July 2007 — Issue 17

McNamee v. Dept. of Treasury

__ F.3d. __, Docket No. 05-6151-cv, 2007 WL 1487686 (2nd Cir. (Conn.) 2007),

The Second Circuit joined the Sixth Circuit in upholding the validity of the check-the-box regulations and affirming the ability of the IRS to hold a single member of a disregarded LLC personally liable for unpaid employment taxes. McNamee was the owner of a single member LLC that had not elected to be treated as a corporation under the check-the-box regulations. The LLC failed to pay any required payroll taxes (i.e., unemployment, social security and Medicare as well as withheld employee income taxes and employee FICA contributions) for a year and a half. The IRS assessed the taxes against McNamee personally and placed a lien on his property. McNamee argued that the IRS did not have authority to pierce the veil of an LLC and that the check-the-box regulations conflicted with the Internal Revenue Code. The court of appeals held that the check-the-box regulations are eminently reasonable in light of the emergence of LLCs and the ambiguous statutory treatment under the Internal Revenue Code. The court also rejected McNamee’s argument that proposed changes to the regulations (under which a disregarded LLC’s owner would not be liable for payroll taxes) indicate that the current regulations are wrong. The court held that the proposed changes provide no basis for finding the existing regulations unreasonable. Finally, the court rejected McNamee’s argument that the IRS’s attempt to collect the LLC’s unpaid payroll taxes from him violates state law. The court concluded that single member LLCs are entitled to whatever advantages state law provides, but state law cannot abrogate the owner’s federal tax liability.

NAMA Holdings, LLC v. Related World Market Center, LLC

__ A.2d __, C.A. Nos. 2755-VCL, 2756-VCL, 2007 WL 1500027 (Del. Ch. 2007).

The plaintiff, an indirect owner of a Delaware LLC, sued the LLC and one of the LLC’s two members, seeking to enforce provisions of the LLC’s operating agreement as to which the plaintiff was an explicit third party beneficiary. The plaintiff sought access to the LLC’s books and records and specific performance of a provision requiring the defendant member to segregate funds when a dispute arose regarding the amount of certain payments and fees to various related entities. The defendants moved for dismissal of the claims on the basis that the claims were subject to arbitration. The defendants also argued that the specific performance action was moot because the defendant member had assured the plaintiff that it had taken the action requested. Further, the defendants argued that the specific performance action required the joinder of indispensable parties and that the plaintiff had an adequate remedy at law. The court held that the claims were not subject to arbitration because the arbitration clause relied upon by the defendants merely permitted, but did not require, the parties to the operating agreement to jointly consent to arbitrate disputes between themselves that were not otherwise required to be arbitrated. The court stated that it would be inequitable and illogical to hold that an arbitration clause acts more broadly on a third party beneficiary than upon one of its signatories. The court concluded that a second arbitration clause pertaining to disputes over certain exhibits did not apply to the plaintiff’s claims either. The plaintiff, as a third party beneficiary who was not a signatory of the agreement, only had standing to bring claims based on rights found in certain provisions of the agreement, and the inspection right did not turn on the exhibits referenced in the arbitration clause. The court also rejected the defendants’ argument that arbitration was required under an arbitration clause in another agreement to which the defendants were not parties. The court next determined that the plaintiff’s action was not moot because the plaintiff’s claims and demands revealed an actual live controversy regarding the extent to which disputed funds had been segregated. The defendants argued that various other entities were necessary parties because the requested relief might deprive them of funds to which they were due, but the court found that the non-parties would not be deprived of their rights to ultimately protect their interest in the segregated funds. The court determined that the LLC must remain a party to the specific performance action, even though no substantive allegations were made against the LLC in that action, because the complaint sought an order segregating the disputed funds in a separate account of the LLC. Finally, the court found that the plaintiff did not have an adequate remedy at law because money damages for the failure to comply with the operating agreement might not be available. The operating agreement provided that the defendant member’s duties were ministerial and that the member would have no liability for any action taken or omitted except for willful misconduct, gross negligence, or bad faith, so long as the member acted in good faith. Thus, even if the plaintiff proved non-compliance by the other member, the plaintiff would be left without a remedy if the non-compliance occurred only negligently and in good faith. Furthermore, the court stated that money damages would not provide a complete and efficient remedy such as that provided in the contractual covenant the plaintiff sought to enforce. The court stated that it could not put a meaningful dollar value on the unique economic bargaining power conferred on the plaintiff under the provision requiring the segregation of funds.

Truckstop.Net, L.L.C. v. Spring Communications Company, L.P.

Nos. CV-04-561-S-BLW, CV-05-138-S-BLW, 2007 WL 1366546 (D. Idaho Jan. 12, 2007).

