August 2008 — Issue 30

LLPs: Red River Wings, Inc. v. Hoot, Inc.

751 N.W.2d 206, Nos. 20070087, 20070088, 20070089 (N.D. 2008)

Two individuals who were partners in an LLP that was a limited partner in limited partnerships that owned franchised restaurants were held liable for the LLP’s breach of fiduciary duty as a limited partner in connection with seizing control of the limited partnerships and ousting the general partner. The court relied upon the veil piercing provision of the North Dakota LLP statute which states that principles of corporate veil piercing apply to LLPs. The court stated that the evidence of the participation of the LLP partners in the takeover of the limited partnership in which the LLP was a limited partner supported the trial court’s implicit finding that it would be inequitable if the LLP partners’ acts were treated as those of the LLP alone and that the trial court did not err in holding the partners of the LLP liable.

LLCs: Wood v. Baum

953 A.2d 136, No. 621,2007 (Del. 2008)

The plaintiff brought a derivative suit against the then-current members of the board of a Delaware LLC alleging breach of fiduciary duty claims based on alleged improper valuation of certain non-performing assets, improper charitable contributions, related party transactions, and failure to maintain accounting and monitoring controls and procedures. The Court of Chancery dismissed the complaint for failure to allege particularized facts sufficient to establish that demand on the board would have been futile. The Delaware Supreme Court stated that the test set forth in Aronson v. Lewis applies when it is alleged that directors made a conscious business decision in breach of their fiduciary duties, and the test in Rales v. Blasband applies when the subject of the derivative suit is a violation of the board’s oversight duties. The plaintiff attempted to create a “reasonable doubt” that the board would have properly exercised its business judgment by alleging that the board was disabled because of a substantial risk of personal liability. In evaluating that claim, the court stated that the exculpation clause in the LLC’s operating agreement must be kept in mind. Under the operating agreement and the Delaware LLC statute, the directors’ liability was limited to claims of “fraudulent or illegal conduct” or “bad faith violation[s] of the implied contractual covenant of good faith and fair dealing.” The court stated that, where directors are contractually or otherwise exculpated from liability, a serious threat of liability may only be found to exist if the plaintiff pleads with particularity a non-exculpated claim. Thus, the plaintiff in this case was required to plead particularized facts demonstrating that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper. The court characterized the issue before it as whether the complaint alleged with particularity that a majority of the directors knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. The court concluded that the plaintiff failed to meet this pleading burden. The plaintiff did not plead with particularity any claim based on fraudulent conduct. Although the complaint alleged many violations of securities and tax laws, the complaint did not allege with particularity that the directors knowingly engaged in such conduct or that they knew such conduct was illegal. The court rejected the plaintiff’s argument that such knowledge should be inferred from the fact that the transactions had to be authorized by the board and because they were related party transactions, but the court stated that Delaware law is clear that board approval of a transaction, even one that turns out to be improper, is not alone enough to infer culpable knowledge or bad faith. The court also stated that the plaintiff’s assertion that membership on the audit committee is a sufficient basis to infer the requisite scienter was contrary to well-settled Delaware law. The court distinguished a “bad faith violation of the implied contractual covenant of good faith and fair dealing” from the fiduciary duty breaches asserted by the plaintiff, and concluded that the complaint did not allege any contractual claims, let alone a “bad faith” breach of the implied contractual covenant of good faith and fair dealing. The court commented that the failure to allege with particularity any facts from which particular directors’ knowledge of accounting irregularities may be inferred is frequently compounded by a failure to make a statutory books and records request, and the court noted that the plaintiff in this case chose not to make a books and records request. In sum, the court concluded that, given the broad exculpating provision in the operating agreement, the plaintiff’s factual allegations were insufficient to establish demand futility.

