April 2009 — Issue 38

LLP Cases: Evanston Insurance Company v. Chargois & Ernster, LLP,

Civil Action No. H-03-4888, 2009 WL 490013 (S.D. Tex. Feb. 25, 2009).

Chargois and Ernster registered their law firm as an LLP in 2002. In 2003 Dillard Departments Stores, Inc. (“Dillard’s”) sued the firm for trademark infringement. Later in 2003, the firm’s insurer brought suit against the partners and Dillard’s for indemnity, and Dillard’s cross-claimed against the firm. In 2004, Chargois withdrew from the firm, and the partners dissolved the firm through a separation agreement but did not wind it up. The assets and liabilities were managed as they had been previously. By the summer of 2004, the firm’s LLP registration had expired. In the fall of 2004, Dillard’s was awarded attorney’s fees and expert fees on its claim against the firm. After being unable to collect the debt, Dillard’s brought a third party complaint against the partners individually for enforcement of the earlier judgment. Dillard’s claimed that when the firm’s LLP registration expired in 2004, the firm lapsed into a general partnership under the common names of Chamois and Ernster, and, because the partners continued to control the assets and kept them from creditors, they became general partners. Dillard’s argued that Chargois and Ernster knew that the firm had never paid the judgment in favor of Dillard’s and were, therefore, jointly and severally liable for the firm’s debts. Ernster and Chargois argued that they were not responsible for the firm’s debt to Dillard’s because the debt was incurred at the time of the tort (i.e., infringement of the Dillard’s mark) in 2003 when the firm was an LLP, not when the judgment was entered in 2004. The court stated that there is a responsibility to maintain the legal fiction in order to receive the benefits of an LLP. The court gave an example in which it stated that an LLP might fail to keep up formalities and continue doing business under an assumed name, in which case the partners will be directly responsible for all liabilities under the assumed name. If, however, the partners in an LLP quit doing business after disregarding corporate formalities, the court stated that the partners would not be responsible for the liabilities of the business. The court stated that when the “limited-liability entity of Chargois & Ernster, LLP, died in early 2004, all of its protection died with it.” By not winding up the business at dissolution and continuing the business under the assumed name of the firm, the court stated that the partners became joint obligors. By controlling and using the assets of the firm– such as contingent fee cases–instead of discharging obligations to the firm’s creditors–such as Dillard’s–the court said the partners continued the partnership as general partners. The court stated that the firm “lost its authority as a distinct juridical entity, and they had essentially ratified the firm’s debts.” As obligors of the debts of the partnership, the court concluded that Chargois and Ernster were each responsible “for what they had not closed properly. Otherwise, no one would be responsible for the debts of an illegitimate yet fully operating corporation.” The court cited provisions of the Texas Revised Partnership Act requiring winding up and the application of partnership property to discharge obligations to creditors and imposing joint and several liability on partners. The court rejected limitations and due process arguments made by the partners. The court stated that limitations against the partners began to run when the final judgment was entered, and Chargois and Ernster were not deprived of due process by not being separately represented in the underlying litigation. As obligors, the court stated that they could not sit idly on the sidelines while their partnership’s debt was being litigated and then later complain that they had no opportunity to be heard. They were served with process in the new proceeding, appeared, asserted their defenses, and were afforded hearings. Thus, the court concluded that the judgment in favor of Dillard’s could be enforced against Chargois and Ernster.

LLC Cases: Spellman v. Katz

C.A. No. 1838-VCN, 2009 WL 418302 (Del. Ch. Feb. 6, 2009).

