December 2010 — Issue 57

November 2010 and December 2010

LLP Cases: Henry v. Masson

333 S.W.3d 825 (Tex. App. 2010)

Henry and Masson were partners in an orthopedic surgery practice. They formed their practice as an LLP in 2001, and personal disputes led to litigation in 2003. During a hearing in the case, they agreed in principle to wind up the LLP and sever all ties between them. Additional disputes and issues arose, and another suit was filed. In an attempt to resolve all their differences, they executed a settlement agreement. Litigation ensued over alleged breaches of the settlement agreement. Among the issues addressed in this appeal was a claim by Masson that the trial court erred in ordering Henry and Masson to make capital contributions to the partnership to allow the partnership to pay out funds it had taken in that actually belonged to two new entities formed by the parties. Masson based his argument on the fact that the partnership was an LLP and the provision of the Texas Revised Partnership Act providing that partners in an LLP are protected from individual liability for the debts and obligations of the partnership incurred while the partnership is an LLP. The court stated that neither the partnership agreement nor the statute prevented the trial court from ordering contributions to the partnership during winding up. According to the court, the payments the trial court ordered Henry and Masson to make were capital contributions to discharge debts of the partnership during winding up, not an adjudication of individual liability for the debts or obligations as contemplated by the statute. The court relied upon the partnership agreement, which provided that if no partner agreed to lend funds needed to discharge the partnership’s debts, obligations, and liabilities as they came due, each partner was required to timely contribute the partner’s proportionate share of funds needed. Masson argued that this provision was not intended to apply in the winding up process and that reference elsewhere in the partnership agreement to payment of the partnership’s debts upon dissolution “to the extent funds are available” evidenced the partners’ intent that they would not be required to make additional capital contributions during the winding up. The court stated that the phrase relied upon by Masson appeared in a section referring to steps to be taken after the sale of partnership property, and the court did not interpret the agreement to mean that sale of partnership property was the only source of funds to pay debts. The court also rejected Masson’s argument that the reference in the capital contribution provision to payment of debts as they become “due and payable” was evidence that the parties did not intend to require capital contributions during winding up. The court stated that “due and payable” simply modified the type of debt to be paid and did not limit the provision to “operational” status of the partnership.

LLC Cases: GTSI Corp v. Eyak Technology, LLC

10 A.3d 1116 (Del. Ch. 2010)

A minority member brought this action against the LLC, other members of the LLC, and managers and officers of the LLC for declaratory relief and specific performance, breach of fiduciary duty, breach of implied covenant of good faith and fair dealing, and breach of the LLC agreement, and the defendants moved to stay the action until an arbitrator could determine whether the claims were subject to arbitration under the LLC agreement. The LLC agreement contained a broad arbitration clause in which the members agreed “that any dispute between them or between any of them and the Company arising out of, or in connection with, the execution, interpretation, performance or non-performance of this Agreement (including the validity, scope and enforceability of these arbitration provisions) shall be settled by arbitration....” The plaintiff relied upon another provision of the agreement in which the members agreed that they would be irreparably damaged if the agreement were not performed in accordance with its specific terms, that monetary damages would be inadequate, and that non-breaching members would be entitled to injunctive relief to prevent breaches and specifically enforce the agreement. The plaintiff argued that the Delaware Supreme Court’s decision in James & Jackson, LLC v. Willie Gary, LLC required the court to first determine whether the LLC agreement “generally provides for arbitration of all disputes,” and the plaintiff argued that the arbitration clause did not do so based on the equitable remedies provision and other provisions of the agreement. The court rejected the plaintiff’s argument, stating that the plaintiff ignored the threshold question of whether the LLC agreement clearly and unmistakably assigned to the arbitrator the task of determining substantive arbitrability. Because the arbitration clause here plainly did so, it was dispositive. The court also addressed whether the assertion that the underlying dispute was arbitrable was “wholly groundless,” since a court will answer the question of substantive arbitrability in such a circumstance based on concerns for efficiency. The court concluded that the plaintiff failed to satisfy this exception because, although the agreement preserved the right to seek provisional relief from a court to preserve the parties’ respective rights to arbitration, the plaintiff sought final and binding relief, not provisional relief. Further, although the equitable remedies provision tracked a similar provision in Willie Gary, the LLC agreement as a whole could be read to contemplate mandatory arbitration of all disputes. Unlike the arbitration clause in Willie Gary, the arbitration clause in this case specifically provided for the arbitrator to determine substantive arbitrability, empowered the arbitrator to award equitable relief, and carved out only a limited opportunity to seek provisional relief until the arbitrator can address the parties’ equitable claims. Further, the equitable remedies provision fit coherently in a unitary remedial scheme and, read literally, did not provide a right of action in any court. Thus, the court stated that there was good reason to question whether, as the plaintiff argued, the equitable remedies provision was designed to give the first filing party the option to decide whether to arbitrate or sue. Thus, the court determined there were non-frivolous arguments in favor of arbitrability, and the court stayed the case pending the arbitrator’s decision on substantive arbitrability.

