January 2009 — Issue 35

Kahn v. Portnoy

Civil Action No. 3515-CC, 2008 WL 5197164 (Del. Ch. Dec. 11, 2008)

The plaintiff, a “shareholder” of a publicly traded Delaware LLC, brought a derivative action against the directors of the LLC alleging that the directors breached their fiduciary duties to the LLC by approving a transaction designed to benefit one of the directors and certain entities affiliated with the director. The directors moved to dismiss the action on the basis that the directors acted in accordance with their duties under the LLC agreement. The court found that there was more than one reasonable interpretation of the LLC agreement and denied the motion to dismiss because the court was not at liberty to choose between reasonable interpretations of ambiguous contract provisions when considering a motion to dismiss under Rule 12(b)(6). The LLC agreement provided that the duties of the directors would be identical to those of a board of directors of a business corporation organized under the Delaware General Corporation Law unless otherwise specifically provided for in the LLC agreement. Section 7.5(a) of the LLC agreement modified the duties of directors of a Delaware corporation by providing that “[i]t shall be presumed that, in making its decision and notwithstanding that such decision may be interested, the Board of Directors acted properly and in accordance with its duties (including fiduciary duties), and in any proceeding brought by or on behalf of any Shareholder or the Company challenging such approval, the Person bringing or prosecuting such proceeding shall have the burden of overcoming such presumption by clear and convincing evidence.” Adopting a reasonable interpretation that was most favorable to the plaintiff, the court found that the sentence read in context could be interpreted to apply only to board decisions that involved a conflict of interest between a shareholder and the board or a shareholder and the LLC because the prior sentence of Section 7(a) specifically referred to such situations. The challenged transaction did not involve such a conflict, and, therefore, at least one reasonable interpretation of the provision did not alter the duty of loyalty in this case. Further, the court stated that the “clear and convincing” standard in the provision did not necessarily alter the pleading standard. The court proceeded to analyze whether the plaintiff stated a claim for breach of the directors’ duty of loyalty under corporate law as altered by exculpatory provisions in the LLC agreement. The LLC agreement contained two “arguably conflicting” exculpatory provisions, which the court was unable to explain as “anything other than poor drafting or a strategy that ‘if one exculpatory provision is good, then two must be better.’” One provision eliminated personal director liability for money damages for a breach of duty subject to certain exceptions including breach of a director’s duty of loyalty to the LLC or shareholders, as modified by the agreement, and acts or omissions not in good faith. Another provision of the LLC agreement, which applied “notwithstanding anything to the contrary” in the agreement, eliminated monetary liability of directors absent a final judgment that the person acted in “bad faith” or engaged in certain other types of misconduct. The court discussed the concept of bad faith and the factual allegations and concluded that the plaintiff alleged sufficient facts to establish a showing for purposes of Rule 12(b)(6) that the directors acted in “classic, quintessential bad faith.” The court also addressed whether the plaintiff had alleged sufficient facts to establish demand was excused in this derivative action. The court noted that corporate case law supplies the governing principles for evaluating demand futility and thus applied the Aronson test, under which demand is excused if the plaintiff alleges particularized facts that establish a reasonable doubt that (1) the directors are disinterested and independent, or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Based on its prior discussion of Section 7.5(a) of the LLC agreement, the court stated that Section 7.5(a) would not alter the Aronson analysis because the conflicts alleged in the case did not involve a conflict between a shareholder and a director or a shareholder and the LLC. Further, even assuming that Section 7.5(a) applied to the board’s decision whether to initiate suit in the case, the court was not convinced that the demand futility or Aronson requirements were altered by the LLC agreement. The court noted that the LLC agreement could have altered the demand futility and Aronson requirements, but the court did not interpret Section 7.5(a) to eliminate or modify the ability of shareholders to bring a suit on behalf of the LLC or modify the prerequisites for doing so. Taking the well-pleaded complaint as true, the court concluded that it created a reasonable doubt as to the disinterestedness or independence of a majority of the board.

Downs v. Rosenthal Collins Group, L.L.C.