Two doctors, Spellman and Katz, each owned a 50% interest in a Delaware LLC formed for the purpose of constructing an office building in which the parties leased space for their joint medical practice. After their relationship deteriorated, Spellman left to practice on his own and the two were unable to agree on how to become disentangled from each other. Spellman eventually sought a judicial dissolution of the LLC pursuant to the Delaware LLC statute or an order appointing a liquidating trustee to effectuate the winding up of the LLC because the LLC had allegedly already dissolved by express will of its members pursuant to the LLC agreement. The LLC agreement provided that the LLC “shall be dissolved and its affairs wound up as soon as possible after the construction of the building had been completed, the condominium documents have been finalized and a certificate of occupancy has been issued with respect to each condominium unit . . . .” Neither member disputed that each of the preconditions to dissolution set forth in the LLC agreement had been satisfied, but Katz argued that the dissolution and winding up of the LLC was improper because the LLC agreement did not accurately reflect the original intentions of the parties regarding dissolution. Katz asserted that neither party knew that this provision was part of the LLC agreement and that the parties intended to operate the LLC for at least as long as the mortgage’s interest obligation and real estate tax benefits remained available to offset profits from the practice. In support of this position, Katz pointed to the failure of either party to pursue the dissolution and winding up of the LLC following the completion of the construction of the building. Applying contract construction principles to the LLC agreement, the court concluded that the agreement was unambiguous and should be enforced in accordance with its terms. Because the LLC agreement was unambiguous on its face, the parol evidence rule precluded outside evidence to dispute its terms. Accordingly, the court held that the LLC had been dissolved by express will of its members under LLC agreement and winding up of its affairs was necessary. With respect to Spellman’s request for the appointment of a liquidating trustee pursuant to the Delaware LLC statute, the court held that there was cause for appointment of such a person because the parties were deadlocked on how to proceed with the winding up of the LLC and were not able to implement the winding up provisions of the LLC agreement. Katz asserted a derivative counterclaim alleging that Spellman had breached his fiduciary duties to the LLC by refusing to participate in the refinancing of the building’s mortgage. Spellman sought dismissal of the counterclaim based on Katz’s failure to adequately plead demand futility. Katz argued that demand futility was demonstrated because Spellman could veto any proposed action, and it would be futile to request Spellman’s permission for the LLC to sue Spellman. Noting that case law governing corporate derivative suits is equally applicable to suits on behalf of Delaware LLCs, the court stated that the mere threat of personal liability is insufficient to show a substantial likelihood of personal liability. To establish demand futility, Katz was required to (i) show a “substantial likelihood” of Spellman’s personal liability and (ii) plead “with particularity” the facts supporting his claim that there was a “substantial likelihood” of personal liability. The court stated that Katz had pleaded only the naked assertion of a breach of fiduciary duty and the counterclaim showed no more than a mere threat of personal liability. Thus, it was insufficient to satisfy the pleading requirements, and the motion to dismiss the counterclaim was granted.

