October 2008 — Issue 32

LLCs: NetJets Aviation, Inc. v. LHC Communications, LLC

537 F.3d 168, No. 06-3340-cv (2d Cir. 2008)

The plaintiffs sought to hold the sole member of a Delaware LLC liable for the breach of contract of the LLC on the basis that the member was the LLC’s alter ego. The trial court granted summary judgment in favor of the member on the ground that the plaintiffs had not adduced sufficient evidence to pierce the veil of the LLC. The Second Circuit Court of Appeals discussed Delaware corporate veil piercing principles and concluded that such principles are generally applicable to an LLC, with the caveat that somewhat less emphasis is placed on whether the LLC observed internal formalities in an alter ego analysis of an LLC. The court stated, however, that if two entities with common ownership “‘failed to follow legal formalities when contracting with each other it would be tantamount to declaring that they are indeed one in the same.’” The court examined the evidence that the LLC and its sole member operated as a single entity and found that the evidence, viewed most favorably to the plaintiffs, showed that the LLC was started with a capitalization of no more than $20,100, that it proceeded to invest millions of dollars supplied by its member, and that the member put money into the LLC as needed and took money out as the member needed it. The LLC had only one officer other than its member, and the officer was paid by the member or one of his corporations. The LLC shared space with other companies owned by the member and shared employees with the member or other companies owned by the member. The member formed the LLC to be used as an investment vehicle for him to make investments, and the ultimate decisions were always made by the member. The court reviewed evidence relating to financial transactions involving the LLC, including transfers to the member or third parties on his behalf in connection with living expenses. The individual in charge of the LLC’s financial records testified that the member made the decision to treat moneys deposited into the LLC as loans so that the member could make withdrawals as he needed money without having to pay taxes on the money withdrawn. The loans were not evidenced by written agreements, and there were no set repayment programs or terms. The member decided when to put money in or take money out of the LLC. The court concluded that this evidence was ample to permit a reasonable factfinder to find that the member completely dominated the LLC and treated its bank account as one of his pockets. The court then reviewed evidence relating to fraud, illegality, or injustice and stated that there may be overlap in the proof offered to show the LLC and member operated as a single entity and the proof relating to unfairness. The court found evidence of injustice in an affidavit submitted by the member to counter the plaintiffs’ contention that the LLC was undercapitalized. The affidavit stated that the member did not intend for the monies paid to the LLC to be treated as loans and that such payments were in fact capital contributions. The court pointed out that the individual in charge of the LLC’s books testified that the member instructed him to treat the payments as loans so that the member could take money out of the LLC without tax consequences. The court pointed out that the member’s withdrawals of money from the LLC would be properly characterized as distributions if the payments to the LLC were capital contributions and that distributions to the member may well have violated the prohibition on distributions under the Delaware LLC statute given that the LLC had ceased operating and was unable to pay its debt to the plaintiffs. The court stated that a factfinder could infer that the member’s payments to the LLC were deliberately mischaracterized as loans to mask the fact that the member was making withdrawals prohibited by law. The court also stated that a reasonable factfinder could find that the member operated the LLC in his own self-interest in a manner that unfairly disregarded the rights of the LLC’s creditors given various payments and withdrawals on the member’s behalf at a time when the LLC was unable to pay its debt to the plaintiffs and evidence that the member withdrew more money from the LLC than he put in. The court concluded by finding that neither the LLC member nor the plaintiffs were entitled to summary judgment on the veil piercing claim.

Tunney v. Hilliard

C.A. No. 1317-VCN, 2008 WL 3875620 (Del. Ch. Aug. 20, 2008)

Tunney and Hilliard owned and operated a corporation (which was the operating entity) and an LLC (a real estate holding entity) in connection with their restaurant business. After they sold the business, Tunney argued that he was entitled to a “commission” out of the sales proceeds based on an oral agreement reached with Hilliard when Tunney assumed additional management responsibilities in Hilliard’s absence. Hilliard denied making this agreement with Tunney and claimed that any additional efforts by Tunney were de minimis or within the scope of their original 50-50 agreement. The court reviewed the evidence and agreed with Hilliard. The court found that Hilliard’s decreased presence resulted in few changes in the business. The stock certificates of the corporation evidenced equal ownership, and the written LLC agreement provided for equal distribution of the profits. The court acknowledged that Delaware law permits oral modifications of written agreements, but stated that they were not favored for “a host of policy and pragmatic reasons.” Thus, a party seeking to prove an oral modification must prove the intended change with sufficient specificity and directness as to leave no doubt of the intended change to the formal document. The court concluded Tunney fell well short of that mark. The court also rejected Tunney’s promissory estoppel claim because he failed to prove that Hilliard promised him additional compensation. Finally, the court rejected various equitable claims by both parties for compensation for “additional”efforts expended in operating the business. The court found that each contributed more or less equally to the success of the business and that they were left to abide by their original 50-50 agreement.