CML V, LLC v. Bax

6 A.3d 238 (Del. Ch. 2010), aff’d, 28 A.3d 1037 (Del. 2011)

In a lengthy analysis, the court concluded that, unlike creditors of an insolvent Delaware corporation, the creditors of an insolvent Delaware LLC do not have standing to sue derivatively for breach of fiduciary duty to the LLC. A creditor of an insolvent LLC asserted derivative claims on behalf of the LLC for breach of fiduciary duty by the managers in connection with certain acquisitions and sales by the LLC. The court dismissed the claims for lack of standing because the Delaware LLC statute states that the plaintiff in a derivative suit must be a member or assignee. The court acknowledged that this conclusion “might surprise wizened veterans of the debates over corporate creditor standing,” but the court pointed out that the LLC was not a corporation, and the court concluded the plain language of the LLC statute dictated this result. The court contrasted the exclusive language of the LLC statute with the non-exclusive language in the Delaware General Corporation Law, and the court also traced the development of the derivative suit provisions in the Delaware limited partnership statutes since the LLC derivative suit provision was based on the provision in the Delaware Revised Uniform Limited Partnership Act. Although the court was not able to discern why NCCUSL drafted the derivative suit provisions of the 1976 Revised Uniform Limited Partnership Act in exclusive terms (and noted that the uniform language may simply have resulted from a desire to avoid use of the passive voice), the court found it significant that Delaware adopted such language faced with a clear choice between the non-exclusive provisions of Delaware’s prior limited partnership statute and the exclusive language of RULPA. The court rejected the implicit assumption in dicta of two chancery court opinions that a creditor of an insolvent alternative entity can sue derivatively for breach of fiduciary duty, and the court found nothing absurd about the application of differing legal principles to corporations and LLCs. According to the court, barring creditor derivative standing does not conflict with the overarching purpose or structure of the LLC statute because of the contractarian emphasis of the statute. The court stated that creditors can protect themselves contractually and that limiting creditors to their negotiated rights and denying them the additional right to sue derivatively on behalf of an insolvent entity is consistent with the contractarian approach taken by the LLC statute. The court pointed out various provisions of the LLC statute that appear to have been drafted with creditors in mind and that allow creditors to avail themselves of additional rights and protections. The court characterized the provision of the LLC statute allowing creditors to enforce contribution obligations under certain circumstances as satisfying any equitable desire to enable LLC creditors to enforce subscription agreements and removing any impetus for an experiment with LLCs similar to the evolution of the corporate trust fund doctrine and eventual corporate creditor derivative action. In sum, according to the court, “In light of the expansive contractual and statutory remedies that creditors of an LLC possess, it does not create an absurd or unreasonable result to deny derivative standing to creditors of an insolvent LLC” and, rather than frustrating any legislative purpose of the LLC statute, such an outcome “fulfills the statute’s contractarian spirit.”

