July 2010 — Issue 53

Ross Holding and Management Company v. Advance Realty Group, LLC

C.A. No. 4113-VCN, 2010 WL 3448227 (Del. Ch. Sept. 2, 2010)

The plaintiffs, members of a Delaware LLC, sought the immediate appointment of a receiver for the LLC based on the LLC’s insolvency resulting from gross mismanagement and self-dealing by the defendant board. The defendants objected because neither the LLC agreement nor the Delaware LLC statute provided for the appointment of a receiver in the event of insolvency and because plaintiffs failed to plead behavior sufficiently egregious to merit the appointment of a receiver in accordance with the court’s equity powers. Both parties acknowledged that the Delaware LLC statute is silent on the issue of the appointment of a receiver except as provided in the case of the cancellation of the certificate of formation. The plaintiffs asserted that the Delaware General Corporation Law (“DGCL”), which provides for the appointment of a receiver where a corporation is insolvent, should apply by analogy. The defendants argued that the silence of the LLC statute on the appointment of a receiver in the context of insolvency demonstrated the legislature’s intent to omit an analogous provision in the LLC statute. The court agreed with the defendants. The court concluded that the omission in the LLC statute of the provision for the appointment of a receiver in the case of insolvency was an intentional act by the legislature because the provision of the LLC statute addressing receivership for an LLC tracks closely the general provision of the DGCL establishing the process for appointing a receiver, with the notable exception of the circumstances in which a receiver may be appointed. Furthermore, because the courts had developed standards for the appointment of a receiver long before the codification of the general receivership provision of the DGCL, the court found there was no obvious statutory gap in need of filling, as there was already a well-established equity standard for the appointment of a receiver. According to the court, the appointment of a receiver is a drastic remedy that will not be resorted to if milder measures will adequately protect the plaintiff’s rights. The court will only use its equitable powers to appoint a receiver “when fraud and gross mismanagement by corporate officers, causing real imminent danger of great loss, clearly appears, and cannot be otherwise prevented.” A receiver will not be appointed where there have simply been errors of judgment in the management of a business. Most of the plaintiffs’ allegations involved self-dealing, and the alleged wrongful acts fell into three principal categories: (1) that the board transferred properties to companies affiliated with management for no consideration while continuing to guarantee underlying loans, (2) that the board allowed the company to default on certain loans while making unnecessary interest payments on loans owed to insiders, and (3) that the LLC inappropriately compensated its senior management and provided millions of dollars to board members in a time of financial crisis of the LLC. The court could not conclude that the plaintiffs had not asserted facts that if true would meet the high standard necessary to invoke the equitable remedy of receivership. Because material facts remained in dispute, the court held that a trial would be necessary, and the court denied plaintiffs’ motion for appointment of a receiver pending the outcome of the trial. The court denied the plaintiffs’ request to amend their complaint to add a claim against the defendants for violation of Section 18-305(g) of the Delaware Limited Liability Company Act, which requires unanimous member approval to limit a member’s ability to obtain certain information. The plaintiffs alleged that the elimination of a provision of the operating agreement which required the board to provide certain financial information and a change in the governing law provision of the operating agreement from Delaware law to New York law violated Section 18-305 of the Delaware LLC statute because the changes occurred without approval of all members. The court denied the plaintiffs’ motion to amend their complaint to add this claim because the operating agreement as amended did not purport to restrict information rights under Section 18-305, but rather was silent on the issue. The court stated that there could be no violation of the statute if the plaintiffs retained their rights under the statute, whether or not the amended agreement limited any broader contractual rights that might have been available under the prior agreement. With respect to the change in the governing law provision, the court stated that the plaintiffs did not articulate how, if at all, their statutory rights to access to information had been affected.