R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC

Civil Action No. 3803-CC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008)

The petitioners sought judicial dissolution of nine Delaware LLCs. With respect to two of the LLCs, the court held that the petitioners did not have standing under the Delaware LLC statute to seek dissolution and winding up because only managers or members have standing to do so under the statute. The court stated that there was no authority for the proposition that a member of an LLC that is itself a member of another LLC can seek dissolution or the winding up of the latter LLC. The court held that the claim for receivership survived because the statute permits a “creditor, member or manager... or any other person who shows good cause” to present an application for receivership. With respect to the other seven LLCs, the court dismissed the action because the members waived the right to seek dissolution or the appointment of a liquidator in the LLC agreements. Although the LLC agreement specified events of dissolution that included entry of a decree of judicial dissolution, the court did not find that this provision conflicted with the waiver of dissolution rights contained elsewhere in the LLC agreement because the Delaware statute permits a court to enter a decree of judicial dissolution upon an application by or for a member or manager, and the members or managers cannot waive the rights of others to make such applications for them. The court proceeded to address freedom of contract in the LLC context to waive rights to seek judicial dissolution and the appointment of a liquidator. The court concluded that the Delaware LLC statute does not preclude waiver of these rights. The court rejected the argument that statutory provisions that do not include the qualification “unless otherwise provided in a limited liability company agreement” (or some variation thereof) are mandatory and may not be waived. The court noted that the statute did not expressly prohibit waiver of such rights, and the judicial dissolution and receivership provisions are phrased in permissive terms (i.e., the court of chancery “may” decree dissolution or appoint a trustee or receiver under such provisions). The most important factor in the analysis according to the court was the fact that the rights waived in the LLC agreement were not designed to protect third parties. The court pointed out that it had previously recognized that third parties have no interest in a judicial dissolution proceeding under the Delaware LLC act, and the LLC agreement did not affect the statutory right of creditors to petition for appointment of a receiver. The court also rejected the argument that the waiver of rights to seek dissolution and receivership violated the public policy of Delaware. Stressing the policy of contractual freedom and the enforceability of voluntary agreements of sophisticated parties, the court concluded that the policy of Delaware mandated that it respect the parties’ agreement. According to the court, there is no threat to equity in enforcing a waiver of the right to seek dissolution because the unwaivable implied covenant of good faith and fair dealing ensures that members will not be trapped in an LLC at the mercy of others acting unfairly and in bad faith.

Monier v. Boral Lifetile, Inc.

C.A. No. 3117-VCN, 2008 WL 2168334 (May 13, 2008)

Monier, Inc. (Monier) and Boral Lifetile, Inc. (Boral) each owned 50% interests in a Delaware LLC that was managed by a management committee consisting of three representatives of each member. Monier sought a declaratory judgment determining the percentage of net income that must be distributed under the LLC operating agreement, and Boral sought dismissal of Monier’s claim. The operating agreement specified that 50% of the net income would be distributed each year unless the management committee approved a greater or lesser distribution without any dissenting vote. In 2000, the management committee adjusted the distribution rate to 100% of the audited net profits, and the parties disputed whether this was a change that was intended to be in effect on an ongoing basis for the indefinite future. Monier argued that making the change on an ongoing basis was a valid exercise of the management committee’s authority under the operating agreement or, alternatively, constituted an amendment of the operating agreement. Boral argued that the operating agreement gave authority to vary the 50% default distribution rate under the operating agreement from time to time, but not in perpetuity, and that the 2000 action was a limited policy change that was reaffirmed annually by action of the management committee until 2005, when the policy was questioned. Boral also argued that Monier’s construction demonstrated a violation of the management committee’s fiduciary obligations as an impermissible abdication of the committee’s duty to manage. Finally, Boral argued that the requirements for amending the operating agreement were not met. Boral interpreted the operating agreement to impose the following requirements for amendments: (1) approval by the management committee without dissent; (2) approval by all members; and (3) a signed writing of both members. The court concluded that Monier stated a claim for its interpretation of the operating agreement (i.e., that the agreement authorized the management committee to change the distribution rate for an indefinite period of time). Though Monier’s interpretation might not ultimately prevail, it was not unreasonable and survived the motion to dismiss. The court also concluded that Boral could not demonstrate that the mere setting of the distribution rate to 100% until the management committee unanimously determined otherwise constituted an abdication and breach of fiduciary duty.