In re Atlas Energy Resources, LLC

C.A. No. 4589-VCN, 2010 WL 4273122 (Del. Ch. Oct. 28, 2010)

The plaintiffs, unitholders in a publicly traded LLC, sued the LLC\'s controlling member, directors, and certain officers of the LLC for breach of their fiduciary duties in connection with the merger of the LLC with its controlling member. The plaintiffs claimed that the merger was the result of an unfair process and resulted in terms that were unfair to the minority unitholders. The defendants sought dismissal of the claims. The defendants argued that the LLC agreement contractually eliminated all their traditional fiduciary duties and contractually imposed different duties for purposes of negotiating and entering into the merger. The court first explained that, absent explicit provisions in the LLC agreement to the contrary, the traditional fiduciary duties owed by controlling shareholders and directors under Delaware law apply in the LLC context. Thus, the court was required to construe each relevant provision of the LLC agreement to determine (1) whether the provision applies to a particular defendant under the circumstances, (2) if so, whether the provision imposes a duty that differs from the traditional duties, and (3) whether the plaintiffs stated a claim for breach of any applicable duty. The court first addressed the duty of the controlling member and, in that regard, analyzed a provision in the LLC agreement stating that \"[w]henever a potential conflict of interest exists or arises between any Affiliate of the Company, on the one hand, and the Company or any Group Member, on the other, any resolution or course of action by the Board of Directors in respect of such conflict of interest shall be permitted and deemed approved by all Members, and shall not constitute a breach of this Agreement . . . or of any duty existing at law, in equity or otherwise, including any fiduciary duty, if the resolution or course of action in respect of such conflict of interest is (i) approved by Special Approval . . . .\" The parties agreed that the controlling member was an \"Affiliate\" of the LLC for purposes of this provision. The court stated that Delaware case law teaches that controlling members in a manager-managed LLC owe minority members the traditional fiduciary duties owed by controlling shareholders to minority shareholders. The court noted that it was particularly wary of eliminating such duties in the context of a publicly traded LLC without sufficient evidence of the parties\' intent to do so. The court distinguished the provision in this case from provisions in several other cases and concluded that the provision, while addressing conflicts between the LLC and its Affiliates, did not address conflicts of interest between an Affiliate (i.e., the controlling member) and the LLC\'s public unitholders, who were owed fiduciary duties directly by the controlling member in this transaction. Thus, the provision did not supply the standard of review applicable in this case. The court applied the \"entire fairness\" standard and concluded that the plaintiffs\' allegations detailing unfairness of the price and unfairness in the negotiation process precluded dismissal of the claims against the controlling member. With regard to the directors and officers, the court held that the following provision unambiguously eliminated the traditional fiduciary duties of the LLC\'s directors and officers: \"Except as expressly set forth in this Agreement or required by law, none of the Directors, nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Company or any Member.\" Another provision of the agreement imposed a contractual duty of good faith on the LLC\'s directors and officers unless another provision of the LLC agreement expressly provided otherwise. The agreement defined good faith as a subjective belief that an act is in the best interest of the LLC, thus dispensing with the objective component of the test of good faith under Delaware common law. The plaintiffs argued that this narrower definition of good faith was unenforceable because it eliminated the implied covenant of good faith and fair dealing, which is not permitted under the Delaware LLC statute. The court stated that this argument misconstrued the role of the implied covenant of good faith and fair dealing, which only addresses events that could not have been reasonably anticipated at the time the parties contracted. \"[W]here the parties have contractually agreed to eliminate fiduciary duties, they may not invoke the implied covenant as a back door through which duties may be reimposed after the fact.\" The plaintiffs relied upon a provision in the LLC agreement that the directors had no duty to approve or consent to a merger and were free to decline to do so without any fiduciary duty or obligation to the LLC or any member. The plaintiffs argued that this provision imposed different fiduciary duties when the directors acted to approve a merger, but the defendants argued that it eliminated the duty of good faith imposed by the agreement when the directors declined to approve a merger and left the duty of good faith under the agreement when approving a merger. The court agreed with the defendants and thus proceeded to determine whether the plaintiffs sufficiently alleged that the directors and officers subjectively believed they were not acting in the LLC’s best interest when they negotiated and approved the merger. The court first undertook this analysis with regard to the three members of the Special Committee that was formed to consider alternatives, and the court concluded that the plaintiff\'s allegations were not sufficient to defeat the motion to dismiss. Next the court examined the allegations against the remaining individual defendants and likewise concluded that the plaintiffs did not allege they acted with subjective bad faith.

