membership interest because the Louisiana LLC statute provides that the assignor remains a member unless and until the assignee is admitted as a member, which requires unanimous consent of the other members. The court next considered the validity of the authorization of the bankruptcy filing and concluded that an LLC’s petition in bankruptcy must be authorized by a majority of the members unless the articles of organization or operating agreement provide otherwise. The court relied upon the statutory provision requiring a majority of the members to authorize “the sale, exchange, lease, mortgage, pledge, or transfer of all or substantially all of the assets of the limited liability company.” The court noted that neither the statute nor the LLC’s governing documents contained any express requirement that member decisions be made by resolution or at formal meetings. The court noted the paucity of case law interpreting the Louisiana LLC statute but pointed to secondary authorities emphasizing the flexibility and informality of the LLC as compared to a traditional business corporation. The court concluded the Louisiana legislature could easily have imposed more formal decision making procedures on LLCs if it had intended to impose such requirements. The court observed that the legislature had done just that in providing for removal of a manager only “at a meeting expressly called for that purpose.” According to the court, that provision suggested that the omission of formal requirements elsewhere in the statute was intentional.

Lio v. Zhong

10 Misc.3d 1068(A), No. 600455/05, 2006 WL 37044 (N.Y. Sup. Jan. 6, 2006)

The plaintiff, a member of a New York LLC, sued the other two members alleging claims of breach of fiduciary duty, waste, mismanagement, conversion, and an accounting. The plaintiff also sued the spouse of one of the members for tortious interference with prospective economic advantage and sued an attorney for conversion and aiding and abetting a breach of fiduciary duty. The court first discussed the failure of the New York LLC statute to address derivative actions and concluded that the omission was deliberate and precludes member derivative suits. The court held, however, that managing members owe statutory and common law fiduciary duties that give rise to a personal claim on the part of a member. The court found that the plaintiff’s claim for usurpation of a business opportunity supported a breach of fiduciary duty claim by the plaintiff. The operating agreement identified the purpose of the LLC as the development of a specific piece of property, and the defendant members argued their purchase of another piece of property was not within the LLC’s purpose. The court pointed out that the operating agreement gave the LLC the power to purchase other real estate that may be “necessary, convenient, desirable or incidental” to accomplish its purpose. Further, the operating agreement contained restrictions on competition and conflicting business ventures. The court also pointed to the fiduciary duties traditionally applied in other business contexts with respect to business opportunities, citing Meinhard v. Salmon. The court found no basis for a breach of a fiduciary duty claim in connection with failed buy-out negotiations among the members, concluding the negotiations were simply an attempt to settle the differences that had arisen. The plaintiff’s mismanagement claims withstood dismissal notwithstanding the defendants’ argument that they were protected by the business judgment rule. The court acknowledged that the business judgment rule may ultimately provide the defendants protection, but stated the rule did not require dismissal at the pleading stage. The court noted that the allegations referred to conduct outside the scope of protection of the business judgment rule, such as the allegation that one of the defendants hired employees away from the LLC for her own business dealings. The court recognized the plaintiff’s right as a member to bring an action for an accounting based on the alleged breach of fiduciary duty of the managing members, but dismissed the plaintiff’s other claims. The court concluded that the plaintiff’s cause of action for waste was subsumed within the plaintiff’s first cause of action for breach of fiduciary duty to the extent it was a personal claim, and it could not be derivatively asserted by the plaintiff to the extent it represented rights of the LLC. The court found the plaintiff’s claim for gross mismanagement was a breach of fiduciary duty claim subsumed in the plaintiff’s cause of action for breach of fiduciary duty. The court concluded the plaintiff’s claims for conversion and tortious interference with prospective economic advantage related to rights belonging to the LLC and could not be asserted by the plaintiff. The court also dismissed the plaintiff’s claims against an attorney. The attorney had represented the LLC, one of the defendant members, and the defendant member’s spouse at various points, but the attorney never represented the plaintiff and did not have a duty to the plaintiff personally. The court acknowledged that a third party may have aiding and abetting liability where the third party knowingly participates in a breach of fiduciary duty by providing substantial assistance to the violator; however, the court held the plaintiff’s allegations against the attorney did not state a claim in this regard.

Kandi v. United States

No. C05-0840C, 2006 WL 83463 (W.D. Wash. Jan. 11, 2006)

A single member LLC incurred employment taxes, and the IRS sought to collect payment of the taxes from the sole member of the LLC. The IRS argued that the member was the employer for employment tax purposes because the LLC was a disregarded entity under the check-the-box regulations. After the parties had submitted their original motions and cross motions for summary judgment, the IRS issued proposed regulations reversing its position that an owner of a single member LLC is personally liable for the LLC’s employment tax liability. The IRS proposal specifically provided that the change would not take effect until the regulations became final, but the petitioner argued that not applying the regulation retroactively would be an abuse of discretion. The court found that the refusal to apply the regulations retroactively was not an abuse of discretion and that the current regulations rather than the proposed regulations governed the petitioner’s case. The court agreed with the IRS’s position that disregarding the separate existence of a single member LLC for “federal tax purposes” includes employment tax purposes and makes the employment taxes a member liability that is properly assessable against the member. The court found no textual support for the petitioner’s argument that the check-the-box regulations affect only the assessment of income taxes. The court also rejected the argument that the IRS’s interpretation strips the sole member of an LLC of the limited liability provided under state law. The court concluded that the employment tax liability in the case of a disregarded LLC is the member’s liability ab initio and is never attributable to the LLC. The court noted that the sole member has an election regarding its treatment and that any personal tax liabilities resulting from the failure to elect corporate treatment are attributable to the member’s choice rather than any attempt by the IRS to pierce the LLC veil.

