October 2006 — Issue 9

In re Grupo Dos Chiles, LLC

Civil Action No. 1447-N, 2006 WL 2507044 (Del. Ch. Aug. 17, 2006)

The court awarded attorney’s fees in an LLC dispute based on the bad faith exception to the American Rule. The court concluded that the respondents, Martinez and her son Rivera, acted in bad faith in arguing that Rivera, who was named as the initial member in the certificate of formation, was the sole member of the LLC at all relevant times. Martinez had previously stated on multiple occasions (in deposition testimony in the Delaware litigation and in pleadings and requests for admission in related litigation in Virginia), that she and the petitioner were the members of the LLC. Only just before trial did Martinez and Rivera squarely begin to rely on the certificate of formation for the proposition that Rivera was the sole member of the LLC. The court recognized that there are few cases addressing LLCs and that there was no controlling precedent on the question of who was a member under the facts in this case. The court concluded, however, that Martinez and Rivera were in bad faith because their position was so strained and wholly at odds with the operative reality as to fall outside the bounds of good faith advocacy, and they could not in good faith aver, under oath, facts directly contradictory to what they had averred in the Virginia litigation. The court concluded that bad faith was not established with respect to the argument that Martinez, acting alone, had authority to return the LLC to good standing in Delaware.

Roemmich v. Eagle Eye Development, LLC

No. 1:04-cv-079, 2006 WL 2433410 (D. N.D. Aug. 16, 2006)

In litigation resulting from a falling out between members of a North Dakota LLC, the court declined to order a buy-out in favor of the minority member because the minority member breached his duty to act in an honest, fair, and reasonable manner; however, the court fashioned relief for the minority member to the extent the court concluded that the majority member acted unreasonably by failing to fulfill the minority member’s expectation that basic financial information would be provided without demand. In a lengthy opinion, the court set forth findings of fact and conclusions of law in connection with the minority member’s claims of wrongdoing on the part of those in control. The court concluded that a number of the minority member’s specific claims were barred by the statute of limitations based on the dates on which a reasonable person would have been on notice of the claims; however, with respect to the minority member’s claim for equitable relief based on unfairly prejudicial conduct under the North Dakota LLC Act, the court concluded that once there is some proof of actionable conduct within the limitations period, evidence of conduct occurring outside the limitations period may be considered for other purposes, such as background. The court found acts within the limitations period that raised an issue with respect to whether the controlling member acted in an unfairly prejudicial manner. These acts included the failure to hold meetings, the practice of sending no information other than K1's to the minority member, and the failure to maintain records of decision-making. In analyzing the minority member’s claim that he was shut out of decision-making and management and that unauthorized actions took place, the court reviewed the authority of the LLC’s president, the history of the LLC’s compliance with its governing documents and the North Dakota statute, the obligations of members as governors in self-dealing transactions, and the duties owed in closely held companies. The court noted the broad authority of the president of an LLC under the North Dakota LLC Act and the LLC’s operating agreement, but pointed out that the LLC’s governing agreements constrained the authority of the president in certain respects by requiring approval of the governors for certain transactions. Although the court recognized that the failure to follow these formalities was merely a “technical” violation given the ultimate control exercised by the majority member, the court stated that persons who ignore corporate formalities in operating an LLC do so at their peril, particularly when there are dissenting minority owners. The court stated that these matters were relevant in the court’s consideration of the claims of unfairly prejudicial conduct. With respect to numerous self-dealing claims, the court concluded that the transactions were fair and reasonable and therefore complied with the North Dakota LLC statute. The court discussed provisions of the North Dakota LLC statute authorizing a court to grant equitable relief under various circumstances, including “unfairly prejudicial” conduct. The court considered the meaning of the term “unfairly prejudicial” and concluded that the term should be given a broad reading consistent with the broad approach taken by the North Dakota Supreme Court when interpreting the term “oppressive.” According to the court, the term “unfairly prejudicial” should be “construed liberally to cover virtually any form of unreasonable conduct that has an unfair impact, even though the conduct may not have been fraudulent or illegal and regardless of whether there has been bad faith.” The court stated that the term includes conduct that amounts to a freeze out and conduct that breaches the duty to act honestly, fairly and reasonably, as well as conduct that deprives minority members of their “reasonable expectations.” Based on what the minority member could reasonably expect in connection with the LLC’s business, the court rejected the minority member’s claim that he had been frozen out by not receiving financial benefits in the form of employment or distributions. The court also concluded that the minority member had not been improperly squeezed out of participating in the active management, finding that the minority member forfeited any right or expectation of active participation due to his own inequitable conduct and breach of fiduciary duty to act fairly and reasonably. Although the court found the controlling member’s reluctance to send the minority member information without specific demand understandable, the court concluded that the minority member had a reasonable expectation of being furnished basic information on a periodic basis without demand. The court concluded that the equities did not favor dissolution of the LLC or a buy-out of the minority member’s interest because the minority member’s inequitable conduct substantially outweighed any inequitable or unreasonable conduct on the part of the controlling member, but the court fashioned remedies to address the controlling member’s failure to provide information to the minority member on an ongoing basis, failure to document decision-making, and failure to hold member meetings. The court recognized that the majority member’s conduct was not illegal and, for the most part, complied with the governing documents, but the court concluded that the obligation of a member in a closely held company goes beyond minimal compliance with state law and the governing documents. The court’s order imposed certain restrictions and requirements on the operations of the LLC and required the LLC and its members and governors to take the following actions: hold at least one members’ meeting per year (to discuss, at a minimum, operating results, tax returns for the prior year, an operating budget for the next year, and decisions regarding distributions); provide to each member, on an annual basis, copies of financial information for the prior calendar year; and prepare minutes reflecting action taken at all meetings and send copies to all members within ten days of the meeting.