Vila v. BVWebTies LLC

C.A. No. 4308-VCS, 2010 WL 3866098 (Del. Ch. Oct. 1, 2010)

Bob Vila, the well-known home improvement expert, and George Hill formed an LLC to promote, a home improvement website. The case primarily presented the question of whether it is “reasonably practicable” under the Delaware LLC statute for an LLC to continue to operate in conformity with its LLC agreement when the co-equal owners and managers whose agreement is required for any action of the LLC are deadlocked as to the future direction and management of the enterprise and there is no mechanism in the LLC agreement to break the deadlock. The court concluded that it is not and that judicial dissolution was thus appropriate. Vila sought judicial dissolution after the LLC lost its biggest advertiser, the LLC’s licensing agreement with Vila was terminated by Vila, and Vila and Hill could not agree on the direction of the LLC. Vila argued that it was not reasonably practicable for the LLC to continue because it was impossible for the LLC to continue to perform its purpose of operating the website after Vila terminated the LLC’s licensing agreement, and the two managers could not agree on how to operate the business, thus making it impossible for the LLC to take any action. The court analogized the situation to cases brought under the judicial dissolution provision of the Delaware General Corporation Law, which applies when two 50% stockholders have engaged in a joint venture and are unable to agree on whether to discontinue the venture or how to dispose of the assets. The court concluded that the deadlock and loss of the licensing agreement were sufficient grounds for judicial dissolution. The court noted that this was not a case in which Vila in bad faith manufactured a phony deadlock, terminated the licensing agreement on short notice, and sought dissolution to take profits for himself that otherwise would have come to the LLC. The court rejected counterclaims by Hill that Vila breached the LLC agreement, breached the implied covenant of good faith and fair dealing, and breached his fiduciary duties. The court found no basis for the claims that Vila breached the LLC agreement. With respect to a claim that Vila engaged in competition violating a clause of the operating agreement that allowed the managers to engage in and possess other ventures and investments that were not in direct competition with the LLC, the court concluded that Hill approved and participated in the transaction of which he complained, and the court was not persuaded that the transaction was directly competitive. The court also found Hill’s sparse evidence relating to two other claims of impermissible competition failed to establish a breach of the agreement. The court next rejected Hill’s argument that Vila breached the implied covenant of good faith and fair dealing by seeking judicial dissolution and rejecting supposed offers to purchase the LLC. The court stated that Vila did not breach the implied covenant by pursuing a meritorious claim for dissolution, a remedy that was expressly contemplated by the LLC agreement. The court also noted that Delaware law imposes no general duty on the part of an equity owner to consider selling his interest at a price he views as suboptimal, and the agreement implied nothing to the contrary. Finally, the court rejected the breach of fiduciary duty claims because a dispute arising from obligations that are expressly addressed by contract is treated as a breach of contract claim. Hill’s breach of fiduciary duty claims were based on the same allegations of competition underlying the breach of contract claims and were foreclosed as superfluous. The court reiterated that Hill failed to prove these claims in any event.

In re LaHood (LaHood v. Covey)