385 Ill.App.3d 47, 895 N.E.2d 1057 (Ill. App. 2008)

The plaintiff sought indemnification from an LLC for attorney’s fees incurred in successfully defending an earlier action against him by the LLC for breach of fiduciary duty and breach of contract. The plaintiff was the CEO and a member of the LLC, and the operating agreement of the LLC provided that the LLC “shall indemnify each Member for any act performed by such Member with respect to Company matters permitted by this Agreement and/or Majority Approval, but in no event for fraud, willful misconduct, negligence, or an intentional breach of this Agreement.” The plaintiff asserted that all actions underlying the complaint were taken with respect to LLC matters and that he was entitled to indemnification for his defense costs in the prior suit because the claims were dismissed against him as factually and legally without merit. The court of appeals affirmed the trial court’s dismissal of the plaintiff’s claim for indemnification because the operating agreement did not specifically address attorney’s fees. The court stated that an indemnification agreement must be strictly construed with respect to attorney’s fees, and the court found no language in the operating agreement indicating the parties’ intent to include attorney’s fees.

Racing Investment Fund 2000 v. Clay Ward Agency, Inc.

No. 2007-CA-0022820MR, 2008 WL 5102151 (Ky. App. Dec. 3, 2008)

An insurance agent obtained an agreed judgment against an LLC for unpaid policy premiums, and the LLC made partial payment and claimed it was no longer actively conducting business and had tendered the entirety of its assets. The insurance agent filed a motion to hold the LLC in contempt, and the court issued an order holding the LLC in technical contempt and ordering that the judgment be paid in 90 days. The issue was whether the LLC was required to pay the insurance agent the remaining balance based on a provision in the operating agreement that provided for routine capital calls of the members “to pay operating, administrative, or other business expenses which have been incurred, or which the Manager reasonably anticipates will be incurred” or whether dissolution of the LLC forestalled payment of the judgment. The court found that the provision in the operating agreement fell within the provision of the Kentucky LLC statute that allows members of an LLC to alter their limited liability in a written operating agreement. Because other provisions of the agreement addressing the limited liability of the members contained provisos referring to the capital call provision, the court rejected the argument that these other provisions overrode the capital call provision. The court also stated that the instant case was not about the personal liability of the LLC’s members, but rather involved an order against the LLC, a separate legal entity, to make a capital call for the purpose of complying with its obligations under the agreed judgment. The court pointed out that the dissolved LLC still existed, and the court agreed with the trial court that it was reasonable and possible for the LLC to obtain the funds necessary to pay the agreed judgment. The court stated that the LLC’s members or its manager must meet the mandates of the trial court order, and the court upheld the trial court’s finding of civil contempt.

Della Ratta v. Dyas

183 Md.App. 344, 961 A.2d 629 (Md. App. 2008)

Della Ratta and Dyas were equal owners of an LLC and a general partnership, and Dyas filed an action against Della Ratta alleging that Della Ratta was attempting wrongfully to squeeze out Dyas from the LLC and partnership. The action was filed in Anne Arundel County. A month later, Dyas filed an amended complaint requesting dissolution of the general partnership. Nine months later, Della Ratta moved to have the entire action transferred to Montgomery County on the basis that the general partnership’s principal office was located in Montgomery County and that the Montgomery County circuit court had exclusive jurisdiction under the Maryland Revised Uniform Partnership Act by virtue of the request for dissolution. In a later amended complaint, Dyas added a count seeking dissolution of the LLC, and Della Ratta argued as a defense that the court in Anne Arundel County lacked jurisdiction under the Maryland Limited Liability Company Act, which provides that, on application by a member, the circuit court in the county in which the principal office of the LLC is located may decree dissolution when it is not reasonably practicable to carry on the business in conformity with the articles of organization or the operating agreement. The case was tried in Anne Arundel County, and the circuit court concluded, inter alia, that it was no longer reasonably practicable to carry on the business of the LLC or general partnership and that the facts were sufficient to warrant dissolution, but that only the Montgomery County circuit court had jurisdiction to grant dissolution. The action was transferred to Montgomery County, and the court there entered orders for dissolution. Della Ratta argued on appeal that the plain and unambiguous language of the partnership and LLC statutes gave exclusive subject matter jurisdiction of a dissolution action to the circuit court in the county in which the principal offices of the partnership and LLC were located, and that the orders entered by the Montgomery Court were void because the “applications” for dissolution were filed in Anne Arundel County. The court of appeals discussed and analyzed the partnership and LLC dissolution statutes at some length, comparing them to the limited partnership and corporate dissolution statutes, and concluded that the provisions in issue were venue provisions and not provisions that withdrew subject matter jurisdiction from all other circuit courts. Assuming, alternatively, that the LLC and general partnership statutes conferred subject matter jurisdiction on the circuit court of Montgomery County, the court held that the statutes were not violated because the Montgomery County court ordered the dissolution of the LLC and supervised the winding up of the general partnership. The court rejected the argument that the statutory reference to the filing of an “application” by a member or partner deprived the Anne Arundel County court of subject matter jurisdiction to hear testimony and find facts that would support relief in the form of involuntary dissolution or judicially supervised winding up. According to the court, the statutory provisions specifying that the circuit court in the county in which the principal office of a partnership or LLC is located may decree dissolution or order judicial supervision of winding up on the application of a member or partner does no more than identify the class with standing to bring an action.