Lola Cars International Limited v. Krohn Racing, LLC, et al

C. A. Nos. 4479-VCN 4886-VCN, 2010 WL 3314484 (Del. Ch. Aug. 2, 2010)

Two entities, Lola Cars International Limited (“Lola”) and Krohn Racing, LLC (“Krohn”), formed a joint venture for the purpose of constructing and selling race cars. The joint venture was organized as a Delaware LLC. Lola held 51% of the interest in the LLC and Krohn held 49%, but the parties agreed to equal representation on the LLC’s board, with each party appointing one director. Krohn appointed Hazell as director and agreed to contribute Hazell’s services as the LLC’s CEO. The parties’ relationship deteriorated, and they asserted numerous breach of fiduciary duty and breach of contract claims against one another. Lola also sought judicial dissolution of the LLC. Lola claimed that Hazell mismanaged the LLC, thereby breaching his fiduciary duties of care and loyalty. The court noted that a manager of a Delaware LLC owes the LLC and its members the traditional fiduciary duties of care and loyalty, which may be contractually limited by agreement among the members. The members in this case did not agree to limit Hazell’s fiduciary duties as the manager of the LLC; therefore, the court found that Hazell was bound by the traditional duties of care and loyalty. Lola argued that Hazell’s effort to challenge a recently amended design regulation was a violation of his duty of care. The court stated that to prove a claim for breach of the duty of care, Lola must demonstrate that Hazell acted with gross negligence, and the court concluded that Lola failed to meet its burden. While Hazell had been advised that efforts to lobby for an exemption from the regulation were likely to fail, there were legitimate reasons for doing so. Lola also argued that Hazell’s failure to sell any LLC vehicles was motivated by his loyalty to Krohn. The court found that Hazell’s lack of independence and potential conflicts were known from the outset and that there was insufficient evidence to conclude that Hazell deliberately or recklessly stunted the LLC’s sales efforts as a means of furthering Krohn’s interests. The court next addressed various breach of contract claims asserted by Lola and Krohn against each other. Lola sought a declaratory judgment that it had terminated the LLC operating agreement and had the right to assume control pursuant to a provision that allowed a party to terminate the agreement by written notice if the other party committed a material breach and failed to cure the breach within the period provided by the operating agreement. In the absence of a definition of “material” in the operating agreement, the court looked to the factors in the Restatement (Second) of Contracts for guidance and concluded that the breaches Lola pointed out were all immaterial breaches. The court also concluded that Lola failed to prove Krohn breached the implied covenant of good faith and fair dealing by failing to consider Hazell’s replacement as CEO of the LLC. The court stated that the record demonstrated Krohn expressed a willingness to consider Hazell’s replacement but refused to do so without further information. On these facts, and given that Lola failed to prove most of its claims, the court concluded that Krohn did not breach the implied covenant of good faith. Among Krohn’s claims for breach of contract was a claim that Lola violated the operating agreement by bringing its initial claim for dissolution. Krohn claimed that Lola breached the operating agreement by seeking judicial dissolution before pursuing the termination or deadlock procedures in the operating agreement. The court rejected these arguments because Lola did not premise its first complaint on the termination provision and the deadlock procedure was permissive. Neither provision precluded filing suit for dissolution, breach of contract, or breach of fiduciary duty, and there was no basis to conclude Lola breached the agreement by suing for dissolution or other relief. The court also addressed Lola’s request for judicial dissolution. Under the Delaware LLC statute, a court of chancery may decree dissolution when it is not reasonably practicable to carry on the business in conformity with the LLC agreement. The court noted that the decision to enter a decree of dissolution is within the discretion of the court even where the standard is met. The court stated that the exercise of its discretion in judicial dissolution cases has been guided by factors that include: (1) whether there is deadlock between the members at the board level, (2) whether the operating agreement gives a means of navigating around the deadlock, and (3) whether, due to the company’s financial position, there is still a business to operate. The court found that there technically was no deadlock among the members. While representation on the LLC’s board was split evenly between the members, management of the LLC’s daily business affairs was vested in Hazell, who could not be unilaterally removed. The court acknowledged that deep concern was warranted as to whether the parties were capable of working together cooperatively to attain the success envisioned under the operating agreement, but that concern was tempered by the deadlock procedure (a shotgun buy-sell provision available in the event of an unresolved dispute) in the operating agreement. The court recognized that the procedure might not provide a precise or ideal remedy for Lola’s dissatisfaction with Hazell and Krohn, but it provided a method by which Lola could exit the business if it chose. The court also pointed out that the deterioration in the relationship between the parties was brought about in large part by Lola. In the absence of success in proving its claims, Lola’s frustration amounted to little more than disappointment with how the LLC was structured and managed. Given its overzealous role in escalating the dispute, the court left it to Lola to assess whether to exercise the deadlock procedure. The court concluded by emphasizing that a party to an operating agreement may not seek judicial dissolution as a means of freeing itself from what it considers to be a bad deal, even when the relationship of the parties has been badly damanged, because such a rule would unfairly permit one party to defeat the reasonable expectations of the other.

