March 2010 — Issue 49

LLC Cases: Whittington v. Dragon Group, L.L.C.

991 A.2d 1 (Del. 2009)

The Delaware Supreme Court decided, as a matter of first impression, that the typed word “seal” next to an individual signatory’s name was sufficient to create a “specialty contract,” i.e., a contract under seal, which is subject to a twenty-year statute of limitations under Delaware law rather than the three-year statute of limitations applicable to regular contracts. The dispute in this case involved the rights of family members with respect to a Delaware LLC. The plaintiff brought this action against the LLC, the plaintiff’s siblings, and other family members to enforce his rights as an alleged member of the LLC, and the chancery court concluded that the plaintiff’s rights were ultimately predicated on a global settlement agreement entitled “Agreement in Principle” (“AIP”) entered into by the plaintiff and his siblings in 2001 during prior litigation between the parties. The terms of the AIP were never carried out because of ongoing disputes between the parties. The chancery court held that the plaintiff’s equitable action to enforce his rights under the AIP was barred by laches by analogy to the statute of limitations applicable in at action at law on the contract. The plaintiff argued that the AIP was a contract under seal to which the common law twenty-year statute of limitations would apply. The typed word “seal” appeared next to each party’s signature, but the chancery court determined that more than a minimal reference to a seal was required for contracts other than documents of debt, such as mortgages or promissory notes, to escape the three-year statute of limitations. The Delaware Supreme Court reviewed conflicting trial court decisions in Delaware and case law in other states and noted that many states have enacted statutes that address the issue of what constitutes a contract under seal. In the absence of legislative guidance in Delaware, the Delaware Supreme Court was persuaded by a decision of the Delaware Orphan’s Court in a 1940 case. Under this rule, the presence of the word “seal” next to an individual’s name (in contrast to a corporation) is all that is required to create a sealed instrument regardless of whether there is any indication in the rest of the contract that it was intended to be a sealed instrument. Thus, the court remanded to the chancery court for reconsideration of its holding by applying the twenty-year statute of limitations for purposes of analogy in determining the laches issue. Justice Jacobs dissented, arguing that it is unreasonable and unadvisable in today’s commercial environment to subject parties to commercial contracts to the risk of litigation for twenty years without requiring at least minimally persuasive evidence (i.e., more than use of the boilerplate term “seal”) that the parties intended that result.

Colborne Corporation v. Weinstein

__ P.3d __, 2010 WL 185416 (Colo. App. 2010, pet. granted)

The plaintiff, a creditor of a Colorado LLC, sought to hold the managers and members of an LLC liable for an unlawful distribution. The creditor argued that the managers were liable for breach of a common law fiduciary duty owed to the creditor and that members were liable under the Colorado LLC statute, which provides for liability of the members to the LLC in the event the members knowingly receive an impermissible distribution. The plaintiff argued that the court should follow Colorado case law in the corporate area by analogy, but the trial court dismissed the plaintiff’s claims because there was no appellate decision extending either the statutory interpretation of the corporate statute or the common law limited fiduciary duty of directors to members or managers of an LLC. The court of appeals reversed the trial court on both issues. With respect to the statutory liability of the members, the court held that case law in the corporate context allowing creditors of the corporation to enforce the liability of directors “to the corporation” for wrongful distributions should also apply to extend standing to creditors of an LLC who sue members under the LLC statutory provision providing for liability of the members “to the [LLC].” The court gave three reasons for relying on the corporate case law: (1) the corporation and LLC statutes are closely related statutory schemes that frequently, as in this case, employ identical language; (2) the legislature directed the courts to apply case law applicable to corporations in determining personal liability in the LLC context (i.e., the LLC statute provides that corporate veil piercing case law is applicable in determining liability of LLC members); and (3) the reasoning for extending standing to creditors is just as applicable to an LLC as it is to a corporation. The defendants argued that the plaintiff did not have standing to sue because the corporate cases extended standing to all creditors as a group, and the plaintiff did not file suit on behalf of all creditors. The court refused to dismiss the case merely because the plaintiff failed to expressly state that it was the only unpaid creditor. The court expressed no opinion as the standing of the plaintiff if the defendants on remand presented evidence that other unpaid creditors existed. The court of appeals next addressed the plaintiff’s claim against the managers for breach of fiduciary duty. After the trial court dismissed the case, a division of the Colorado Court of Appeals held that managers of an insolvent LLC owe to creditors the same fiduciary duty owed by directors and officers of an insolvent corporation, i.e., the limited duty to avoid favoring their own interests over creditors’ claims. The defendants did not argue that Sheffield v. Trowbridge was wrongly decided but merely challenged the sufficiency of the pleadings with regard to whether the managers favored their own interests over the plaintiff’s. The court concluded that the allegation that the managers authorized distributions to themselves as members when the distributions rendered the LLC unable to meet its financial obligations was sufficient to state a claim that the managers favored their own interests over the LLC’s creditors.

