August 2009 — Issue 42

Garnett v. Commissioner of Internal Revenue

132 T.C. No. 19, 2009 WL 1883965 (U.S. Tax Ct. 2009)

The taxpayers held interests in seven LLPs and two LLCs engaged in agribusiness operations, and the issue was whether the taxpayers’ interests should be considered interests in limited partnerships held as a limited partner so as to be treated as presumptively passive under the special rule of IRC Section 469(h)(2). The court rejected the taxpayers’ argument that limited liability was the controlling issue. The court stated that it was necessary to look at the facts and circumstances to ascertain the nature and extent of the taxpayers’ participation since they were not precluded under state law from materially participating in the business of the entities. Accordingly, the court concluded that the taxpayers held their interests as general partners for purposes of the temporary regulations.

B.A.S.S. Group, LLC v. Coastal Supply Co., Inc.

Civil Action No. 3743-VCP, 2009 WL 1743730 (Del. Ch. June 19, 2009)

A disloyal employee (Burkett) who embezzled funds from his employer (Coastal Supply Co., Inc. or “Coastal”), formed an LLC with a friend (Webb) and used the embezzled funds to purchase property for the LLC. When Coastal discovered the embezzlement, it fired Burkett and entered a restitution agreement with him, which included transferring the property from the LLC to Coastal. Webb then commenced this action to void the transfer of the property to Coastal and to obtain other relief for alleged breaches of fiduciary duty by Burkett. Coastal counterclaimed for unjust enrichment and conversion and sought relief in the form of a constructive trust over the property or a money judgment. Both sides sought summary judgment. The court granted Coastal’s motion for summary judgment on its unjust enrichment and conversion claims and denied the motion of the LLC and Webb for avoidance of the transfer of the property and breach of fiduciary duty. Webb and the LLC argued that the transfer of the property from the LLC to Coastal was void or voidable because Burkett lacked authority and the LLC did not receive any consideration. The court first analyzed the actual authority of Burkett and concluded that there were factual issues bearing on the matter of actual authority that precluded summary judgment. The court examined the provisions of the LLC agreement and concluded that there was an issue as to whether Burkett acted in “good faith” for purposes of a provision of the agreement that designated Burkett as an “Authorized Person” with power of attorney to act for both members. Under the provision, any representation or action of the Authorized Person acting in good faith pursuant to the power of attorney was binding as to both members. Webb argued Burkett did not act in good faith because he transferred the property solely for his own benefit. Coastal argued that Burkett acted in good faith because he protected the LLC from potential tort liability for conversion and potential criminal liability for receiving stolen property. The court noted that “much ink has been spilt analyzing the concept of good faith” in Delaware. The parties provided the court little guidance as to the meaning of “good faith” in this context, but the court noted that a fiduciary in the corporate context does not act in good faith if the fiduciary acts subjectively believing that the fiduciary’s actions are not in the best interest of the corporation. Because there were disputed issues of fact concerning Burkett’s state of mind as well as the reasonableness of his actions, the court denied summary judgment. Further, the court concluded that denial of summary judgment was supported by the fact that a more contextually specific definition of good faith might need to be applied. The court also found fact issues bearing on Burkett’s apparent authority to transfer the property. The court described apparent authority as requiring reasonable reliance on indicia of authority originated by the principal. The court stated that Coastal perhaps could have reasonably believed Burkett had authority, but it was less clear whether Coastal relied upon anything the LLC or Webb did or did not do in forming its arguably reasonable belief that Burkett had authority to transfer the property. Coastal maintained it did not know Webb was a member and did not ask for or examine the LLC agreement before it obtained the deed, but Burkett controverted that assertion to some extent, and the court commented that Coastal might have a difficult time proving the defense of apparent authority. In any event, the court found that factual disputes precluded summary judgment on the issue of apparent authority as well as actual authority. The court also denied summary judgment on the issue of inadequacy of consideration for the transfer, stating that it was possible that the consideration involved not only the recited $10, which Webb claimed was never paid to the LLC, but also consideration flowing from the restitution agreement, to which the LLC was a putative party. On the issue of unjust enrichment and conversion, the court found Coastal was entitled to judgment as a matter of law, and the court discussed the possibility of imposing a constructive trust. The court rejected the argument that Webb and the LLC were innocent parties who should not be penalized by Burkett’s acts. First, the court stated that the knowledge of an officer, director, or manager of a business entity is generally imputed to the entity. Additionally, restitution is permitted in Delaware even when the party retaining the benefit is not a wrongdoer. The court indicated that it would likely impose a constructive trust over the property if the court voided the transfer for any of the reasons argued by Webb. Because unjustly obtained funds could be traced to the specific property obtained by the LLC, a constructive trust could be imposed regardless of the culpability of the LLC if the LLC was not a bona fide purchaser for value. Here, the embezzled funds could be traced directly to the property, and the LLC was not a bona fide purchaser because, regardless of whether the LLC gave any consideration for the funds received from Burkett (i.e., whether the funds were a loan or a capital contribution), the court viewed the LLC and Burkett as equally culpable because Burkett was acting on behalf of the LLC when he purchased the property, and his knowledge that he was using the embezzled funds to purchase the property was imputed to the LLC. The court rejected Webb’s suggestion that a charging order upon Burkett’s units in the LLC for the benefit of Coastal would be adequate. The court did not consider a charging order to be an adequate remedy because the LLC was unjustly enriched and a charging order would leave Coastal with a 50% economic interest without any voting rights and at the mercy of the controlling member who had been engaged in litigation with Coastal. The court noted that there was a question as to who should capture any upside of the property after repayment, with interest, to Coastal of the amount of funds embezzled, but the parties did not address this issue in any detail, and the court left the issue for further consideration, if necessary, at trial.