Bushi v. Sage Health Care, PLLC

203 P.3d 694 (Idaho 2009)

Three psychiatrists who were members of a professional LLC formed under the Idaho Limited Liability Company Act became disillusioned with the fourth member, Bushi, because he was dating a nurse practitioner employed by the LLC. There was also an issue between the members regarding Bushi’s unauthorized use of the LLC’s line of credit for personal expenses. After a meeting at which the other members told Bushi they wanted him out because of his relationship with the nurse practitioner, Bushi became concerned about his future with the LLC and joined another psychiatry group. Bushi and the other members failed to agree regarding the terms of a buy-out of Bushi’s interest, and Bushi’s lawyer informed the other members that Bushi would continue as a member and retain his financial rights until a mutually acceptable dissociation and buy out agreement had been reached. The operating agreement provided that a member could be dissociated by a majority vote of the other members upon the happening of certain events (such as loss of the member’s license or conviction of a felony), none of which had occurred, but the operating agreement also provided that it could be amended with the consent of all but one member. The members other than Bushi voted to amend the operating agreement to require mandatory dissociation upon an affirmative vote by all but one of the members, and the members other than Bushi then voted to dissociate Bushi. Applying the formula in the operating agreement, the LLC’s accountant determined the value of Bushi’s interest, and the LLC tendered payment to Bushi, which he refused. Bushi filed suit asserting various claims including claims for breach of fiduciary duty and breach of the implied covenant of good faith and fair dealing. The trial court granted the other members’ motion for summary judgment, finding that the members did not breach their contract with Bushi by amending the operating agreement to allow his involuntary termination, that the members were entitled to summary judgment on Bushi’s claims against them for breach of the covenant of good faith and fair dealing and breach of fiduciary duty, and that the provisions on dissociation and valuation were clear and unambiguous and that the LLC’s valuation followed the provisions. On appeal, the supreme court upheld the trial court’s summary judgment against Bushi on the breach of implied covenant of good faith and fair dealing claim, but reversed the summary judgment on the breach of fiduciary duty claim. With respect to the breach of implied covenant of good faith and fair dealing claim, the court stated that contract terms are not overriden by the implied covenant of good faith and fair dealing, and Bushi could identify no specific term of the operating agreement that was breached by amending the agreement to involuntarily dissociate him. With regard to the breach of fiduciary duty claim, the court discussed the Idaho LLC statutes and stated that the original LLC statute (which is repealed effective July 1, 2010) identifies certain duties that members owe to one another, but does not use the term “fiduciary,” does not state that it is an exhaustive list, and does not address the conduct at issue in the case. In 2008, the legislature adopted the revised Uniform Limited Liability Company Act, which explicitly provides that members of an LLC owe each other the fiduciary duties of loyalty and care, but the LLC in this case was governed by the prior act because it was formed prior to July 1, 2008 and had not elected to be subject to the new act. The court stated that it appeared that a majority of courts considering the issue have concluded that members of an LLC owe one another fiduciary duties of trust and loyalty, and the court concluded that members of an LLC owe one another fiduciary duties under the original act because it provides that the principles of law and equity supplement the act unless displaced by particular provisions of the act. The court stated that whether a fiduciary duty has been breached is a question of fact and discussed case law from other jurisdictions illustrating that actions taken in accordance with the operating agreement can still be a breach of fiduciary duty if improperly motivated to obtain financial gain. If the members acted in bad faith in order to advance their personal financial interests, they would be liable to Bushi despite their technical compliance with the operating agreement. Drawing all reasonable inferences in Bushi’s favor, the court could not conclude that there was no genuine issue of material fact with regard to the members’ motivation in dissociating Bushi.

In re LmcD, LLC (Schwab v. Damenti’s, Inc.)

405 B.R. 555 (Bankr. M.D. Pa. 2009)

A master ice carver, McDonald, formed a Pennsylvania LLC for the purpose of showcasing the work of various ice artisans. The LLC incurred far more debt than revenue from admission fees and donations, and the LLC filed a Chapter 7 bankruptcy. The trustee sought to pierce the LLC veil and hold McDonald and his wife liable for the LLC’s debts. The trustee also sought to use veil piercing to hold a corporation owned by McDonald liable for the LLC’s debts. The LLC argued that the McDonalds and the LLC were alter egos of each other and that McDonald’s interest in the corporation, a restaurant, could be reverse pierced so as to hold the restaurant liable for the debts of McDonald. Additionally, the trustee relied on the single entity, or enterprise, theory to hold the restaurant liable for the LLC’s debts on the basis that they advanced the business of the LLC on a joint basis. The court noted that the Pennsylvania LLC statute makes clear that the equitable remedy of “piercing” is available with respect to an LLC, and the court analyzed the issues of undercapitalization, adherence to company formalities, intermingling of affairs, and use of the corporate form to perpetrate fraud in order to determine whether the McDonalds should be held liable for the LLC’s debts. The court found that the LLC was undercapitalized with an initial capital contribution of $25,000, but stated that undercapitalization was not alone dispositive. The court found that the LLC well-documented its fundamental dealings with the government based on the LLC’s certificate of organization, registration of fictitious name, application for employer ID number, bank account documentation, commercial lease, certificate of occupancy, food and beverage license, tax returns, and separate books. The court reviewed evidence of intermingling of McDonald’s personal and corporate affairs and concluded that there may have been intermingling of their identities, but there was no evidence of commingling of assets, financial records, or employees. The court also found that the facts showing that the McDonalds may not have run their businesses on a strictly separate basis did not amount to fraud that would overcome the presumption against piercing. The court next analyzed the same factors to determine whether reverse piercing of the restaurant was justified, and the court concluded that the evidence did not overcome the presumption against piercing in that regard. Finally, the court considered the trustee’s argument that the restaurant was liable for the LLC’s debts based on the single entity theory. The court noted that the theory has not yet been adopted in Pennsylvania, and the court stated that the Pennsylvania Supreme Court might be reluctant to adopt the theory, but the court also stated that the stage had been set to adopt the theory based on the Third Circuit’s consideration of reverse piercing under Pennsylvania law, which could lead to “triangular piercing” of commonly controlled entities. The court concluded, however, that the evidence did not satisfy the elements of the single entity theory so as to hold the restaurant liable for the LLC’s debts even assuming the Pennsylvania Supreme Court would accept the single entity theory.