Marsh v. Billington Farms, LLC

No. 04-3123, 2006 WL 2555911 (R.I. Super. Aug. 31, 2006)

Two individuals, Marsh and Despres, and their spouses, formed an LLC for the development of certain real estate. Marsh was appointed sole manager by the terms of the operating agreement. The operating agreement permitted the LLC to enter into contracts or other arrangements with “affiliated persons” as defined by the operating agreement. The LLC contracted with a corporation owned and operated by Mr. and Mrs. Marsh (the “Marsh corporation”) and a corporation owned and operated by Mr. and Mrs. Despres (the “Despres corporation”). The Marshes filed suit alleging that Despres breached his fiduciary duty by engaging in oppressive behavior and self-dealing in transactions with the Marsh corporation and the Despres corporation. The Marshes alleged that Despres, as manager of the LLC, failed to pay fees owed to the Marsh corporation, and the Marshes disputed billings made by the Despres corporation and alleged that certain discounts received by the Despres corporation were not passed on to the LLC. The Marshes also complained of certain other transactions. Despres relied upon the provision of the operating agreement permitting transactions with affiliates and the business judgment rule as defenses. The court stated that Depres owed the LLC and the Marshes a fiduciary duty of the utmost care and loyalty by virtue of his position as the controlling manager. The court described the duties of corporate directors and partners and noted that the Rhode Island Supreme Court has not yet expounded upon the “quality and scope” of the fiduciary duty owed by managers of an LLC. The court noted that Rhode Island courts have looked to Delaware law in the past when faced with a dearth of authority on corporate law, and the court concluded that, under Delaware law, managers of an LLC are held to the same fiduciary duties as directors of a corporation. Furthermore, because the Rhode Island Supreme Court has held that shareholders in a closely held corporation may owe a duty to one another similar to that owed by partners, the court concluded that the members of the LLC assumed a heightened fiduciary duty to the LLC and one another. The court relied upon the close relationship among the four members and their active participation in the business to reach this conclusion. The court found, however, that neither party established as a matter of law that Despres did or did not breach his strict duty of loyalty, care, and good faith. The court described “oppressive conduct” as conduct that substantially defeats the reasonable expectations held by minority shareholders in investing in a close corporation, and the court found that genuine issues remained as to whether the reasonable expectations of the Marshes were defeated. The court also concluded that fact issues remained with respect to the fairness of the self-dealing transactions. The provisions in the operating agreement permitting transactions with affiliates did not alter the court’s conclusion because, while the operating agreement authorized the initial contracts with the related corporations, the court did not view the provisions as diluting the ongoing duty owed by Despres to the LLC and its members. The court stated that the business judgment rule acts as a rebuttable presumption that corporate directors or LLC managers have acted with due care, in good faith, and in the best interest of the corporation or LLC, but concluded that the business judgment rule did not apply to the actions of Despres because the alleged breaches stemmed from actions taken by Despres as an interested manager. The court relied upon Delaware case law to conclude that the Marshes claim was derivative in nature, but the court adopted the American Law Institute rule allowing a court to treat a derivative action as a direct action in the context of a closely held corporation. Employing the ALI approach, the court found the claim was properly alleged as a direct cause of action. The court found that a prior consent order in which the parties agreed to a buy-out of the Marshes’ interest as an alternative to dissolution did not preclude litigation of the issues addressed in this case.