Bernards v. Summit Real Estate Management, Inc.

213 P.3d 1 (Or. App. 2009)

Two individuals (Walter Bernards and Jerry Bernards) who were members of two member-managed LLCs (Greenbrier Apartment Buildings, LLC (“Greenbrier”) and Pioneer Ridge Apartments, LLC (“Pioneer Ridge”)), brought a derivative suit against the other members for breach of fiduciary duty based on the defendant members’ refusal to take legal action against Summit Real Estate Management, Inc. (“Summit”), the management company for the apartment complexes owned by the LLCs, and McKenna, one of Summit’s officers, after McKenna admitted embezzling approximately $172,000 from Greenbrier and $160,000 from Pioneer Ridge. The LLC operating agreements required unanimous consent to authorize a member to resort to legal action on behalf of the LLC where the amount exceeded $5,000, and the other members refused to consent without explanation. After a direct action by Walter Bernards against Summit and McKenna was dismissed, the plaintiffs filed amended complaints adding Jerry Bernards as a plaintiff and adding derivative claims against the member defendants. The defendant members moved to dismiss the claims against them on the basis that the plaintiffs failed to allege facts showing or implying that the defendants breached their fiduciary duties or otherwise failed to act in good faith, on an informed basis, and in the best interest of the LLCs. The plaintiffs argued that they need only allege that they made demand on the defendants to cause the LLCs to sue in their own right and that the demand was refused or ignored or the reason that demand was not made. The plaintiffs asserted that no allegation of wrongdoing was necessary, and that, if it was, the complaints alleged facts from which wrongdoing could be inferred. The court of appeals concluded that an allegation of either demand refusal or demand futility was necessary but not sufficient to state a derivative claim against LLC members. The court held that an allegation of facts sufficient to show bad faith, gross negligence, fraud, or willful or wanton misconduct was also required. The court noted that the pleading requirements in the Oregon statute requiring an allegation of demand refusal or demand futility are subject to variation by contract because the statute begins with the phrase “Except as otherwise provided in writing in the articles of organization or any operating agreement,....” The court stated that the members had altered the pleading requirements by agreeing in the operating agreement that a member shall not be liable to the other members or the LLC for honest mistakes of judgment or for action or inaction taken in good faith for a purpose reasonably believed to be in the best interest of the LLC provided that such mistake, action, or inaction does not constitute gross negligence, fraud, or willful or wanton misconduct. The court stated that the plaintiffs’ claims against the defendant members were claims for breach of contract, and the contract insulated the members from liability short of the wrongful conduct described in the operating agreement. The court also pointed out that it had held that wrongful conduct is a necessary element of a derivative action in the context of derivative actions by shareholders against directors and that the LLC statute and the corporate statute on derivative actions are identical with the exception of the introductory clause in the LLC statute permitting variation of the pleading requirements by contract. The court discussed the case law in the corporate context requiring a party to rebut the business judgment rule to avoid the pre-litigation demand requirement. The court acknowledged that the present case involved demand refusal rather than demand futility, but the court could find no reason to conclude that one context requires an allegation of wrongdoing and the other does not. Thus, the court concluded that, unless plaintiffs’ complaints alleged facts showing that the member defendants’ action in refusing to institute legal proceedings against Summit and McKenna was not the exercise of business judgment – or, in the more specific language of the operating agreements, that the member defendants’ decision was made in bad faith or amounted to gross negligence, fraud, or willful or wanton misconduct – the complaints did not state a claim. The court rejected the argument of the defendants that the complaints would fall short even if they contained allegations of wrongful conduct. In this regard, the defendants argued that the provision of the operating agreements requiring unanimous consent for legal action replaced the pleading requirements for a derivative action and gave each member the unfettered ability to block any legal action on behalf of the LLC. The court stated that parties to a contract are bound by a requirement of good faith and fair dealing, and the operating agreement expressly provided for liability for bad faith, gross negligence, fraud, or willful or wanton conduct. Thus, the court said the agreement confirmed that consent could not be withheld except for a valid reason. The court of appeals agreed with the trial court that the complaints did not allege facts from which a factfinder could conclude that the defendants acted with gross negligence or in bad faith. The court stated that the plaintiffs had to allege facts sufficient to overcome the presumption afforded by the business judgment rule that the defendants acted for the benefit of the LLC – that they acted with the requisite culpability required by the operating agreement. Further, the court stated that, due to the unanimous consent requirement of the operating agreement, the plaintiffs had to allege facts demonstrating that all of the members acted with the requisite culpability. If even one of the members refused to proceed for a valid business reason, the LLCs could not bring the action against Summit and McKenna. According to the court, the scant facts alleged did not support an inference of wrongdoing as opposed to a mere possibility. The court discussed case law in the corporate context regarding the refusal to bring legal action when a right of recovery is clear and concluded that the plaintiffs had not presented facts sufficient to support an inference that legal action by the LLC would have led to “clear recovery” as that concept was interpreted by the court. Thus, dismissal of the plaintiffs’ complaint was proper.