The plaintiff, a Delaware LLC, provided wireless internet access to subscribers through access points at truck stops. The plaintiff sued Sprint for losses allegedly caused by faulty networks installed by Sprint that led to the cancellation of subscriptions by many of plaintiff’s customers. Sprint counterclaimed for fees owed by the plaintiff for installation of the networks. After the deadline for amendments had passed, Sprint sought to amend its counterclaim to pierce the veil of the plaintiff and hold investors liable. The court noted that Sprint did not identify any Delaware decision that expressly applies veil piercing doctrines to LLCs, but the court agreed with the author of a law review article cited by Sprint that Delaware courts would apply corporate veil piercing or some variation to LLCs. Sprint advanced two veil piercing arguments. The first was that the investors hid the LLC’s inadequate capitalization and insolvency from Sprint, refused to fund the LLC, and chose to put the LLC out of business. The court concluded that Sprint knew of the LLC’s financial condition and that the investors were refusing to bail it out long before it sought to amend its pleadings, and there was no good cause for the delay in amending. Sprint’s second argument for piercing the LLC veil was based on more recent deposition testimony by investors that they stood ready to invest additional capital if the networks were installed properly. The court stated that this argument could not form the basis to pierce the veil. The court stated that evidence of co-mingling assets could support piercing, but Sprint offered no evidence of co-mingling. According to the court, if the proposed investment could only have been accomplished by co-mingling, Sprint might have had a stronger position, but no evidence supported such speculation. The court stated that the LLC agreement contemplated non-obligatory loans or capital contributions under certain conditions, signaling that an investor could make a non-obligatory investment without disregarding the separate structure of the LLC.

In re Regional Diagnostics, LLC (Morris v. Zelch)

__ B.R. __, Bankruptcy No. 05-15262, Adversary No. 06-1957, 2007 WL 1587256 (Bankr. N.D. Ohio 2007).

Defendant managers of an LLC argued that the trustee failed to state a claim against them under Delaware law for breach of fiduciary duty. The court reviewed the duties of loyalty and care of a director of a Delaware corporation and stated that Delaware courts have applied the business judgment rule in the LLC context. The court noted that fiduciary duties of LLC managers may be altered by agreement and quoted a recent article by Justice Steele for the proposition that “[t]here is an assumed default to traditional corporate governance fiduciary duties where the agreement is silent, or at least not inconsistent with the common law fiduciary duties.” The court rejected several arguments advanced by the manager defendants regarding the sufficiency of the trustee’s pleading. The defendants argued that the LLC agreement eliminated liability for breach of the duty of loyalty, but the court rejected this argument because the provision did not restrict or limit the managers’ fiduciary obligations; it only limited their liability to the extent they acted in good faith. Since a breach of the duty of loyalty can be premised on a failure to act in good faith the agreement did not eliminate potential liability for breach of the duty of loyalty. The managers next argued that the complaint failed to state a claim because it did not contain specific facts to overcome the business judgment rule. The court stated that the heightened pleading standard required by Delaware courts does not apply in federal courts where notice pleading is the standard. Thus, the trustee was not required to plead specific facts to overcome the business judgment rule. To the extent the business judgment rule is an affirmative defense, the court found the complaint did not show on its face that relief was barred since the trustee pled that the defendants were not protected by the rule by virtue of their financial interests in the LLC and the leverage buyout in issue. Finally, the court concluded that the trustee stated a claim for breach of the managers’ duty of loyalty by their intentional failure to exercise oversight responsibilities. The facts alleged in the complaint, viewed in the light most favorable to the plaintiff, raised a reasonable expectation that discovery would reveal evidence of a lack of good faith and conscious lack of oversight.

Darwin Limes, LLC v. Limes

No. WD-06-049, 2007 WL 1378357 (Ohio App. May 11, 2007).