Gowin v. Granite Depot, LLC

272 Va. 246, 634 S.E.2d 714, Record No. 052240 (Va. 2006)

An individual (Gowin) was admitted as a 20% member of an LLC and executed a promissory note in the amount of $12,500 for his capital contribution. Gowin claimed that the other member (Stathis) told him that the note was something the LLC’s lawyer said had to be done, that Gowin should not worry about it, and that the LLC would take care of it. Gowin never paid the note. After the relationship between Stathis and Gowin deteriorated, Stathis amended the articles of organization to provide that the members by majority vote may eliminate another member who fails to make a required capital contribution. Stathis, as majority member, executed a written consent of members eliminating Gowin as a member for failure to make his required contribution by defaulting on the note. Gowin filed a derivative suit against Stathis alleging various acts of wrongdoing and requesting an accounting and judicial expulsion of Stathis. The trial court dismissed the suit on the basis that Gowin’s membership had been properly terminated and that Gowin was thus without standing to prosecute a derivative suit. Gowin appealed, and the Virginia Supreme Court held that informal action in the LLC context may bind an LLC just as informal action in the closely held corporation context may bind a corporation, but the court concluded that the LLC in this case was not bound by Stathis’s oral waiver of payment of the note because Stathis, as manager and controlling member, did not generally conduct the affairs of the LLC in an informal manner. Furthermore, the court held that Stathis did not breach a fiduciary duty to the LLC by adopting the amendment to the articles of organization. The court determined, however, that the promissory note signed by Gowin was a demand note on which demand was never made; therefore, the note never became overdue, and Gowin remained a member because termination of his membership for non-payment of the note was improper. With respect to the oral waiver issue, the court began by reviewing the provisions of the Virginia LLC statute addressing compromise of a contribution obligation. The statute provides that a member’s obligation to make a contribution may be compromised only by consent of all members unless the operating agreement or articles of organization provide otherwise. Neither the LLC’s operating agreement nor its articles of organization addressed capital contributions. The court stated that the LLC statute allows actions to be taken outside the context of a meeting only when the requisite number of members sign a written consent, and the LLC’s articles of organization authorized action by written consent in lieu of a meeting. The court decided as a matter of first impression that the principles permitting informal action to bind a corporation in the close corporation context should apply as well in the LLC context; however, the court determined that an oral waiver by Stathis regarding payment of the note would not bind the LLC in this case because there was no evidence that Stathis generally conducted the business of the LLC in an informal manner. Gowin pointed to a number of transactions or practices as evidence of a disregard for formalities, but the court found that Stathis did not act outside his authority as manager or controlling member and did not show a disregard for the LLC statute, articles of organization, or operating agreement. Gowin argued that the oral waiver occurred at a meeting of the members at which both Gowin and Stathis were present, but the court stated that the oral waiver was insufficient to bind the LLC, even if it occurred at such a meeting, in the absence of written documentation reflecting consent of the members. The court also rejected Gowin’s argument that delivery of the note itself was his capital contribution and that he thus could not be removed for failure to satisfy his capital contribution. The court stated that failure to pay the note would be a failure to meet a capital contribution requirement for which a member may be removed under the Virginia LLC statute. The court also rejected Gowin’s argument that Stathis breached his fiduciary duty to the LLC by amending the articles of organization to provide for elimination of Gowin’s membership interest upon nonpayment of a capital contribution. The court stated that the purpose of the amendment was to ensure the LLC received capital contributions to which it was entitled and to preclude a member from realizing a benefit from membership without satisfying his financial obligation to the LLC. Stathis testified that he adopted the amendment both to benefit the LLC and to eliminate Gowin’s interest. The court concluded that there was no evidence that adoption of the amendment alone had any impact on the LLC or was otherwise a breach of fiduciary duty. The court concluded that Gowin remained a member of the LLC, however, because the court determined that the promissory note executed by Gowin was a demand note upon which demand was never made. Because the note never became overdue, Gowin never defaulted on a payment obligation, and termination of his membership was improper. The case was accordingly remanded for further proceedings consistent with the court’s opinion.

