May 2010 — Issue 51

Kuroda v. SPJS Holdings, L.L.C.

Civil Action No. 4030-CC, 2010 WL 925853 (Del. Ch. March 16, 2010)

Kuroda became involved with several individuals whose relationship was governed by a series of agreements and contracts that formed a complex web of interrelated companies and partnerships, the purpose of which was to establish an efficient structure to manage and provide investment advice to certain funds. Kuroda was a non-managing member of an LLC that was created to serve as the general partner of the funds. As such, Kuroda had no decision-making authority in connection with the funds or the LLC. Through an entity of which he was a shareholder, Kuroda provided investment analyst and consulting services to the investment manager of the funds. In the course of performing these services, Kuroda acquired high-level proprietary and confidential information. The consulting agreement between the investment manager and the entity through which Kuroda rendered services, and certain other documents, included confidentiality provisions. Tension developed between Kuroda and other individuals involved in the investment activities, and Kuroda announced that he was resigning as a consultant to the investment manager and intended to establish his own fund. Kuroda then launched a fund that directly competed with the funds with which he was previously involved. Kuroda sued for unpaid consulting fees, and the defendants counterclaimed for misappropriation of trade secrets, breach of fiduciary duty, breach of contract, and breach of the implied covenant of good faith and fair dealing based on various alleged acts. The court first addressed the counterclaim against Kuroda for breach of fiduciary duty. The defendants alleged that Kuroda violated fiduciary duties that arose from the terms of the consulting agreement between the investment manager and the corporation through which Kuroda provided consulting services as well as duties that arose through Kuroda’s role in the LLC and his “central role” in the overall structure of the business endeavor. The court held that Kuroda did not owe fiduciary duties to anyone who had alleged harm. Because Kuroda was neither a manager nor a controlling member of the LLC, the court held he had no fiduciary duties based on his non-managing member role in the LLC. The court also stated that, no matter how “central” Kuroda was to the entire business endeavor, his centrality was governed by contractual duties rather than fiduciary duties. Citing Shakespeare and Lewis Carroll, the court emphatically rejected the notion that Kuroda should be characterized as a fiduciary, concluding that if the “defendants wanted everyone to enjoy a red rose of fiduciary duty, they should not have planted white roses of contractual obligations and now ask [the court] to paint over them.” Thus, the court dismissed the counterclaim for breach of fiduciary duty. The court next addressed the counterclaim against Kuroda for breach of confidentiality provisions contained in the fund agreements. Although Kuroda was not identified as a party in the fund agreements, the defendants argued that Kuroda was bound by the confidentiality provisions in the agreements because he authorized the managing members of the LLC to make the promises on his behalf. This argument was based on the LLC agreement signed by Kuroda, which provided that the managing members had the authority to act on behalf of the LLC and to enter into and perform all contracts and other undertakings deemed necessary, advisable, or incidental to carry out the purposes of the LLC. The LLC agreement also provided that each member appointed each managing member as the member’s representative and attorney-in-fact to execute any instrument or document necessary or desirable to accomplish the business and objectives of the LLC. The court rejected the argument that these provisions permitted the managing members to bind Kuroda to the fund agreements. According to the court, the provisions relied upon did not give the managing members authority to bind individual members, as opposed to the LLC itself, to any kind of contract. The court stated that the boilerplate provision appointing the managing members as attorney-in-fact for the members could include authority to sign documents or agreements that require pro forma the signature of all members, but not a major agreement that would impose new rights and obligations on Kuroda. Thus, the court dismissed the counterclaim for breach of contract. Finally, the court addressed the counterclaim against Kuroda for breach of the implied covenant of good faith and fair dealing. The defendants contended that the LLC agreement included the following implied promises: not to misappropriate trade secrets; not to cause the entity through which Kuroda provided consulting services to commit a material breach of the consulting agreement’s confidentiality provision; not to commit, or cause the LLC to commit, a material breach of the fund agreements’ confidentiality provisions; and not to engage in conduct destructive to the business of the LLC and the funds. The court stated that the implied covenant of good faith and fair dealing requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct that has the effect of preventing the other party from receiving the fruits of the bargain. The implied covenant cannot be invoked to override the express terms of the contract. Further, rather than constituting a free floating duty, the implied covenant can only be used conservatively to ensure that the parties’ reasonable expectations are fulfilled. General allegations of bad faith conduct are insufficient to allege a claim for breach of the implied covenant; a party must allege a specific implied contractual obligation and how the violation denied the party the fruits of the contract. The court believed that implying a confidentiality provision in the LLC agreement would override its express terms. The defendants included confidentiality provisions in other agreements involved in the business arrangement while excluding duties relating to confidentiality from the LLC agreement. The court stated that the defendants’ “somewhat muddled discussion of other wellsprings for the duty of confidentiality –including the common law, fiduciary duties, and contractual intentions–cannot cloud the fact that the LLC Agreement specifically excluded any duties relating to confidentiality....” The court noted that the defendants appeared to be going to great lengths to avoid the argument that Kuroda had contractual obligations under the consulting agreement, which contained a provision mandating arbitration in Tokyo. Finding the defendants did not state a claim for breach of the implied contractual covenant of good faith and fair dealing, the court dismissed the claim.