Trover v. 419 OCR, Inc.

921 N.E.2d 1249 (Ill. App. 2010)

The plaintiff, a member of two LLCs, filed a derivative suit alleging various claims on behalf of the LLCs against fellow members of the LLCs and two non-member entities affiliated with the member defendants. The defendants sought to compel arbitration based on broadly worded arbitration clauses in the LLC operating agreements. The court found that the dispute in question, which involved a land transaction, fell within the scope of the arbitration clauses, but the court concluded that the non-member defendants were not bound by the arbitration clauses and thus could not enforce the arbitration clauses as to the counts against them. Further, the court held that the LLCs were not bound by the arbitration clauses because they were not parties to the operating agreements. The court characterized this issue as one of first impression in Illinois and stated that Illinois law and the facts of the case required a different result from Elf Atochem North America, Inc. v. Jaffari, in which the Delaware Supreme Court concluded that an LLC was bound to arbitrate by an arbitration clause in the operating agreement even though the LLC was not a signatory to the agreement. In Jaffari, the arbitration clause covered all disputes, and the court specified that the members of the LLC were the real parties and that the LLC was simply a joint business vehicle for the members. In distinguishing the law and facts of this case from that involved in Jaffari, the court emphasized that the arbitration clauses here specified that the controversy must be “between the parties,” and the court relied upon the separate legal existence of an LLC under the Illinois LLC statute, the LLC’s power to sue and be sued, the recitation in the operating agreements that the agreements were by and among specified parties that did not include the LLC, and the signatures (which did not refer to or purport to bind the LLCs) at the end of the agreements. The court also pointed to a provision of the operating agreements that gave the managing member authority to sign contracts on behalf of the LLCs when authorized by the members, thus indicating that the drafters understood what was necessary to contractually bind the LLCs. The court also relied on the statutory authorization for a derivative suit and the unlikelihood that the defendant members would have brought the derivative actions naming themselves as defendants. The court concluded that a fraud claim brought by the plaintiff individually against the other members was subject to the arbitration clause, and a defendant member who was not an original signatory of the operating agreements but was subsequently admitted as a member was entitled to enforce the arbitration clause under the terms of the agreements.