Zokaites v. Pittsburgh Irish Pubs, LLC

962 A.2d 1220 (Penn. 2008)

A judgment creditor sought an order compelling the judgment debtor, who owned a 20.5% membership interest in two LLCs, to transfer his membership interests in the LLCs to the sheriff for sale to satisfy the judgment. The Pennsylvania Supreme Court affirmed the trial court’s decision that Pennsylvania law does not permit such an order. The court noted that the Pennsylvania LLC statute and its comments make clear that a member may transfer the economic portion of the member’s interest but may not transfer the governance rights associated with the member’s interest without the consent of all other members unless a written operating agreement provides otherwise. Under the statute, unless otherwise provided in a written operating agreement, if all of the members do not consent to the transfer of a member’s interest, the transferee has no right to participate in the management of the business and affairs of the LLC or to become a member, and the transferee shall only be entitled to receive the distributions and return of contributions to which the member would otherwise be entitled. The court quoted from commentary to the statute stating that the “right to participate in management” retained by a member upon an unapproved transfer is intended to include the right to vote, as well as rights to information and to compel dissolution of the LLC. The court noted a dearth of case law interpreting the scope of the Pennsylvania Limited Liability Company Law, but noted decisions in other states dealing with situations similar to that at hand. The court stated that “[i]t is manifest from reading Pennsylvania’s Limited Liability Company Law, and the decisions of our sister states interpreting similar laws, that the purpose sought by the Legislature in promulgating our limited liability statute was to preclude a judgment creditor from securing more than repayment of his debt by means of a ‘charging order,’ which is the remedy for a judgment creditor against a member’s interest in a limited liability company.” The court stated that there was “no justification...to ignore the intent of the Legislature to protect the close-knit structure of the limited liability company and violate the other members’ interests and rights by declaring that they must accept a judgment creditor of a member into full membership with all the rights appurtenant thereto when the judgment debtor could not transfer those rights himself,” and the court found the judgment creditor’s attempt to expand his recoupment efforts from one of just securing economic rights to also obtaining governance rights was proscribed by the Pennsylvania LLC statute and applicable case law.

In re Heritage Organization, L.L.C. (Faulkner v. Korman)

Bankruptcy No. 04-35574-BJH-11, Adversary No. 06-3377-BJH, 2008 WL 5215688 (Bankr. N.D. Tex. Dec. 12, 2008).