437 B.R. 330 (C.D. Ill. 2010)

The judgment creditor of an LLC member claimed that it obtained a lien on the member’s membership interest by serving a citation to discover assets pursuant to the general judgment collection procedures in the Illinois statutes. The bankruptcy court concluded that the general provision for perfecting a judgment lien by service of a citation to discover assets is trumped by the charging order provision and that the charging order is the exclusive mechanism for impressing a judgment lien upon a judgment debtor’s interest under Illinois law. The judgment creditor appealed, and the district court reversed the bankruptcy court on this issue. The district court reviewed the general statutory provision for perfection of a judgment lien by citation and the charging order provision in the Illinois LLC statute and noted that the issue was one of first impression on which “there is very little authority that is even marginally relevant.” The court considered Dowling v. Chicago Options Associates, Inc., an Illinois appellate court decision in which the only issue was whether a public sale by the sheriff was required and the validity of a lien on a membership interest by service of a citation to discover assets was not challenged, and Bobak Sausage Co. v. Bobak Orland Park, Inc., an unpublished federal district court opinion in which the court acknowledged the charging order provision in the course of determining that a public sale by the sheriff should not be the only method of disposal of an LLC interest that has been subjected to a judgment lien under the general citation provision. The court stated that these cases arguably stand for the proposition that liens against a member’s LLC interest may be created through the service of a citation or by obtaining a charging order, and the court thus disagreed with the bankruptcy court’s conclusion that the judgment creditor could not have created a lien via service of citation. The court remanded for the bankruptcy court to determine whether the citation complied with the statutory requirements to create a valid lien. The court stated that the next logical issue, assuming the judgment creditor complied with the citation statute, would be how the lien would be treated in terms of satisfaction or remedy. The court noted a Virginia bankruptcy decision, In re Pischke, that addressed the priority of a charging order lien versus a lien created under the general procedure for execution on intangibles and suggested that the failure to obtain a charging order may prevent a judgment creditor from obtaining priority status in terms of execution or satisfaction of the judgment. Under this rationale, said the court, the judgment lien would not be entitled to priority absent a charging order because the provision of the charging order statute stating that the statute provides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the judgment debtor’s LLC interest would be rendered meaningless if a judgment creditor who obtained a lien by citation could satisfy the lien or obtain a remedy. The court commented that Pischke indicated that it may be possible for a judgment creditor to obtain relief from the automatic stay to seek a charging order, but the court stated that whether such an opportunity was appropriate in this case was not before the court. In light of its conclusion that the judgment creditor could have created a valid lien by serving its citation and the theoretical possibility that a charging order might still be obtained to allow satisfaction of such a lien, the court remanded the matter to the bankruptcy court for further proceedings consistent with the court’s opinion.

Stanley v. Reef Securities, Inc.

314 S.W.3d 659 (Tex. App. 2010)

A judgment creditor obtained a turnover order requiring Stanley, the judgment debtor, to turn over monthly payments received from a limited partnership. The general partner of the limited partnership was an LLC of which Stanley was 90% owner, president, secretary, and sole employee. Stanley was the sole limited partner of the limited partnership. Stanley testified that the monthly payments from the limited partnership were his salary as an employee of the LLC, the amount of which he determined in his capacity as president of the LLC and communicated to himself as president of the limited partnership to be paid by the limited partnership. On appeal, Stanley challenged the turnover order on a number of grounds, including that the charging order was the judgment creditor’s exclusive remedy and that the payments to Stanley were exempt wages. The judgment creditor cross-appealed the trial court’s refusal to appoint a receiver. With regard to Stanley’s argument that a charging order was the exclusive remedy available to the judgment creditor, the court examined the charging order provision in the Texas limited partnership statute and agreed with the judgment creditor that the statute only limits the ability of a judgment creditor to proceed against a partner’s partnership interest and does not limit the ability to apply for turnover relief against the judgment debtor’s non-exempt property. The court discussed the charging order remedy and acknowledged that a charging order is the exclusive remedy by which a judgment creditor may satisfy a judgment out of a judgment debtor’s partnership interest. The court explained that a “partnership interest” is not an interest in specific partnership property; it is the partner’s right to receive his distributive share of the profits and surplus of the partnership. The court further explained that a creditor who obtains a charging order may not compel a distribution of profits by the partnership and does not obtain a right to participate in the partnership. The charging order creates a lien on the partner’s distributive share, but the judgment creditor is prohibited from foreclosing the lien, and the debtor partner has the ability to control the timing and amount, if any, of distributions by the partnership. Once a partnership distribution has been made, however, it ceases to be the partner’s “partnership interest” (i.e., the right to receive his share of the profits) and becomes the partner’s own property. The court concluded that nothing in the language of the statute precludes a judgment creditor from seeking the turnover of proceeds of a partnership distribution once it has been made and is in the debtor partner’s possession. (The Texas Business Organizations Code contains identical charging order provisions in the LLC context.) Another issue addressed by the court was whether the payments by the partnership were exempt from turnover as current wages. Stanley argued that the payments were salary paid to him as an employee of the LLC general partner of the limited partnership. The court pointed out, however, that the payments were not made by the limited partnership to the LLC to be paid in turn to Stanley. Instead, the payments were made directly by the limited partnership to its limited partner, Stanley. The court pointed out that the general rule is that a partner is not entitled to compensation for services, and the court found no circumstances showing an agreement, express or implied, to pay compensation. The partnership agreement contained no such provision, previous tax returns did not treat Stanley as an employee or indicate he was paid compensation, and there was no evidence Stanley devoted any more time or attention to the business than was anticipated at formation. Thus, the court held that the trial court did not abuse its discretion in determining that the payments were distributions from the partnership and not exempt wages. The judgment debtor cross-appealed the trial court’s refusal to appoint a receiver over Stanley’s interests in the LLC and partnership, and the court of appeals concluded that the trial court did not abuse its discretion in refusing to do so. The Texas Civil Practice and Remedies Code gives a trial court discretion to appoint a receiver over a judgment debtor’s non-exempt property with the authority to take possession of the property, sell it, and pay the proceeds to the judgment creditor. Based on Stanley’s testimony, the trial court could have reasonably concluded that a receiver was not necessary to enforce the judgment because Stanley had the means to pay the judgment but had not paid because of the dispute over whether the monthly payments from the partnership were exempt wages or non-exempt distributions. Thus, it was not an abuse of discretion to decline to appoint a receiver. The court referred to the issue as involving appointment of a receiver over Stanley’s “interests” in the LLC and partnership, but did not discuss or reconcile the exclusivity of the charging order with the possibility of a receivership over the “interests.”