Lach v. Man O’War, LLC

256 S.W.3d 563, No. 2005-SC-001014-DG (Ky. 2008)

A limited partnership serving as the sole general partner of another limited partnership was reorganized as an LLC, and a limited partner challenged the reorganization on the basis that it was in effect a conversion for which her consent had not been obtained as required by Kentucky law. The reorganization was accomplished by a series of steps involving the formation of the LLC, transfer to the LLC of the partnership’s interest as general partner in the second limited partnership, and dissolution of the limited partnership resulting in distribution of the LLC ownership to the partners in proportion to their interests in the partnership. The plaintiff argued that the transaction amounted to a conversion under Kentucky law and thus required approval of all the partners. The supreme court reached the same conclusion as the court of appeals, finding that there was no conversion because a conversion involves only one entity changing its legal form. The court noted that the general partners referred to the transaction on a couple of occasions as a conversion, but stated that the transaction must be analyzed for what it was, not what someone said it was. The court also commented that it had not been asked, and had not considered, whether the restructuring constituted a merger under the Kentucky limited partnership statute. The supreme court disagreed with the court of appeals on the issue of whether the restructuring of the limited partnership was a breach of fiduciary duty by the general partners. The court concluded as a matter of law that the restructuring of the limited partnership into an LLC without the limited partner’s approval was a breach of fiduciary duty to her, as was the transfer of the partnership’s assets to the LLC. The court held that the transfer of the limited partnership’s assets to the LLC violated the Kentucky limited partnership statute because the statute deprives a general partner of the authority to do any act which makes it impossible to carry on the ordinary business of the partnership without the written consent of all limited partners. The court also held that the attorney-client privilege could not be used to prevent discovery of information related to the breach of a partner’s fiduciary duty.

Jack J. Morris Associates v. Mispillion Street Partners, LLC

C.A. No. 07C-04-023-RFS, 2008 WL 3906755 (Del. Super. Aug. 26, 2008)

(actual and apparent authority of former manager).

Ventas Finance I, LLC v. California Franchise Tax Board

165 Cal.App.4th 1207, 81 Cal.Rptr.3d 823, Nos. A116277, A117751 (Cal. App. 1st Dist. 2008)

(unconstitutionality of California franchise tax).

In re Lull (Kotoshirodo v. Dorland and Associates, Inc.)

Bankruptcy No. 06-00898, Adversary No. 08-90001, 2008 WL 3895561 (Bankr. D. Hawaii Aug. 22, 2008)

(removal of member/manager as preferential transfer; member as non-statutory insider of other member)

Bond v. Veolia Water Indianapolis, LLC

571 F.Supp.2d 905, Case No. 108-cv-0634-DFH-JMS (S. D. Ind. 2008)

(citizenship of LLC for diversity purposes under Class Action Fairness Act)

Smith v. Riverwalk Entertainment LLC

Civil Action No. 05-1416, 2008 WL 3285909 (W.D. La. Aug. 8, 2008)

(limited liability of LLC member; personal liability of member for fraud; liability of related LLCs under single business enterprise theory)

Wildwood Medical Center, L.L.C. v. Montgomery County

405 Md. 489, 954 A.2d 457, No. 125 Sept. Term 2007 (Md. App. 2008)

(application of recordation/transfer tax exemption to transfer of property from partnership to LLC though property not held in partnership name)

Echelon Homes, L.L.C. v. Carter Lumber Company

No. 277471, 2008 WL 3540210 (Mich. App. Aug. 14, 2008)

(limited liability of members during LLC winding up; power of dissolved LLC to sue and be sued; duties of management during winding up and third party’s lack of standing to assert improper dissolution/winding up of LLC as basis to dismiss LLC’s suit)

546-552 West 146th Street LLC v. Arfa

54 A.D.3d 543, 863 N.Y.S.2d 412 (App. Div. 1st Dept. 2008)

(lack of standing of LLCs to assert breach of duty against member/managers who were sole member/managers at time of alleged wrongdoing; lack of fiduciary obligation of promoters to LLC that does not exist at time of transaction)

Samsara Investment III, LLC v. Wallace

No. 07-cv-9385 (JFK), 2008 WL 3884362 (S.D.N.Y. Aug. 21, 2008)

(waiver by members’ conduct of provisions of LLC operating agreement governed by Mississippi law notwithstanding no-waiver and no-oral modification provisions of agreement)

In re Klingerman

No. 07-02455-5-ATS, 2008 WL 3287199 (Bankr. E.D.N.C. Aug. 2, 2008)

(discretionary authority of court to judicially dissolve or modify terms of deadlocked LLC)