Disputes arose in a family farm organized as an LLC. The LLC was owned by four siblings, Charles, Dale, Donald, and Betty Limes. Charles, Dale, and Donald each owned 32.667%, and Betty owned 2%. Under the original operating agreement, they were each managing members, but the parties agreed in an addendum that Betty was no longer a managing member, although she was still a non-voting member. Donald had traditionally farmed the land on a cash rent basis under an alleged oral lease. The other members decided to terminate any lease arrangement with Donald, and litigation involving claims for receivership, judicial dissolution, and declaratory judgment ensued. While the litigation was pending, Charles and Dale voted to remove Donald as a managing member. They also voted to take bids on a lease of the land from Dale and Donald. Donald won the bid and retained the lease for another year. Donald argued that the LLC was dissolved automatically when both Donald and Dale filed for judicial dissolution and there was no agreement to continue. The court interpreted a provision of the Ohio LLC statute which provides that is an event of withdrawal of a member if the member “files a petition or answer in any reorganization,...dissolution, or similar relief proceeding under any law or rule that seeks for himself any of those types of relief.” Relying on this provision, which was also included in the dissociation provisions of the operating agreement, Donald argued that Dale ceased to be a member (thus causing dissolution of the LLC) upon Dale’s filing of a claim for judicial dissolution of the LLC. The court pointed out, however, that dissociation occurs when a member seeks dissolution for himself or itself. Thus, no member was dissociated when Dale or Donald filed claims for judicial dissolution of the LLC. Additionally, the court concluded that, even if it agreed with Donald’s interpretation that Dale was dissociated, dissolution did not occur under the dissolution provision of the operating agreement, which listed the types of dissociation that would trigger dissolution but did not include the filing of a dissolution proceeding in the list of dissociation events dissolving the LLC. The court next interpreted the standard for judicial dissolution – that it is not reasonably practicable to carry on the business of the LLC in conformity with its articles of organization and operating agreement – and concluded that judicial dissolution was not appropriate. The court pointed out that the business of the LLC was farming, the operating agreement provided for continuation of the LLC even if Donald dissociated, and the LLC was in fact carrying on its business based on the award of the farming lease under the newly instituted bidding procedure. Finally, the court concluded that Donald was properly removed as a managing member. The operating agreement provided that a managing member could be removed for cause by the affirmative vote of all the other members. Donald argued that Betty’s vote was required and not just the vote of the managing members, but the court relied upon the addendum that provided Betty was no longer a voting member to conclude that only the vote of Charles and Dale was required to remove Donald. The court noted that “for cause” was not defined, but the court pointed to the standard of care of a managing member in the operating agreement (good faith discharge of duties in a manner reasonably believed to be in the best interests of the LLC) and concluded that the trial court did not err in considering Donald’s refusal to entertain the possibility of someone other than himself farming the land as cause for removal.

Ptasynski v. CO2 Claims Coalition, LLC

Civil Action No. 02-WM-00830-WDM-MEH, 2007 WL 1306492 (D. Colo. May 3, 2007).

Financial rights upon member’s withdrawal.

Gottier’s Furniture, LLC v. La Pointe

No. CV040084606S, 2007 WL 1600021 (Conn. Super. May 16, 2007).

Unavailability of receivership based on requesting member’s unclean hands and extraordinary nature of remedy.

Tzvolos v. Wiseman

No. CV040488839, 2007 WL 1532760 (Conn. Super. May 3, 2007).

Application of corporate veil piercing principles to LLCs; factors supporting application of instrumentality theory to LLC.

In re Grosman (Bar-Am v. Grosman)

Bankruptcy No. 6:05-bk-10450-KSJ, Adversary No. 6:05-ap-328, 2007 WL 1526701 (Bankr. M.D. Fla. May 22, 2007).

Failure of LLC managing member’s statutory fiduciary duties of loyalty and care to rise to level of express or technical trust required to constitute fiduciary duty under Bankruptcy Code Section 523(a)(4) exception to discharge for defalcation in fiduciary capacity; managing member’s stripping of LLC assets as willful and malicious injury of another entity or its property satisfying exception to discharge under Section 523(a)(6)).

Cathcart v. Magruder

__ So.2d __, No. 2006 CA 0986, 2006 CA 0987, 2006 CA 0988, 2007 WL 1299447 (La. App. 2007).

Discussion of permissible purposes for which LLC may be organized; LLC’s ownership, maintenance, and management of property for recreational and residential use of members as not equating to “commercial” use of property in violation of restrictive covenant.

In re Wells (Andrews v. Wells)

__ B.R. __, Bankruptcy No. 11102, Adversary No. 05-1119, 2006 WL 4526426 (Bankr. M.D. La. 2006).

Member’s standing to sue directly rather than derivatively; fiduciary character of managing member’s relationship to co-member and LLC for purposes of dischargeability exception of Bankruptcy Code.

Westbard Apartments, LLC v. Westwood Joint Venture, LLC

__ A.2d __, No. 1471, Sept. Term 2006, 2007 WL 1518992 (Md. App. 2007).

Application of waivers of jury trial in operating agreement and lease in derivative suit brought on LLC’s behalf against managing member, managing member’s affiliates, and lessor; interpretation of operating agreement provisions and Delaware law regarding fiduciary duties and pursuit of business opportunities.

In re Enron Creditors Recovery Corp.

__ B.R. __, No. 01-16034(AJG), 2007 WL 1531611 (Bankr. S.D. N.Y. 2007).

Analysis of scope of term “corporation” as used in indenture for purposes of determining whether LLC was “subsidiary” as defined in indenture.

Morris v. Younis

Civil Action No. 06-CV-2576, 2007 WL 1314633 (E.D. Pa. May 3, 2007).

Inapplicability of statutory default rule providing for equal division of LLC’s ownership if unwritten operating agreement addresses ownership.

Freeman Management Corporation v. Shurgard Storage Centers, Inc.

No. 3:06cv736, 2007 WL 1541877 (M.D. Tenn. May 23, 2007).

Violation of prohibition on transfer of corporation’s joint venture interest pursuant to merger of corporation into new LLC.