Prior to filing bankruptcy, the debtor, a Delaware LLC, provided estate and tax planning strategies to extremely wealthy individuals. The trustee filed this action against two individuals, Kornman and Walker, and numerous entities affiliated in some way with Kornman. Kornman was the former CEO and president of the manager of the LLC, and Walker was a long-time employee of various Kornman-controlled entities. Various defendants sought summary judgment on fraudulent transfer, preference, breach of fiduciary duty, and veil piercing claims asserted by the trustee. The court found that there were genuine issues of material fact precluding summary judgment on claims that millions of dollars transferred by the LLC to several parties were made with actual intent to hinder, delay, or defraud the LLC’s creditors. The evidence included at least three badges of fraud: the transfers were made to insiders, the LLC had been sued or threatened with suit at the time of the transfers, and there was no reasonably equivalent value given in exchange for the transfers. The court also concluded that the trustee’s preference claims survived summary judgment because the defendants failed to produce evidence that the payments were made according to ordinary business terms. Based on the provisions of the LLC operating agreement, the court granted summary judgment in favor of Kornman and Walker, who were officers of the managing member of the LLC as well as officers of the LLC, on the trustee’s breach of fiduciary duty/gross negligence claims against them. The operating agreement contained a broad exculpation clause as follows: "The Manager shall not be required to exercise any particular standard of care, nor shall he owe any fiduciary duties to the Company or the other Members. Such excluded duties include, by way of example, not limitation, any duty of care, duty of loyalty, duty of reasonableness, duty to exercise proper business judgment, duty to make business opportunities available to the company, and any other duty which is typically imposed upon corporate officers and directors, general partners or trustees. The Manager shall not be held personally liable for any harm to the Company or the other Members resulting from any acts or omissions attributed to him. Such acts or omissions may include, by way of example but not limitation, any act of negligence, gross negligence, recklessness, or intentional misconduct." Walker and Kornman argued that they were protected by this clause as agents of the manager; however, the court found that there were fact issues as to the capacity in which Kornman and Walker acted (i.e., whether as officers of the LLC or as agents of the LLC’s manager), and it therefore was not possible on the summary judgment record to conclude that they were protected by the exculpation clause applicable to the manager. The court thus proceeded to analyze other provisions of the operating agreement bearing on the duties imposed on the LLC’s officers. The court reviewed various provisions of the operating agreement and concluded that, taken together, the operating agreement set up a duty delegation structure beginning with the LLC’s manager. The operating agreement expressly eliminated the duties and liabilities of the manager, and the operating agreement expressly limited the duties of the officers of the LLC to those provided in the agreement. While the operating agreement conferred on the LLC’s president the same duties granted to the manager, the court characterized that provision as “hollow” given the express exclusion of duties of the manager. The officers of the LLC other than the president had only those duties that were prescribed or delegated by the president or the manager, and there was no evidence in the summary judgment record regarding either the manager’s grant of duties to the president or the president’s or manager’s delegation or prescription of duties to any other officer. Faced with an operating agreement that provided only for duties as delegated or prescribed by the manager or president, and no evidence of any delegation or prescription, the trustee argued that the officers owed common law fiduciary duties to the LLC. The court rejected this argument, noting that Delaware LLCs are creatures of contract and that the Delaware LLC statute allows the LLC agreement to expand, restrict, or eliminate any duties a person owes to the LLC. The court stated that the LLC agreement clearly contemplated that the LLC’s officers owed only those duties that were either delegated or prescribed by the LLC’s manager or president, and, absent any delegation or prescription evident in the summary judgment record, the trustee failed to demonstrate the existence of any fiduciary duties by Kornman or Walker. Finally, the court addressed veil piercing claims by the trustee pursuant to which the trustee argued that each of the entities affiliated with Kornman should be liable for the LLC’s debts under one or more of the following theories: (1) single business enterprise, (2) alter ego, and (3) sham to perpetrate injustice. The court stated that Texas looks to the law of the jurisdiction of formation when determining the liability of an owner under a veil piercing claim. With the exception of a Tennessee corporation and a Texas corporation, the entity defendants were all Delaware LLCs, corporations, and limited partnerships. The court concluded that Delaware does not separately recognize the single business enterprise theory or sham to perpetrate injustice or fraud. Rather, the concepts involved in these theories are subsumed in the alter ego analysis under Delaware law. The court granted summary judgment in favor of all the entities on the single business enterprise theory because it is not recognized as a stand-alone theory in Delaware or Tennessee, and the theory was rejected by the Texas Supreme Court after the court’s hearing on the summary judgment motions. The court also granted summary judgment in favor of all the entities other than the Texas corporation on the sham to perpetrate injustice/fraud because Delaware and Tennessee do not recognize that theory as a separate basis to pierce the veil. The court found genuine issues of material fact precluded summary judgment on the trustee’s alter ego claim. The court recognized that the debtor was an LLC rather than a corporation but noted that emerging LLC case law illustrates that situations resulting in a piercing of the LLC veil are similar to those that warrant piercing the corporate veil. The court stated that actual fraud was not required to pierce the veil based upon the alter ego theory under Delaware law, and the court characterized the test under Delaware law as: (1) whether the entities in question operate as a single economic entity, and (2) whether there was an overall element of injustice or unfairness. The court noted that, in an alter ego analysis involving an LLC, “somewhat less emphasis is placed on whether the LLC observed internal formalities because fewer such formalities are legally required,” but stated that the failure of commonly-owned entities to follow legal formalities when contracting with each other is tantamount to a declaration that the entities are one in the same. The court pointed to evidence that Kornman’s entities dealt informally with one other as raising a fact issue on the first prong of the alter ego test. With respect to the second prong (that the entities were used to effectuate fraud or for an unfair or inequitable purpose), the court pointed to the LLC’s failure to disclose to its clients concerns raised by the IRS regarding the LLC’s high risk estate and tax planning strategies, the LLC’s distributions of millions of dollars to its members after the IRS raised concerns, and the LLC’s continued distributions after the filing of multi-million dollar claims against the LLC.