Thor Merritt Square, LLC v. Bayview Malls LLC

C.A. No. 4480-VCP, 2010 WL 972776 (Del. Ch. March 5, 2010)

The plaintiffs purchased a shopping center from two Delaware LLCs pursuant to a contract that made the LLCs responsible for all costs incurred in connection with the work required to bring a JC Penney store in the shopping center into compliance with the fire code. In connection with this obligation, the LLCs deposited approximately $250,000 into an escrow account pursuant to an escrow agreement. The escrow agreement provided that the LLCs were obligated to complete and pay for the work, whether or not the escrowed money was sufficient to pay for it. Almost immediately after purchasing the shopping center, the LLCs distributed virtually all of their assets to their members. The LLCs, however, failed to perform the remedial work required under their contract with the plaintiffs. When the LLCs failed to respond to the plaintiffs’ demands to perform the work, the plaintiffs arranged to have the work completed, which cost over $1 million. The plaintiffs notified the LLCs of the completion and cost of the work. Shortly before such notification, however, the defendants had filed certificates of cancellation terminating the LLCs’ legal existence. After learning of the filing of the certificates of cancellation, the plaintiffs filed this action seeking nullification of the LLCs’ certificates of cancellation on the basis that the defendants had failed to make reasonable provision for the unmatured contract claims of the LLCs prior to the filing as required by the Delaware LLC statute. The defendants moved to dismiss the action, contending that the escrow agreement constituted reasonable provision for the LLCs’ unmatured contract claims and that the LLC statute cannot be read to require an entity to make reasonable provision for claims that it could not anticipate until after its certificate of cancellation was filed. The plaintiffs argued that the defendants were liable for all costs of the remedial work, that the cost of the work exceeded the escrow, and that the defendants knew before the filing of the certificates of cancellation that the cost of the work would exceed the escrow. These allegations were sufficient to withstand a motion to dismiss. The defendants also argued that it was pointless to nullify the filing of the LLCs’ certificates of cancellation because any claims that the plaintiffs could make against the LLCs would be time-barred. The plaintiffs argued that their claims would not be time-barred, and the court held that the defendants had not shown otherwise.

Cline v. Grelock

C.A. No. 4046-VCN, 2010 WL 761142 (Del. Ch. March 2, 2010)

Two friends, Cline and Grelock, co-owned a short-lived Delaware LLC that operated a towing and recovery service. The business operated unsuccessfully, and the relationship between Grelock and Cline deteriorated. After about seven months, Grelock unilaterally dissolved the LLC, and he and his wife formed a new LLC that provided similar services. The new LLC used a vehicle purchased by the original LLC, a trade name and logo used by the original LLC, and a customer list of the original LLC consisting of three customers. Cline sued for damages and an ownership interest in the new LLC, and Grelock sued to enforce the capital contribution Cline allegedly promised to make to the original LLC. The parties disputed their ownership percentages in the original LLC, with Cline claiming he owned a 50% interest. The tax records for the original LLC reflected equal ownership, but Grelock claimed that Cline had never made the required $25,000 capital contribution. Cline did not dispute the fact that he never made his capital contribution, but he claimed that he never signed the LLC agreement that required it. The only contribution that Cline made was as a co-guarantor of the loan for the truck that the original LLC purchased. The court found that it was unreasonable for Cline to claim he was a 50% owner when he did not make a capital contribution. The court acknowledged that Grelock acted improperly and breached his fiduciary duty in connection with his unilateral dissolution of the original LLC and use of its assets in the new LLC, but Cline was unable to prove any damages. Cline argued alternatively that he was entitled to an ownership interest in the new LLC as a wrongfully excluded co-owner of the dissolved LLC. After agreeing that a former partner (or member of an LLC) may be held accountable for profits earned using partnership assets, the court determined that Cline failed to show what his interest should be or how the court should calculate it. Moreover, the court was not persuaded that a person who failed to make a capital contribution should be allowed to claim an interest in a successor company. The court concluded that Cline’s failure to make a capital contribution precluded him from asserting an equity interest or, alternatively, that the amount of capital which Cline reasonably should have contributed far exceeded any value fairly attributable to the original LLC, including its assets now being used for the new LLC’s benefit. Thus, although the court did not condone Grelock’s conduct, Cline could not recover because he did not prove that he was harmed (or, if harmed, what his recovery should be). Grelock’s wrongful conduct, however, precluded Grelock from recovering on his claim to compel Cline to pay his capital contribution for the benefit of the original LLC. Finally, the court ordered Grelock and his wife to exercise all good faith efforts to obtain Cline’s release from the guaranty of the loan on the truck purchased by the original LLC and now being used by the new LLC. Furthermore, the court said that if the Grelocks were unable to secure Cline’s release, they must individually indemnify and hold Cline harmless from any claim arising out of the guaranty. The court assessed the costs of the action against Grelock because of his breach of fiduciary duty.