Decker v. Decker

No. 2004AP3112, 2006 WL 2547366 (Wis. App. Sept. 6, 2006)

Two brothers operated an investment real estate business through a number of LLCs. At one point they reorganized the business by entering an operating agreement and forming a new LLC. Pursuant to the operating agreement, one of the brothers, David, sent a letter to the other brother, Frederick, declaring that a deadlock existed. Frederick did not believe that a deadlock existed and requested that David rescind the letter, but David refused. Frederick then made an offer under the operating agreement to buy David’s interest in the business for $7,000,000, approximately two to three times what the interest was worth. David accepted the offer, but Frederick never closed on the purchase. David brought an action asserting, among other claims, a claim for damages for breach of contract based on Frederick’s failure to buy his interest. The court found that Frederick’s offer and David’s acceptance did not amount to an enforceable contract because the operating agreement provided for the consequences of a failure to close. Upon Frederick’s failure to close, David had an opportunity to purchase Frederick’s interest for the same amount, and if David did not do so, the operating agreement provided for dissolution of the LLC. The court found that Frederick “sabotaged” the buy-out provisions of the operating agreement by making an outrageous offer of $7,000,000 with no intention of closing on the purchase and knowing David would not be inclined to pay that amount, leaving dissolution as the specified remedy under the operating agreement when a purchase and sale of one of their interests did not occur. Frederick argued that the LLC’s properties must then be sold on the open market and that the court-appointed receiver was not authorized to accept an offer by David. The court, however, concluded that the receiver was authorized to accept David’s offer. The court referred to David’s offer as an offer to purchase “Frederick’s share of the assets of the LLCs.” Elsewhere in the opinion, the court referred to David’s offer as an offer to purchase “Frederick’s share of the properties.” The court stated that the receiver had authority to accept David’s offer because it was no different from any third party offer except that it was for “all the property interests held by Frederick and it eliminated costly real estate commissions and other miscellaneous costs.” Furthermore, the court concluded that the trial court had statutory authority to order the sale to David under the judicial dissolution provisions of the Wisconsin LLC statute. These provisions authorize a court decree of dissolution when a controlling member engages in “oppressive” conduct, and the court found Frederick’s “obstructionist” tactics showed a lack of good faith and constituted oppression.

Friedman v. Superior Court

No. B188701, 2006 WL 2497981 (Cal. App. 2 Dist. Aug. 29, 2006)

Membership in LLC; attorney client privilege.

Harper v. Coates-Clark Orthopedic Surgery & Sports Medicine Center, LLC

Case No. 3:05-cv-166-J-MCR, 2006 WL 2523135 (M.D. Fla. Aug. 30, 2006)

Limited liability of member or manager under LLC statute; personal liability of member or manager under Fair Labor Standards Act).

In re A-Z Electronics, LLC

__ B.R. __, No. 05-05758-TLM, 2006 WL 2536298 (Bankr. D. Idaho 2006)

Authority to file bankruptcy petition for LLC.

In re Real Homes, L.L.C.

__ B.R. __, No. 05-02051-TLM, 2005 WL 4705262 (Bankr. D. Idaho 2005)

Authority to file bankruptcy petition for LLC.

Petch v. Humble

__ So.2d __, No. 41,301-CA, 2006 WL 2422914 (La. App. 2006)

Limited liability of member.

W. J. Spano Company, Inc. v. Mitchell

__ So.2d __, No. 2005 CA 2115, 2006 WL 2639973 (La. App. 2006)

Personal liability of LLC member for member’s own professional negligence.

Travelers Indemnity Co. v. Employers Co., Inc.

No. 04-CV-71494, 2006 WL 2457478 (E.D. Mich. Aug. 23, 2006)

LLC veil piercing.

Healthcare Management and Investment Holdings, LLC v. Feldman

Nos. 1:03CV0323, 1:04CV0883, 2006 WL 2660628 (N.D. Ohio Sept. 15, 2006)

Interpretation of operating agreement indemnification and exculpation provisions with respect to terminated officer of LLC.

Jandrain v. Lovald

__ B.R. __, No. CV 06-1015, 2006 WL 2524047 (D. S.D. 2006)

Rejection of member manager’s claim for compensation for various services rendered to LLC in view of inadequate documentation and legal impediments to claim under South Dakota LLC Act.

NEFT, LLC v. Border States Energy, LLC

Nos. 3:04-CV-536, 3:04-CV-570, 2006 WL 2714837 (E. D. Tenn. Sept. 22, 2006)

Limited liability of members under Kentucky law.