Donohue v. Corning

949 A.2d 574, C.A. No. 3733-VCS (Del. Ch. 2008)

Donohue brought an action challenging his removal as managing member of an LLC and sought advancement of his expenses under the indemnification and advancement provision of the LLC agreement. The LLC agreement required indemnification and advancement in connection with the “defense or disposition” of a proceeding in which a covered person is involved or with which a covered person is threatened. The court cited corporate case law regarding the policy of Delaware legislation on indemnification, but the court stated that it could not award advancement merely because Donohue had a plausible argument that he brought suit, at least in part, to advance the interests of the LLC and that advancement in such a situation would comport with public policy behind allowing indemnification in corporate disputes. In view of the broad contractual discretion granted LLCs with respect to advancement, the court stated that Donohue must establish his entitlement to advancement under the terms of the LLC agreement itself. The court found Donohue’s argument telling insofar as Donohue argued that he was responding to a threatened proceeding rather than arguing that the provision contemplated coverage for directors initiating suit to fulfill their fiduciary duties by challenging a wrongful removal. The court agreed with Donohue’s implicit acknowledgment that conduct must be responsive or defensive in nature to give rise to an advancement right under the LLC agreement. The court commented that the “in connection with the defense or disposition” language was likely included to avoid the result in a corporate case in which the absence of such language from the bylaws exposed the corporation to liability for indemnification and advancement in proceedings initiated by directors that were not responsive to an existing or threatened proceeding. The court stated that the “defense or disposition” language would be mere surplusage if it were not interpreted as requiring an action to be defensive or responsive. The court concluded that Donohue was not entitled to advancement under the LLC agreement because he did not identify a threatened proceeding that he was defending or disposing of by bringing his suit. The court stated that a “for cause” removal was not a proceeding as contemplated by the advancement provision. Donohue tried to characterize his removal for cause based on alleged breaches of fiduciary duty as a threatened proceeding, but the defendants repeatedly told Donohue that they were not threatening him with a proceeding, and the court noted that the defendants would thus be estopped to initiate proceedings against Donohue for the actions that allegedly supported his removal for cause. The court found nothing invidious about interpreting the advancement provision as permitting the LLC discretion in instituting or threatening a proceeding that would trigger advancement. The court also noted that the agreement contained an incentive for members or former members to bring meritorious disputes over the LLC agreement by requiring the losing party to pay the fees of the prevailing party.

Maitland v. Int’l Registries, LLC

Civil Action No. 3669-CC, 2008 WL 2440521 (Del. Ch. June 6, 2008)

A 50% member of an LLC did not have authority to retain counsel for the LLC defendant in a case brought by the other 50% member where the plaintiff member did not consent to hiring counsel. The LLC agreement vested management in the members and provided that the decision of the members holding a majority of all interests shall be controlling. The LLC agreement also provided that the initial members were granted all rights, powers, authorities, and authorizations necessary, appropriate, advisable, and convenient to manage the LLC and carry out its affairs, but the court rejected the argument that this latter provision gave one member the power to retain counsel and file an answer for the LLC because such an interpretation would also give the other member the same authority. Since a deadlocked LLC cannot validly retain counsel and file an answer, the court granted the plaintiff member’s motion to strike the answer filed by counsel retained by the other member and disqualify the attorney as counsel for the LLC, but the court permitted the other member to intervene as a party defendant to defend on behalf of the LLC. The court denied the motion of the plaintiff member for commission requesting documents and deposition testimony from the outside auditor of a second LLC defendant. The court stated that the action at its core was an action for inspection of books and records of two LLCs and that granting the motion for commission would effectively give the plaintiff member the relief he sought. The court stated that the plaintiff could not use the discovery process in a books and records case to gain access to the books and records ultimately at issue.

Preferred Real Estate Investments, LLC v. Lucent Technologies, Inc.

Civil Action No. 2:07-CV-05374 (DMC), 2008 WL 2414968 (D. N.J. June 11, 2008)

The plaintiff sought a writ of attachment under a statute which permitted a writ of attachment if the defendant is a corporation created by the laws of another state and that state authorizes attachments against New Jersey corporations authorized to do business in that state. The property involved was owned by a Delaware LLC, and the court noted that a strict reading of the statute would allow business entities to shield themselves from attachment by simply transferring assets to an unincorporated entity. Thus, the court concluded that a more liberal reading of the statute encompassing LLCs was appropriate. Since Delaware has a reciprocal statute allowing for attachment against a corporation not created or existing under Delaware law, the court concluded the statutory grounds for attachment were present.