First Mid-Illinois Bank & Trust, N.A. v. Parker

933 N.E.2d 1215 (Ill. App. 2010)

Multiple judgment creditors of two LLC members obtained charging orders with respect to the members’ membership interests, and the court addressed the priority of the charging order liens. The court recognized that the LLC statute plainly provides that a charging order is a lien against the judgment debtor’s distributional interest and that the charging order is the exclusive remedy by which a judgment creditor may satisfy a judgment out of the judgment debtor’s distributional interest. The court also recognized case law holding that a judgment creditor may not obtain a lien on distributional interests of an LLC by serving the judgment debtor with a citation to discover assets, as would otherwise be allowed under Illinois law. The question in this case was whether the LLC statute also precludes prejudgment attachment procedures provided under Illinois law. One of the judgment creditors argued that its charging order lien took priority based on its relation back to a prejudgment attachment order. The court concluded that the prejudgment attachment provisions of the Illinois Code of Civil Procedure and the charging order provisions of the LLC statute could be read harmoniously. Thus, the court held that the prejudgment attachment procedures were available to a potential judgment creditor to preserve a debtor-member’s distributional interests in an LLC so that once a judgment is entered and a charging order obtained, the charging order relates back to the date of the prejudgment attachment order for purposes of lien priority.

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

320 S.W.3d 654 (Ky. 2010)

The Kentucky Supreme Court held that a provision of an LLC operating agreement requiring the members to contribute to pay expenses of the LLC as determined by the manager did not alter the limited liability of the members and did not authorize the trial court to order a capital call to satisfy the unpaid portion of an agreed judgment against the LLC. The trial court and court of appeals had concluded that the capital call provision 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, and the trial court ordered that a capital call be issued to each member for the member’s pro rata balance owed on an agreed judgment against the LLC. The Kentucky Supreme Court disagreed. The court characterized the capital call provision as a “not-uncommon, on-going capital infusion provision” designed to assure members would contribute additional capital as deemed necessary by the manager. The court acknowledged that the manager could have made a capital call but stated that the provision was not a debt collection mechanism by which a court could order a capital call and effectively abrogate the liability shield. The court stated that assumption of personal liability by an LLC member is so antithetical to the purpose of an LLC that any such assumption must be stated in unequivocal terms leaving no doubt as to the member’s intent to forego liability protection. The capital call provision here did not satisfy that standard.

In re Northlake Development, L.L.C. (Kinnwood Capital Group, L.L.C. v. BankPlus)