In re Mervyn’s Holdings, LLC (Mervyn’s LLC v. Lubert-Adler Group IV, LLC)

426 B.R. 488 (Bankr. D. Del. 2010)

The court determined that the debtor’s complaint against Target Corporation alleged facts sufficient to support collapsing the transactions surrounding the sale of Mervyn’s (including execution of a sale agreement, stripping of real estate assets, increasing the rent under leases, and conversion of the debtor from a corporation to an LLC) so as to state a claim based on fraudulent transfer. The court noted in particular that the conversion of the debtor into an LLC was particularly significant because it enabled Target to transfer its membership interest, which was a major factor in the fraudulent transfer claim. The court also determined that, while no California court has directly and explicitly stated that a sole member of an LLC owes the company fiduciary duties, the California Supreme Court would likely find a sole member owes such duties to the LLC. The court concluded that California law clearly imposes duties on an LLC member to the LLC’s creditors when the LLC is insolvent. The complaint alleged that the debtor was or became insolvent at the time the sale agreement was executed due to the stripping of real estate assets; therefore, Target, which was in control of the debtor, owed fiduciary duties to the LLC’s creditors. Target attempted to rely on an exculpation clause in the debtor’s operating agreement, but the court stated that the exculpatory clause was an affirmative defense and, as such, could not form the basis for a dismissal. The court held that the California four-year statute of limitations for breach of fiduciary duty rather than the Delaware three-year statute applied under the Delaware internal affairs choice of law rule, and the Delaware “borrowing” statute was inapplicable.

In re South Canaan Cellular Investments, LLC (South Canaan Cellular Investments, LLC v. Lackawaxen Telecom, Inc.)