Angel Investors, LLC v. Garrity

216 P.3d 944 (Utah. 2009)

Angel Investors, LLC (“Angel”), a 1% owner of an LLC, brought a derivative suit on behalf of the LLC against six individuals who were the managing members and collectively owned 86% of the LLC. In addition to Angel, there were nineteen entities that had an ownership interest in the LLC. Prior to the derivative suit, Angel had initiated a direct suit against the LLC seeking dissolution of the LLC and other relief. The defendants argued that Angel lacked standing to bring the derivative suit because it did not meet the fair and adequate representation requirement of the Utah rules of civil procedure. The trial court agreed with the defendants, finding that (1) Angel was similarly situated to other minority owners, and (2) Angel could not fairly and adequately represent the interests of those similarly situated because the other minority owners indicated they did not support Angel as a derivative plaintiff and Angel’s direct suit caused a conflict of interest. On appeal, the supreme court disagreed, holding that Angel qualified as a class of one and that the majority owners had not met their burden of showing that Angel was an inadequate representative of the LLC. The court stated that Utah Rule 23A, which speaks in terms of derivative actions brought on behalf of corporations and unincorporated associations, governs derivative actions on behalf of LLCs. In analyzing whether Angel was similarly situated to other minority owners or made up a class of one, the court recognized that closely held corporations are more vulnerable to malfeasance because majority shareholders likely serve on the board and their dual roles may make it easier to commit and justify malfeasance. In light of the greater vulnerability to malfeasance, the court held that a sole dissenting shareholder in a closely held corporation qualifies as a class of one for purposes of a derivative action when that shareholder (1) seeks by its pleadings to enforce a right of the corporation, and (2) does not appear to be similarly situated to any other shareholder. The court also held that a shareholder’s motivation for opposing a derivative action is relevant to determining whether any shareholder is similarly situated to the derivative plaintiff. Angel brought suit alleging corporate malfeasance by the majority owners and alleged that owners other than itself stood to gain from the majority owners’ continued malfeasance. Accordingly, as a sole dissenting shareholder of a “closely held corporation,” Angel qualified as a class of one and there were no other similarly situated shareholders to be represented. The court noted that a derivative plaintiff must be able to fairly and adequately represent the corporation, as well as shareholders similarly situated, although Rule 23A has no explicit requirement as to representation of the corporation’s interest. The majority owners argued that Angel could not be a fair and adequate representative because (1) Angel had a conflict of interest with the LLC due to its suit to dissolve the LLC, (2) Angel did not sign the operating agreement, and (3) Angel stood to gain a relatively small amount of damages due to its minimal ownership interest in the LLC. The court concluded that Utah does not have a per se rule barring simultaneous direct and derivative actions, and that a possible conflict of interest, as found by the trial court, is insufficient to disqualify a derivative plaintiff. The majority owners failed to prove an actual conflict of interest because the relief Angel sought in the direct action (monetary damages and dissolution) was not incompatible with the relief sought in the derivative action, and Angel had to prove the same nucleus of operative facts in both actions. The court declined to address the majority owners’ argument that Angel’s refusal to sign the operating agreement prevented it from fairly and adequately representing the LLC’s interest because the argument was inadequately briefed. The court declined to address the argument that Angel stood to gain relatively little from any recovery and thus could not be considered a fair and adequate representative because the argument was not preserved in the trial court.