Historic Charleston Holdings, LLC v. Mallon

673 S.E.2d 448 (S.C. 2009)

Mallon, Storen, and Historic Charleston Holdings (“HCH”), which was owned by Coker, formed Dixie Holdings, LLC (“Dixie), for the purpose of real estate development in Charleston. Mallon and HCH each owned 49.5% of Dixie, and Storen owned 1%. Mallon and HCH were also equal members in Dixie Developers, LLC (“Dixie Developers”), another real estate development company. In 1999, disputes regarding financial matters of Dixie arose, and the parties agreed that slaes proceeds would be held in escrow pending resolution of such matters. About this time HCH sold its interest in Dixie Developers to Mallon, giving Mallon 100% of that LLC. Dixie sold its remaining two properties, and Mallon placed the sales proceeds from one of the properties (“15 Felix”) in a new Dixie Developers account he had opened. Mallon refused HCH’s demands to place the sale proceeds from 15 Felix in an escrow account in Dixie’s name in accordance with the prior agreement. In 2002, Storen dissociated from Dixie, leaving Mallon and HCH with 50% each of that LLC. HCH filed suit against Mallon, Dixie, and Dixie Developers, individually and derivatively as a member of Dixie, seeking judicial dissolution of Dixie and a full financial accounting of both Dixie and Dixie Developers. The parties referred the case to a special master who found that HCH was entitled to half the 15 Felix sale proceeds and ordered dissolution and termination of Dixie. In this appeal, the issues considered by the court included the following: (1) whether Mallon was entitled to a full accounting for Dixie Holdings and Dixie Developers; (2) whether HCH was entitled to half the 15 Felix sale proceeds; (3) whether the special master erred in holding relief granted to HCH was justified by Mallon’s wrongful dissociation from Dixie; and (5) whether the special master properly awarded HCH statutory costs and attorney’s fees. Mallon argued that he was entitled to a full accounting for Dixie and Dixie Developers, but the court held that a full accounting was not required or appropriate and that the proper resolution was for the court to make a single determination of the parties’ rights with respect to the proceeds of the sale of 15 Felix. The court disagreed with the conclusion of the court of appeals that Dixie’s operating agreement entitled the parties to a formal accounting. The operating agreement provided that Dixie’s members “shall be furnished with a statement setting forth the assets and liabilities of the Company as of the date of the complete liquidation,” but the court distinguished this requirement from the equitable remedy of an accounting sought in this case. Further, even if the statement of assets and liabilities required by the operating agreement entitled the parties to a formal accounting (as argued by the dissent), the court found that Mallon and HCH waived the right by refusing to communicate and cooperate with each other. Additionally, the court found no provision in the LLC statute requiring a court to order a complete accounting under the circumstances. The court stated that the statute gave the court broad discretion in fashioning a remedy in actions between members or between members and the LLC, and the court did not believe a full accounting of Dixie and Dixie Developers was an appropriate remedy in this case because Dixie Developers had no relationship to the matter other than the fact that the funds in issue were in its bank account, and the only contentious issue remaining incidental to the dissolution was the relatively simple matter of the distribution of the 15 Felix sale proceeds. With respect to the proceeds of the sale of 15 Felix, the court rejected arguments by Mallon that it was entitled to a set off for charges associated with Dixie Developers. The court determined that Mallon’s buy-out of HCH’s interest in Dixie Developers was an accord and satisfaction with respect to HCH’s liability for charges associated with Dixie Developers based on the amendment made to the Dixie Developers operating agreement and circumstances surrounding the negotiations of the terms of the buy out. The court also determined that a lack of mutuality precluded the set off. The court rejected Mallon’s claims for other expenses associated with development of the Felix Street properties based on laches and waiver. The court held that Mallon’s dissociation from Dixie, which did not occur until after HCH filed its complaint, was irrelevant to the matters in issue, but the special master’s error in considering it was harmless because there were additional legitimate grounds upon which the special master granted relief to HCH. Although the South Carolina LLC statute authorizes an award of attorney’s fees and costs to a prevailing plaintiff in a derivative action, the court held that HCH failed to properly plead the action as a derivative action and the special master thus erred in awarding attorney’s fees under the statute. While HCH’s complaint stated that HCH brought the action individually and in a derivative capacity, it did not contain particularized allegations necessary in a derivative action. Further, the relief granted was personal to HCH in that the special master ordered a distribution to HCH instead of an initial return of the converted funds to Dixie.