Federal Trade Commission v. Peoples Credit First, LLC

621 F.3d 1327 (11th Cir. (Fla.) 2010)

(non-exclusivity of charging order remedy in context of single-member LLC; court’s authority to order single member of LLC to surrender all “right, title, and interest” in LLC to satisfy judgment against member).

Breen v. Judge

4 A.3d 326 (Con. App. 2010)

(absence of grounds to pierce veil of LLC and hold managing member liable under identity or instrumentality tests; failure of fraudulent transfer claim based on reasonable compensation paid to managing member of LLC).

In re Liebl (Wallner v. Liebl)

434 B.R. 529 (Bankr. N.D. Ill. 2010)

(creditor’s standing as member of LLC to assert derivative action on behalf of LLC against debtor manager in nondischargeability complaint; absence of fiduciary relationship between co-equal members and managers of LLC for nondischargeability purposes).

In the Matter of Application for Tax Exemption of Kouri Place, L.L.C.

239 P.3d 96 (Kan. App. 2010)

(distinction between property of LLC and interest of LLC members; analysis of Kansas and federal statutes dealing with low-income housing and entitlement of LLC to property tax exemption sought under Kansas statute).

Travcal Properties, LLC v. Logan

49 So.3d 466 (La. App. 2010)

(res judicata effect of manager’s declaratory judgment action regarding manager’s authority to act in member’s subsequent derivative suit).

Becher v. Freeman-Waag

No. A09-2256, 2010 WL 3545656 (Minn. App. Sept. 14, 2010)

(application of restrictions on transfer in operating agreement to pledge of LLC interest).

Delareto v. Totaro

2010 WL 3834365 (N.J. Super. A.D. Sept. 29, 2010)

(application of parol evidence rule to alleged oral agreement regarding ownership of LLC prior to execution of written operating agreement).

In re Ichida (Perry v. Ichida)

434 B.R. 852 (Bankr. S.D. Ohio 2010)

(failure of managing member’s misappropriation and mishandling of LLC funds to satisfy nondischargeability claim because failure to comply with fiduciary duties under common law or operating agreement does not meet requirement for express, statutory, or technical trust).