Stevensen 3rd East, LC v. Watts

210 P.3d 977 (Utah App. 2009)

An LLC manager appealed after a jury found that he breached his fiduciary duty of care as a manager of a real estate development LLC and caused damage to the LLC. The manager claimed that the trial court erred in instructing the jury regarding the standard of care for an LLC manager and the measure of damages for a breach of fiduciary duty. The trial court instructed the jury that the “standard of care which a defendant manager, who is also a builder and a real estate developer, must exercise is that amount of skill and learning ordinarily possessed and exercised by other members of the defendant’s profession practicing in the same or similar circumstances.” The court further instructed the jury that “the Defendant has a duty not to act in a manner which would constitute gross negligence or willful misconduct by a builder and real estate developer practicing his profession in this community.” The instruction also stated that the defendant was not held to a standard of perfection and that the law did not demand exceptional skill, learning, and caution. The instruction concluded by stating that the defendant “may make an error in judgment or a mistake in the performance of services, or disagree with other members of the builder and real estate development community without being grossly negligent or engaging in willful misconduct.” The court held that the instruction did not erroneously advise the jury regarding the standard of care of the defendant. The court relied upon the statutory standard of care for a corporate director, i.e., the care of an ordinarily prudent person in a like position under similar circumstances. The court also noted that the corporate statute provides that a director is not liable to the corporation for any action unless the director’s breach of duty constitutes gross negligence, willful misconduct, or intentional infliction of harm on the corporation. Since the LLC was created for the sole purpose of developing a particular piece of real estate, the court concluded it was not error for the trial court to compare the manager’s performance as a manager with that of other managers engaged in the business of building and developing real estate. With respect to damages, the court held that the breach of fiduciary duty claim sounded in tort because, “[l]ike the fiduciary duties of general partners or corporate officers, a limited liability company manager’s duty arises from the corporate relationship itself, independent of any contractual duties.” According to the court, Utah courts have approached damages in a breach of fiduciary duty case as described in the Restatement of Torts, varying the exact measure of damages based on the type of fiduciary relationship involved and the extent to which other areas of substantive law apply to the relationship. In this case, the jury instruction on damages was based on the Model Utah Jury Instruction pertaining to the measure of damages for a business tort. The court found this was the correct analogy, but stated that the trial court erred in failing to instruct the jury to limit the damages to the pecuniary loss to the LLC as measured by lost net profits or any other consequential losses for with the breach of fiduciary duty was the cause. The court concluded, however, that it was not reasonably likely that this error affected the jury’s verdict.