DirecTV Latin America, LLC v. Park 610, LLC

691 F.Supp.2d 405 (S.D.N.Y. 2010)

DirecTV entered into a joint venture agreement with an individual, Avila, under which the parties formed an LLC in which DirecTV had a 45% membership interest, and an LLC formed by Avila (“Park 610\\\") had a 55 % membership interest. DirecTV made it clear that it was critical that Avila not transfer any of his ownership interest in the LLC without DirecTV’s written agreement, and the joint venture agreement made a change in control a default under the contract. When the joint venture agreement was being negotiated, Avila represented that he was the sole owner of the two entities that were the members of Park 610, but he was actually in the process of arranging a transfer of ownership of one of the entities, and he eventually allowed his shares in the other entity to be pledged to or deposited with a third party to secure his obligations under the agreement with the purchaser of the other entity. Park 610 and Avila argued that DirecTV failed to allege a breach of the change of control provision of the joint venture agreement, which provided that a change in control occurs where “any Person (other than the Person who controls a Member on the Date hereof) become[s] the beneficial owner, directly, or indirectly, of more than 50% of the then outstanding voting shares or other equity rights of a Member.” The pleadings alleged that two entities each owned 50% of the outstanding shares or other equity rights of Park 610; therefore, the allegation that the shares owned by one of the entity members were transferred were insufficient to show a change in control because the transfer did not result in an outside person acquiring more than 50% of the outstanding shares or equity rights of Park 610. There was also an argument, however, over the sufficiency of allegations relating to a change in control based on changes in “beneficial ownership.” The term “beneficial owner” was undefined in the joint venture agreement, and DirecTV argued that the term should be interpreted in accordance with the definition of the term under Section 13(d) of the Securities Exchange Act of 1934. Park 610 and Avila argued that this was not a proper definition, but they did not offer an alternative. The court mentioned case law addressing the meaning of “beneficial owner” for purposes of Section 16 of the Exchange Act and ultimately determined that it was plausible that the parties intended the widely known Section 13(d) definition to govern. At a minimum, the court concluded that the term was ambiguous and should not be definitively construed without an opportunity for DirecTV to offer extrinsic evidence. The court also addressed whether the allegations were sufficient to state a claim for violation of a restriction on transfer in the joint venture agreement. Although ownership of one of the parent companies of Park 610 was transferred by Avila to another party, the provision only prohibited attempts by a member, i.e., Park 610 or DirecTV, to transfer an interest in the LLC. It did not prevent the transfer of ownership interests in Park 610 or DirecTV. Thus, this claim for breach of contract was dismissed. Another provision of the joint venture agreement addressed by the court was an ethics provision containing a conflicts of interest clause. Park 610 and related defendants argued that DirecTV did not sufficiently allege a breach of this provision, and the court agreed. DirecTV’s argument hinged in part on veil piercing principles, and the court noted that Delaware law would apply to attempts to pierce Park 610\\\'s veil since it was a Delaware LLC, and Uruguayan law would apply to attempts to control the Uruguayan companies that were members of Park 610. Since the only case law cited by the parties was New York law, however, the court applied New York law to the issue. The allegations were insufficient to support piercing the veil of Park 610 and its entity members, and the breach of contract claim based on the ethics clause was dismissed. Park 610 and related defendants argued that breach of fiduciary duty claims should be dismissed as well, but the court declined to do so. The parties cited a mix of Delaware and New York case law on fiduciary duties without explaining which jurisdiction’s law should apply, but the court concluded the outcome would be the same under either state’s law. The court stated that LLC members owe each other traditional fiduciary duties owed by directors to a corporation in the absence of provisions in an LLC agreement explicitly disclaiming the duties. Similarly, the court stated that the manager of an LLC owes the traditional duties of loyalty and care (which include a duty of disclosure and candor) to the members in the absence of a contrary provision in the LLC agreement. The court held that DirecTV sufficiently alleged that Park 610, as a member, and Avila, as a manager, breached their fiduciary duties to DirecTV by failing to disclose material facts regarding the transfer of a significant ownership stake in Park 610. The court also concluded that allegations of an individual’s acts done to advance the indirect transfer of ownership of Park 610 were sufficient to allege aiding and abetting liability. The court rejected the argument that the fiduciary duty claim was duplicative of the breach of contract claims. The court also rejected the argument that the ethics provision limited the fiduciary obligations of the parties.