U.S. v. Leonard

529 F.3d 83, Docket Nos. 05-5523-cr(L), 06-0080-cr(con), 06-2392-cr(con) (2d Cir. (N.Y.) 2008)

The defendants were convicted of securities fraud, and the court found the evidence was sufficient to support the jury’s finding that interests in two LLCs, each of which was formed to produce a particular movie, were securities. The parties agreed that the only category of security that potentially applied in the case was that of an “investment contract,” and the court applied Howey as interpreted in the Second Circuit. The court noted that a review of the organizational documents of the LLCs in issue indicated that the members were expected to play an active role in the management of the LLCs and would lead to the conclusion that the LLC interests were not securities if the court confined itself to an analysis of the documents. In actuality, however, the evidence showed that the members played an extremely passive role in the operation and management of the business. Although the documents called for members to vote on all important decisions, members testified that they voted, at most, only a couple of times. The documents also called for a number of committees, but only two committees were formed for each LLC, and only a few of the several hundred investors served on those committees. “Interim managers” initially controlled the LLCs and made almost every major production decision regarding the movies prior to the completion of fundraising by the LLCs. The members’ management rights did not accrue until the LLCs were “fully organized.” The court also found it relevant that the members were presented with take-it-or-leave-it subscription agreements and did not appear to have negotiated any of the terms of the LLC agreements. That the members did not play any role in shaping the organizational documents raised doubts as to whether they were expected to have significant control over the enterprise. Finally, the court noted that the members had no particular experience in film or entertainment and thus would have had difficulty exercising their formal right to take over management of the LLCs after they were fully organized.

Dickson v. Rehmke

164 Cal.App.4th 469, 78 Cal.Rptr.3d 874, No. C053512 (Cal. App. 3 Dist. 2008)

(untimeliness of appeal after alternative decree for buy-out of member’s interest in lieu of dissolution)

Focal Point LLC v. CNA Insurance Company, Inc.

No. C 07-05764 MHP, 2008 WL 2397422 (N.D. Cal. June 10, 2008)

(interpretation of D&O policy in relation to suit brought by expelled member against other members)

Whittington v. Dragon Group L.L.C.

Civil Action No. 2291-VCP, 2008 WL 2316305 (Del. Ch. June 6, 2008)

(determination of analogous statute of limitations and analysis of laches in member’s suit regarding rights in LLC arising out of previous settlement agreement)

In re Polo Builders, Inc. (Brown v. Real Estate Resource Management, LLC)

388 B.R. 338, Bankruptcy No. 04 B 23758, Adversary No. 04 A 04032 (Bankr. N.D. Ill. 2008)

(application of corporate veil piercing principles to LLCs; lack of grounds to pierce LLC veil where harm resulted from trustee’s lack of due diligence in dealing with LLC and acceptance of risk associated with shell entity rather than abuse of LLC form)

University of Kansas v. Sinks

565 F.Supp.2d 1216, No. 06-2341-JAR (D. Kan. 2008)

(scope of statutory limitation of liability of member or manager; possible individual liability of member based on alleged active and knowing participation in trademark infringement)

Seymour v. United States

No. 4:06-CV-116, 2008 WL 2509831 (W.D. Ky. June 19, 2008)

(personal liability of sole member of disregarded LLC for employment taxes)

In re Lobell (Brooke Credit Corporation v. Lobell)

390 B.R. 206, Bankruptcy No. 06-11163, Adversary No. 07-1028 (M.D. La. 2008)

(unsettled nature of LLC member’s status as “fiduciary” in Fifth Circuit for purposes of exception to discharge for fraud or defalcation in fiduciary capacity; absence of controlling authority to support creditor’s right to enforce fiduciary duty of member even assuming existence of duty)

Berman v. Sugo LLC

__ F.Supp.2d __, No. 07 Civ. 1795(RPP), 2008 WL 2414052 (S.D. N.Y. 2008)

(insufficiency of allegations to establish oral operating agreement where written letter of understanding specifically contemplated “more formal” operating agreement and draft operating agreement stated it would be effective when signed by all members; member’s fiduciary duty of loyalty to other members based on analogous duties of partners in partnership)

Tal v. Superior Vending, LLC

No. 11709/07, 2008 WL 2447365 (N.Y. Sup. June 6, 2008)

(equitable approach to judicial dissolution where excluded member failed to pursue initial dissolution action and other member commingled assets of LLC with those of new corporation that continued business)

Taurus IP, LLC v. DaimlerChrysler Corporation

559 F.Supp.2d 947 (W.D. Wis. 2008)

(application of Texas veil piercing principles; rejection of piercing claim where claimant failed to establish that LLC was not likely to satisfy judgment)