Lieberman v. Mossbrook

208 P.3d 1296 (Wyo. 2009)

This is the fourth opinion of the Wyoming Supreme Court arising out of this litigation. In this opinion, the court considered the conversion claim of Lieberman, a withdrawn member of a Wyoming LLC that later merged into a corporation. In the prior opinions, the court determined that Lieberman remained an equity holder of the LLC after he withdrew because there was no contractual provision for a buy-out of Lieberman’s interest. On remand after the third supreme court opinion, Lieberman sought a determination and recovery of the value of his interest. The district court relied upon the prior opinions of the supreme court and Lieberman’s membership interest certificate to conclude that Lieberman retained his right to his proportionate equity share after his withdrawal, and the district court further concluded that Lieberman was entitled to payment of his share on the date that the LLC was merged into the corporation. Failure of the Mossbrooks, Lieberman’s fellow members, to account to Lieberman for his equity interest amounted to conversion as a matter of law according to the district court. Following a trial, the court entered a judgment against the Mossbrooks for conversion in the amount of $958,475. The court found for the Mossbrooks on other claims asserted by Lieberman, and both parties appealed. The supreme court analyzed the application of the statute of limitations on the conversion claim and determined that Lieberman’s claim was not barred by the statute of limitations. The court next analyzed the law of the case as encompassed in its three prior opinions and concluded that its statements in the prior opinions were based upon an incomplete record and were of limited value. The court stated that it had only been able to determine that Lieberman retained an equity interest in the LLC and that nothing in the previous decisions precluded the district court from determining whether a conversion had occurred and, if so, the value of the converted property. In reviewing and analyzing the district court’s determination of the date of conversion and value of Lieberman’s interest, the supreme court disagreed with the district court’s determination that Lieberman’s equity interest should be valued as of the date of the merger. The court distinguished Lieberman’s situation from a transferee and concluded that Lieberman was neither a member nor an investor after the return of his capital contribution and cancellation of his membership certificate following his withdrawal. At that time, the court stated that Lieberman’s interest must be treated as if “liquidated” and Lieberman was entitled under the operating agreement to liquidating distributions from the LLC in accordance with the balance in his capital account. Failure of the LLC to do so amounted to a conversion of Lieberman’s interest. This result was not clear from the prior record in the case according to the court because the record did not include evidence of the cancellation of Lieberman’s membership certificate. As the successor to the LLC in the merger, the corporation was liable to Lieberman for the LLC’s conversion of his interest. Because the court had already remanded this case for further findings on three prior occasions, it went ahead and examined the record to determine the amount to which Lieberman was entitled based on the value of his interest at the time of his withdrawal rather than three years later when the LLC merged with the corporation. Based on unrefuted evidence of an independent appraisal secured by the Mossbrooks, the court determined that the value of Lieberman’s interest at the time of the conversion was $72,035. The supreme court found that it was error to enter judgment against the Mossbrooks personally because neither LLC members nor corporate shareholders are ordinarily liable for the acts of the company or corporation. In the absence of any evidence in the record to support piercing the veil of the LLC or successor corporation there was no basis to hold the Mossbrooks individually liable. Based on the statutes addressing the effect of a merger, the court concluded that the corporation was liable to Lieberman for the corrected amount and must be added as a party on remand. The court agreed with the district court that the Mossbrooks did not breach their fiduciary duties to Lieberman by failing to provide copies of tax returns, minutes, or reports of ownership distributions the LLC made after Lieberman withdrew. Lieberman was furnished with a copy of his last K-1 and had no right to the requested information after that.

Utzler v. Braca

972 A.2d 743 (Conn. App. 2009)

(adequacy of evidence to support piercing LLC veil under instrumentality rule).

U.S Medical Neuroscience Investments, L.L.C. v. Morton Plan Hospital Association, Inc.

No. 8:09-cv-464-T-24 MAP, 2009 WL 1651424 (M.D. Fla. June 12, 2009)

(application of exception permitting members to bring claims directly rather than derivatively in context of closely held Indiana LLCs).

Yessenow v. Hudson

No. 2:08-CV-353 PPS, 2009 WL 1543495 (N.D. Ind. June 2, 2009)

(fiduciary duties of LLC members; discussion of exception permitting members to bring claims directly rather than derivatively in context of closely held Indiana LLCs).

In re Greeson

No. 09-11328, 2009 WL 1542770 (Bankr. D. Kan. June 2, 2009)

(discussion of status of property transferred to bankrupt member of dissolved LLC in violation of Kansas winding up provisions).

Equity Trust Company v. Cole

766 N.W.2d 334 (Minn. App. 2009)

(application of veil piercing principles to individuals notwithstanding individuals did not have ownership interest in LLCs).

WIS-Bay City, LLC v. Bay City Partners, LLC

No. 3:08 CV 1730, 2009 WL 1661649 (N.D. Ohio June 12, 2009)

(unenforceability under Ohio law of operating agreement provision barring member’s right to sue other member with regard to note and financing documents).

Fornshell v. Roetzel & Andress, L.P.A.

Nos. 92132, 92161, 2009 WL 1629715 (Ohio App. June 11, 2009)

(fiduciary duties of LLC members; lack of fiduciary duty of LLC’s lawyer to LLC’s minority owner based on entity nature of partnerships and LLCs).

In re SAI Holdings Limited (SAI Administrative Claim and Creditor Trust v. Benecke-Kaliko AG)

Bankruptcy No. 06-33227, Adversary No. 08-3036, 2008 WL 6192000 (Bankr. N.D. Ohio Nov. 10, 2008)

(fiduciary duties of LLC members).

Gadin v. Societe Captrade

Civil Action No. 08-CV-3773, 2009 WL 1704049 (S.D. Tex. June 17, 2009)

(unsettled nature of Texas law with respect to fiduciary duties of LLC members to other members).