Maupin v. Meadow Park Manor

329 Mont. 413, 125 P.3d 611 (Mont. 2005)

Venue; LLP as “same entity that existed before registration”.

Trage v. 311 Meridian

__ So.2d __, No. 3D05-1890, 2006 WL 783440 (Fla. App. 2006)

Lack of authority of non-managing member.

Johnson v. Columbia Properties Anchorage, LP

437 F.3d 894, Nos. 04-35592, 04-35671 (9th Cir. 2006)

Citizenship of LLC for diversity jurisdiction purposes.

Pramco, LLC v. San Juan Bay Marina, Inc.

435 F.3d 51, No.04-1410 (1st Cir. 2006)

Citizenship of LLC for diversity jurisdiction purposes.

Sakata v. Cook

No. F046552, 2006 WL 164915 (Cal. App. Jan. 24, 2006)

Common law alter ego doctrine as applied to LLCs under California LLC statute.

Willie Gary LLC v. James & Jackson LLC

No. Civ.A. 1781, 2006 WL 75309 (Del. Ch. Jan. 10, 2006)

Limitations on scope of arbitration clause in LLC operating agreement.

International Paper Co. v. Cohen

126 P.3d 222, No. 04CA0314 (Colo. App. 2005)

Sales tax on transfer by corporation to LLC subsidiary.

Screen Tech, Inc. v. Carolina Precision Plastics, LLC

No. 3:05CV975(SRU), 2006 WL 197360 (D. Conn. Jan. 25, 2006)

Application of Connecticut foreign partnership long arm statute to foreign LLCs.

Walker v. Maddox

No. CV020391455S, 2006 WL 224112 (Conn. Super. Jan. 4, 2006)

Limited liability of LLC member; member’s liability for member’s own negligence.

FPJ Investements, LLC v. Ameritex, LLC

No. CV054011052S, 2005 WL 3624389 (Conn. Super. Dec. 8, 2005)

Attorney disqualification.

Vasudevan v. Pragosa

No. HHDCV054012416, 2006 WL 328367 (Conn. Super. Jan. 23, 2006)

Limited liability of LLC member.

In re Air Safety International, L.C.

336 B.R. 843, No. 05-80642-CIV (S. D. Fla. 2005)

Existence of administratively dissolved Florida LLC.

Mroz v. Hoaloha Na Eha, Inc.

410 F.Supp.2d 919, No. Civ. 04-00078 ACK/KS (D. Hawaii 2005)

Fiduciary duties of majority owners and member-managers of LLC; wrongful termination of employment of LLC member.

JP Morgan Trust Company, National Association v. Mid-America Pipeline Company

413 F.Supp.2d 1244, No. 05-2231 JWL (D. Kan. 2006)

Effect of conversion of Delaware corporation to Delaware LLC for purposes of pending lawsuit against corporation.

Northeast Realty, L.L.C. v. Misty Bayou, L.L.C.

920 So.2d 938, No. 40,573-CA (La. App. 2006)

Standing of LLC members; LLC property.

MaryCLE, LLC v. First Choice Internet, Inc.

166 Md. App. 481, 890 A.2d 818, No. 2321, Sept. Term 2004 (Md. App. 2006)

Personal liability of LLC officers and agents for participation in violations of electronic communications act.

Kent Tillman, LLC v. Tillman Construction Co.

No. 263232, 2006 WL 143289 (Mich. App. Jan. 19, 2006)

Interpretation of LLC operating agreement provisions on sharing of profits and losses, distributions, reimbursement, expenses, and indemnification; effect of integration clause; interpretation of “willfully unfair and oppressive conduct” as defined by Michigan LLC act.

Prime RX, LLC v. McKendree

917 So.2d 791, No. 2004-CA-01761-SCT (Miss. 2005)

Liability of sole member of LLC on pre-formation contract entered as sole proprietor.

JTL Consulting, L.L.C. v. Shanahan

__ S.W.3d __, Nos. ED 85578, ED 86054, 2006 WL 162745 (Mo. App. 2006)

Binding effect of operating agreement on LLC member; enforceability of nonsolicitation clause in operating agreement.

Wallace v. Hayes

124 P.3d 110, No. 04-755 (Mont. 2005)

Authority to award exemplary damages in arbitration.

Kaufman v. Maresca

Mon-C-335-04, 2005 WL 3577701 (N.J. Super. A.D. Jan. 3, 2006)

Scope of arbitration clause in operating agreement.

Melcher v. Apollo Medical Fund Management, L.L.C.

25 A.D.3d 482, 808 N.Y.S.2d 207 (N.Y. A.D. 1 Dept. 2006)

Scope of Delaware choice of law clause in LLC operating agreement; wrongful removal of manager; applicability of indemnification clause; scope of exculpation clause under Delaware LLC law.

Cortellesso v. Town of Smithfield Zoning Board of Review

888 A.2d 979, No. 2005-21-Appeal (R.I. 2005)

Lack of standing of LLC’s sole member to appeal zoning decision on property conveyed to LLC.

In re JNS Aviation, LLC

334 B.R. 202, No. 04-21055-RLJ-7 (Bankr. N.D. Tex. 2005)

Standing of LLC members to object to claim.

Brew City Redevlopment Group, LLC v. Ferchill Group

__ N.W.2d __, No. 2004AP3238, 2006 WL 327939 (Wis. App. Feb. 14, 2006)

Limited liability of LLC members.