427 B.R. 85 (Bankr. E.D. Penn. 2010)

The debtors, two Delaware LLCs, sued Coughlin, a member of the LLCs, and Lackawaxen Telecom, Inc. (“LTI”), a corporation of which Coughlin was president and a shareholder, for breach of fiduciary duty based on Coughlin’s obtaining information from the LLCs regarding the LLCs’ indebtedness to a bank and LTI’s purchase of the indebtedness from the bank. The LLCs argued that Coughlin’s use of the information to secretly purchase the bank loan at a time when the LLCs were negotiating with the bank to resolve the loan breached Coughlin’s fiduciary duties in various respects. The court discussed fiduciary duties under Delaware law and dismissed the plaintiffs’ claims for breach of fiduciary duty because the complaint did not allege that Coughlin was a managing or controlling member or that the operating agreements imposed on him any fiduciary duties. The court noted the flexibility provided by the Delaware LLC statute to define duties but assumed that the operating agreement was silent on duties since the operating agreement was not attached to the complaint and the complaint did not allege that the operating agreement imposed any duties. The court rejected the plaintiffs’ argument that all members of an LLC owe fiduciary duties to the LLC as a matter of common law. Analogizing to corporate and limited partnership case law, and relying on Delaware LLC cases, the court concluded that Delaware common law does not impose fiduciary or other related duties on LLC members who are neither managers nor controlling members. The complaint did not allege that Coughlin exercised any control or management duties involving the LLCs, either directly or through an agent, nor that he had any right to do so, and the court stated that he had owed no fiduciary duties to the LLCs as a mere minority member. The court thus dismissed the plaintiffs’ various claims against Coughlin for breach of the duties of loyalty, candor and disclosure, good faith, care, fiduciary duty, and good faith and fair dealing. The court also dismissed the claim against LTI for aiding and abetting Coughlin’s breach of fiduciary duty since the breach of fiduciary duty claims failed. The court dismissed the plaintiffs’ claim for breach of the implied contractual covenant of good faith and fair dealing, finding it difficult to apply Delaware law without the operating agreements and stating that the court must dismiss unless the LLCs demonstrated that it was clear from the contract that the parties would have agreed to proscribe the act complained of had they thought to negotiate the matter. Furthermore, the court believed that any claim for breach of an implied covenant in the operating agreements should be asserted by the LLC members rather than by the LLCs. In any event, assuming the LLCs had standing and that the absence of the underlying agreements was not dispositive, the court concluded that the LLCs failed to state a cause of action because the Delaware LLC statute permits LLC members to lend money to the LLC and transact other business with the LLC on the same terms as a non-member unless the operating agreement provides otherwise. In the absence of any allegation that the operating agreements provided otherwise, the court stated that Coughlin was free to become a creditor of the LLCs and it was not persuasive to argue that he breached an implied covenant by having an entity of which he was president become a creditor by assignment of the loan. Additionally, the court relied upon the statutory provisions governing access by the LLC members to information about the LLC. The court pointed out that an LLC manager need not disclose confidential information if the manager believes it will be harmful to the LLC, and the court found the Delaware statute to implicitly recognize that non-fiduciaries obtaining information may make use of the information for their own benefit. The court stated that the good faith implied in all contracts primarily imposes a duty not to use contract rights unreasonably, but that non-managing members may generally act in their self-interest. The court stated that Coughlin’s demand for information under the Delaware LLC statute could have been refused by the LLCs if disclosure would be harmful, and the LLCs must have concluded that disclosure of the limited and general information disclosed four months prior to the assignment of the loan would not be harmful. Furthermore, the court pointed out the information was not the subject of any confidentiality agreement. As Coughlin was under no fiduciary obligation to the LLCs and was free to act in his self-interest, free to become a creditor of the LLCs, and was accused of no more than using limited and general information he either had a statutory right to obtain (or, if not, that the LLCs elected not to deny him), the court concluded that the LLCs stated no cause of action for breach of an implied contractual covenant of good faith and fair dealing.

In re Ekstrom

No. 08-07750-SSC, 2010 WL 1254893 (Bankr. D. Ariz. March 23, 2010)

(refusal to disregard or consolidate entities to treat property of LLC as property of debtor for purposes of classification of creditor with lien on property).

Lee v. Yum

No. 1 CA-CV 08-0575, 2010 WL 989907 (Ariz. App. March 8, 2010)

(dissolution of LLC on death of member; rights of estate of deceased member to receive distributions as assignee).

Julian v. Julian

Civil Action No. 1892-VCP, 2010 WL 1068192 (Del. Ch. March 22, 2010)

(interpretation of language in stockholder agreement referring to “real estate held by” corporation as including real estate held indirectly through LLC).

McWilliams Ballard, Inc. v. Level 2 Development

697 F.Supp.2d 101 (D.D.C. 2010)

(sufficiency of allegations to support liability of individuals and related LLCs for LLC’s indebtedness under alter ego theory).

Onuss Ortak Nokta Uluslararasi Haberlesme Sistem Servis Bilgisayar Yazilim Danismanlik ve dis Ticaret Limited Sirketi v. Terminal Exchange, LLC

No. 09-80720-CIV-MARRA, 2010 WL 935972 (S.D. Fla. March 10, 2010)

(insufficiency of allegations to support liability of LLC on pre-formation transaction; common law and statutory promoter liability with respect to transaction prior to formation of LLC).

Braucher v. Swagat Group, L.L.C.

702 F.Supp.2d 1032 (C.D. Ill. 2010)

(limited liability of LLC members for tortious acts of LLC; potential liability of LLC member for member’s own actions taken on behalf of LLC).

Department of Agriculture v. Appletree Marketing, L.L.C.

779 N.W.2d 237 (Mich. 2010)

(personal liability of sole manager and member of LLC for common law or statutory conversion without “piercing corporate veil” based on individual’s tortious acts).

West Town Line Associates, LLC v. Mack & Meldrum Associates, LLC

No. 288384, 2010 WL 785938 (Mich. App. March 9, 2010)

(interpretation of operating agreement provisions regarding capital calls and loans; authority of managing member to bring suit on behalf of LLC).

Great Investment Properties v. Bentley

No. 9-09-36, 2010 WL 892122

(Ohio App. March 15, 2010) (interpretation of operating agreement regarding capital contributions and loans).

Partners Coffee Company, LLC v. Oceana Services and Products Company

700 F.Supp.2d 720 (W.D. Penn. 2010)

(application of alter ego theory to LLC and insufficiency of allegations to support contention of liability).