Gale v. Carnrite

559 F.3d 359 (5th Cir. 2009)

(standing of members to pursue claim of involuntarily dissolved Nevada LLC).

Parsons & Whittemore Enterprises Corporation v. Cello Energy, LLC

Civil Action No. 07-0743-CG-B, 2009 WL 323081 (S.D. Ala. Feb. 7, 2009

(application of rule against perpetuities to invalidate option to purchase LLC interest).

Premium Allied Tool, Inc. v. Zenith Electronics Corp.

No. 08 C 2527, 2009 WL 395476 (N.D. Ill. Feb. 17, 2009)

(continuation of corporation’s rights under escrow agreement entered prior to corporation’s conversion to LLC under Delaware law providing that LLC is deemed to be same entity as former corporation).

Perkins v. Brown

901 N.E.2d 63 (Ind. App. 2009)

(necessity of accounting to determine amounts due one member from another in LLC’s dissolution).

Appling v. Tatum

670 S.E.2d 795 (Ga. App. 2008

(inclusion of father’s K-1 income from LLC in calculation of gross income for purposes of determining child support notwithstanding retention of income in LLC to operate business).

Bootheel Ethanol Investments, L.L.C. v. SEMO Ethanol Cooperative

No. 1:08CV59SNLJ, 2009 WL 398506 (E.D. Mo. Feb. 17, 2009)

(Missouri LLC statutory provision precluding enforcement of capital contribution; member’s lack of standing to complain of other member’s withdrawal of capital contribution).

Baird v. Macklin

6 Pa. D. & C. 5th 193, 2008 WL 5600765 (Pa. Com. Pl. Dec. 11, 2008)

(members as appropriate defendants in suit for judicial dissolution; insufficiency of allegations to support claim for judicial dissolution; unavailability of partition claim with respect to LLC property; permissibility of accounting claim in dissolution action).

Mazloom v. Mazloom

675 S.E.2d 746 (S.C. App. 2009)

(estoppel of members to deny co-member’s ownership interest; valuation of member’s interest; punitive damages associated with breach of fiduciary duty claim against members).

In re Houston Drywall, Inc. (West v. Seiffert)

Bankruptcy No. 05-95161-H4-7, Adversary No. 06-03415, 2008 WL 2754526 (Bankr. S.D. Tex. July 10, 2008)

(veil piercing of LLC general partner to impose fiduciary liability to limited partners).

Luria v. Board of Directors of Westbriar Condominium Unit Owners Association

672 S.E.2d 837 (Va. 2009)

(absence of liability of member for distributions occurring before plaintiff became creditor assuming, without deciding, managing member owed duty to plaintiff as creditor).