In the Matter of 1545 Ocean Avenue, LLC

893 N.Y.S.2d 590 (App. Div. 2d Dept. 2010)

Two LLCs (“Crown Royal” and “Ocean Suffolk”) formed an LLC to purchase and develop some property. Crown Royal and Ocean Suffolk each contributed 50% of the capital, and the operating agreement provided for two managers, Van Houten (a member of Ocean Suffolk) and King (a member of Crown Royal). There were some disagreements between King and Van Houten, and eventually King announced that he wanted to withdraw his investment. There were discussions about a possible buy-out by Ocean Suffolk of Crown Royal’s interest and vice versa, but no agreement was reached. Van Houten viewed King as having resigned, and Van Houten continued work on the project. Crown Royal sought judicial dissolution of the LLC on the sole basis of deadlock between the managers. Van Houten and Ocean Suffolk argued that business was being done in accordance with the operating agreement and that the only significant dissension stemmed from the inability of the parties to agree on a buy-out. Crown Royal did not dispute that the project was near completion when the proceeding was commenced. The court analyzed whether the circumstances met the sole standard for judicial dissolution specified in the LLC statute, i.e., that is was “not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” The court stressed that the standard should not be confused with the standard for judicial dissolution of corporations or partnerships and stated that the standard for LLCs was unresolved under New York law. The court approached the matter initially as a contract-based analysis and noted that the operating agreement did not contain any specific provisions relating to dissolution. Because the operating agreement did not require regular meetings, but only required meetings to be held at such times as the managers from time to time determined, the court rejected Crown Royal’s argument that the failure of the parties to hold meetings was a basis for dissolution. The record showed that the managers communicated regularly without the formality of meetings. In analyzing the argument that the managers’ disagreements resulted in a deadlock, the court noted that deadlock itself was not a basis for judicial dissolution. The court found it necessary to consider the managers’ disagreement in light of the operating agreement and the continued ability of the LLC to function. Because the operating agreement of the LLC in this case permitted any one manager to take action permitted under the agreement, thus allowing each manager to take unilateral action in furtherance of the business, the agreement avoided the possibility of a deadlock. The court noted case law in other jurisdictions addressing the “reasonably practicable” standard and ultimately concluded that a petitioning member seeking judicial dissolution under the New York LLC statute must establish, in the context of the terms of the operating agreement or articles of organization, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible. The court concluded that judicial dissolution was inappropriate in this case. The dispute between the managers was not shown to prevent the LLC from achieving its purpose. The project was almost complete and, despite complaints made by Crown Royal, the record indicated that it ratified the efforts of Van Houten. A claim relating to the hiring of a construction company of Van Houten’s to perform work on the project was not deemed by the court to be a basis for judicial dissolution. The court stated that a derivative claim was available to Crown Royal if it was truly aggrieved by Van Houten’s actions as manager, but such remedy was not a basis for dissolution unless the wrongful acts giving rise to the derivative claim were contrary to the contemplated functioning and purpose of the LLC.

Zambelli Fireworks Manufacturing Co., Inc. v. Wood

592 F.3d 412 (3rd Cir. 2010)

(determination of citizenship of LLC for diversity jurisdiction purposes on basis of citizenship of each member).

Ferrell v. Express Check Advance of SC LLC

591 F.3d 698 (4th Cir. 2010)

(determination of citizenship of LLC for diversity jurisdiction purposes in Class Action Fairness Act context on basis of state of organization and state of principal place of business).

In re Brisbin (Oliver Holdings, Inc. v. Brisbin)

Bankruptcy No. 08-12236-SSC, Adversary No. 08-AP-937, 2010 WL 276755 (Bankr. D. Ariz. Jan. 19, 2010)

(LLC membership interest, but not operating agreement, as investment contract security)

Dunbar v. Willis

No. D054146, 2010 WL 336406 (Cal. App. 4th Dist. Jan. 28, 2010)

(analysis and interpretation of operating agreement provisions in context of trust as member and death of trustee).

Modern Motors, LLC v. Yelder

No. 2009-CA-000648-MR, 2010 WL 323305 (Ky. App. Jan. 29, 2010)

(provisions of rules of procedure as controlling over foreign qualification provisions of LLC statute for purposes of foreign LLC’s ability to assert compulsory counterclaim)

In re Resource Energy Technologies

LLC, 419 B.R. 746 (Bankr. W.D. Ky. 2010)

(inapplicability of stay in LLC’s bankruptcy to discovery of LLC documents sought from members in state litigation).

One to One Interactive, LLC v. Landrith

920 N.E.2d 303 (Mass. App. 2010)

(analysis of breach of fiduciary duty claims by minority member based on various improper actions including maneuvering to renege on buy-out deal and subjecting minority member to tax obligation without distribution to satisfy tax liability)

Christopher’s Partner, LLC v. Christopher’s of Colonie, LLC

893 N.Y.S.2d 689 (App. Div. 3rd Dept. 2010)

(ability of LLC member to seize LLC’s assets securing member’s loan to LLC without breaching fiduciary duty to LLC).

In re Law Offices of James Sokolove, LLC

986 A.2d 997 (R.I. 2010)

(approval of national law firm’s application to practice law as LLC)

In re HRM Holdings, LLC (Seidel v. Hospital Resources Management LLC)

421 B.R. 244 (Bankr. N.D. Tex. 2009)

(application of corporate veil piercing principles to LLC and insufficiency of allegations to satisfy veil piercing standards).