614 F.3d 140 (5th Cir. (Miss.) 2010)

Kinwood Capital Group, L.L.C. (“Kinwood”), a member-managed LLC, was formed for the purpose of purchasing and developing a tract of land. Under the operating agreement, the affirmative vote of at least 75% of all membership interests was required to dispose of substantially all of the assets outside the ordinary course of business as part of a single transaction. Kinwood had two members, and the 25% member signed a deed conveying Kinwood’s property to Northlake Development, L.L.C. (“Northlake”), an LLC wholly owned by the minority member, without the authorization or knowledge of Kinwood’s 75% member. Northlake then borrowed money from BankPlus and executed a deed of trust on the property conveyed by Kinwood to secure the loan. The bankruptcy court found that Kinwood’s minority member had no authority to convey the property from Kinwood to Northlake, that the deed from Kinwood to Northlake did not pass title of any kind, and that the deeds from Kinwood to Northlake and from Northlake to BankPlus were void. The Fifth Circuit Court of Appeals stated that the provisions of the Mississippi LLC statute applicable to this transaction (a new LLC statute was adopted effective January 1, 2011, but prior law applied to this proceeding) did not directly answer the question presented in this case because Kinwood and BankPlus did not have any dealings with each other. Under the LLC statute, a member is an agent of an LLC for the purpose of conducting its business, and the member’s act for apparently carrying on in the usual way the business of the LLC binds the LLC unless the member lacks authority and the person with whom the member is dealing knows of the lack of authority. An act of a member or manager not apparently carrying on in the usual way the business of the LLC does not bind the LLC unless authorized in accordance with the LLC agreement, and no act of a manager or member in contravention of a restriction on authority binds the LLC to persons having knowledge of the restriction. The court stated that the statute addresses Kinwood’s obligations to Northlake but does not determine whether a deed that is valid on its face but that does not bind the grantor becomes valid when passed to an innocent third-party purchaser. The court stated that the deed was at least voidable under the statute and noted several other situations in which Mississippi courts have held deeds voidable rather than void ab initio. The court found none of these other situations answered the question in this case and certified the following question to the Mississippi Supreme Court: “When a minority member of a Mississippi limited liability company prepares and executes, on behalf of the LLC, a deed to substantially all of the LLC’s real estate, in favor of another LLC of which the same individual is the sole owner, without authority to do so under the first LLC’s operating agreement, is the transfer of real property pursuant to the deed: (i) voidable, such that it is subject to the intervening rights of a subsequent bonafide purchaser for value and without notice or (ii) void ab initio, a legal nullity?”

Sturm v. Harb Development

2 A.3d 859 (Conn. 2010)

Personal liability of LLC actor based on application of common-law tort exception applicable where corporate actor commits or participates in commission of tort.

418 Meadow Street Associates, LLC v. Clean Air Partners, LLC

1 A.3d 1194 (Conn. App. 2010)

Analysis of adverse interest for purposes of triggering statutory exception to requirement that action on behalf of LLC requires majority vote.

General Electric Capital Corporation v. JLT Aircraft Holding Company, LLC

Civil No. 09-1200 (JNE/AJB), 2010 WL 3023316 (D. Minn. July 28, 2010)

Charging orders under Minnesota and Delaware law.

In re Yellowstone Mountain Club, LLC

436 B.R. 598 (D. Mont. Bankr. 2010)

Nature of notes from Montana LLCs as shams to disguise distributions to founding owner; duties of loyalty and care of founding owner of LLC; violation of statutory prohibition on distributions to LLC members.

In re Soderberg and Shafer CPAs, LLC

441 B.R. 262 (Bankr. N.D. Ohio 2010)

Eligibility of judicially dissolved Ohio LLC to be debtor under Bankruptcy Code.

MTG Guarnieri Manufacturing, Inc. v. Clouatre

239 P.3d 202 (Ok. Civ. App. 2010)

Potential individual liability of manager and sole member for misappropriation of trade secret by LLC under Oklahoma LLC statute.

White v. SmithKline Beecham Corporation

Civil Action No. 10-2141, 2010 WL 3119926 (E.D. Pa. Aug. 6, 2010)

Effect of conversion of Pennsylvania corporation into Delaware LLC and inapplicability of two-year post-dissolution survival statute.

Georgia Bank & Trust Company of Augusta v. Trenery

C/A No. 3:08-2371-JFA, 2010 WL 3271732 (D.S.C. Aug. 18, 2010)

Interpretation of operating agreement provision on “involuntary withdrawal” and necessity of judicial reformation due to contradictory terms of operating agreement.

Sherron Associates Loan Fund V (Mars Hotel) LLC v. Saucier

237 P.3d 338 (Wash. App. 2010)

Status of undistributed assets of terminated LLC.

In re Arnhoelter

431 B.R. 453 (E.D. Wis. 2010)

Unavailability of homestead exemption for debtor’s residence where residence was owned by debtor’s LLC at time of judgment.