Best Western International, Inc. v. Furber

No. CV-06-1537-PHX-DGC, 2008 WL 5102064 (D. Ariz. Dec. 2, 2008)

(standing of LLC manager to assert tortious interference claim against third party as direct claim based on harm suffered by way of decrease in LLC revenues used to measure management fee)

In re Johnson (Gates v. Johnson)

Bankruptcy No. 2:07-BK-06248-SSC, Adversary No. 2:08-AP-00189-SSC, 2008 WL 5071756 (Bankr. D. Ariz. Oct. 21, 2008)

(absence of proof of fiduciary capacity of LLC members for purposes of discharge exception in view of silence of Arizona LLC statute regarding fiduciary duties and absence of operating agreement from record)

Kahane v. Jansen

No. A115269, 2008 WL 5077628 (Cal. App. 1 Dist. Dec. 3, 2008)

(discussion of attorney-client privilege in LLC context)

Strong v. JCM Partners, LLC

No. C055163, 2008 WL 5077591 (Cal. App. 3 Dist. Dec. 3, 2008)

(application of corporate veil piercing principles to LLCs and insufficiency of facts to pierce veil of LLC parent to hold subsidiaries liable for acts of parent or each other)

Baird v. Manayan

No. H032241, 2008 WL 4998341 (Cal. App. 6th Dist. Nov. 25, 2008)

(estoppel to assert defense of illegality regarding operating agreement of LLC engaged in chiropractic and acupuncture where party asserting illegality drafted agreement)

Polak v. Kobayashi

Civ. No. 05-330-SLR, 2008 WL 4905519 (D. Del. Nov. 13, 2008)

(direct versus derivative nature of claims; deadlock and loss of trust as grounds for judicial dissolution of LLC)

Boucher v. Shaw

124 Nev. 96, 196 P.3d 959 (Nev. 2008)

(limited liability of managers and management level employees for unpaid wages under Nevada statute providing for liability of employers).

Baron v. Rocketboom, LLC

57 A.D.3d 269, 868 N.Y.S.2d 661 (N.Y. App. Div. 1st Dept. 2008)

(LLC member’s lack of standing to intervene; lack of basis for joinder of member)

Yuko Ito v. Suzuki

57 A.D.3d 205, 869 N.Y.S.2d 28 (N.Y. App. Div. 1st Dept. 2008)

(sufficiency of allegations for claim against attorney for aiding and abetting LLC manager’s breach of fiduciary duty)

Manitaras v. Beusman

56 A.D.3d 735, 868 N.Y.S.2d 121 (N.Y. App. Div. 2nd Dept. 2008)

(requisite vote for sale of all assets of LLC)