September 2010 — Issue 55

LLP Cases: Roe v. Ladymon

318 S.W.3d 502 (Tex. App. 2010)

(limited liability of partner in LLP; effect of conversion from LLP to limited partnership; arbitration clause not binding on partner who signed contract as representative of partnership)

LLC Cases: 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 the 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.

Related Westpac LLC v. JER Snowmass LLC

C.A. No. 5001-VCS, 2010 WL 2929708 (Del. Ch. July 23, 2010)

The operating member of two LLCs formed for a land development project in Colorado sued the other member of the LLCs seeking to require the defendant member to pay damages and meet future capital calls on the theory that the defendant’s refusal to give consents and to meet the capital calls made by the operating member was “unreasonable.” According to the plaintiff, when the funding needs for the project exceeded the agreed upon budget, the defendant refused to meet capital calls and give its consent to various major decisions. The court dismissed the complaint because the operating agreements, while prohibiting the defendant from unreasonably withholding consent to certain decisions, did not constrain the defendant’s decisions as to the decisions in issue in the case. The court stated that the plaintiff’s express breach of contract claim failed because it was clearly contrary to the bargain it made. The operating agreement preserved for the defendant the freedom to withhold consent to the decisions in issue if that was in the defendant’s self-interest whereas the defendant’s consent in other situations was subject to the commonplace standard that consent “shall not be unreasonably withheld.” The plaintiff’s effort to have the court recognize an implied reasonableness condition as part of the operating agreement’s implied covenant of good faith and fair dealing was similarly rejected by the court on the basis that the express bargain covered the subject and implying such an obligation would override the express bargain. Additionally, the defendant had no contractual obligation to pay damages for failing to fund capital calls. The operating agreements provided that a member who did not fund a capital call did not have any personal liability, the other member’s sole remedy being to revoke its contribution or fund the non-contributing member’s share. For similar reasons, the court rejected the plaintiff’s unjust enrichment and breach of fiduciary duty claims. The court stated that the plaintiff sought to deprive the defendant of the freedom it preserved under its contract by imposing a fiduciary duty to act in the reasonable best interests of the LLCs at all times. The court stated that to do so would nullify the parties’ express bargain. According to the court, “[w]hen a fiduciary duty claim is plainly inconsistent with the contractual bargain struck by parties to an LLC or other alternative entity agreement, the fiduciary duty claim must fall, otherwise ‘the primacy of contract law over fiduciary law in matters involving ... contractual rights and obligations [would be undermined].’” Thus, the plaintiff failed to state a claim for breach of fiduciary duty.

Borin v. Rasta Thomas LLC

C.A. No. 5344-CC (Del. Ch. May 4, 2010)

The defendants moved to alter or amend a judgment by the court in an action arising out of the repurchase by the defendant LLC of a member’s 40% interest in the LLC. Under the repurchase agreement, the member received payments characterized as “closing date cash consideration,” “unpaid annual salary,” and “return of capital contribution,” which were collectively characterized as the “purchase price” at the closing of the repurchase in December, 2009. The LLC agreement provided that 40% of the LLC’s income would be allocated to the member for tax reporting purposes and also provided that the LLC would make a tax distribution of 35% of the income allocated to the member so that the member could pay her taxes. After the closing of the repurchase, the member received a Schedule K-1 from the LLC reflecting allocation to the member of $184,306 of the LLC’s income for 2009. The member requested a tax distribution from the LLC of 35% of that amount, and the member sued the LLC when it failed to make the tax distribution. The defendants argued at trial that the LLC did not have to pay the member a tax distribution because the LLC agreement was superseded by the repurchase agreement. The court disagreed, finding that it was inconsistent for the defendants to treat the LLC agreement as binding on the parties for purposes of allocating income to the member while at the same time treating it as superseded and not binding for purposes of making the tax distribution tied to the income allocation. The defendants argued that the court’s judgment would result in a windfall to the member, which would be manifestly unjust. The court found that the payments to the member under the repurchase agreement were not intended to satisfy the LLC’s tax distribution obligation and thus denied defendants’ motion.

Hughes v. Kelly

C.A. No. 4814-VCN, 2010 WL 3767624 (Del. Ch. June 30, 2010)

The plaintiffs sought to dismiss the defendants’ counterclaims in which defendants’ sought to enforce indemnification, non-disparagement, and release provisions in the LLC agreement of Fund Administration Holdings, LLC (“FAH”), a holding company that controlled International Fund Services (N.A.), LLC (“IFS”). In 2002, FAH sold IFS to State Street Bank and Trust Company (“State Street”). One month before the sale, FAH’s LLC agreement was amended to designate defendant Kelly as the managing member of FAH, thus making Kelly responsible for distributing to FAH’s members the proceeds of the sale. Part of the sale price was to be paid to FAH in a lump sum at closing, with the balance determined according to IFS’s financial performance over the three-year period following the sale. Under the sale agreement, Kelly was obligated to serve as CEO of IFS during the three-year post-closing period and not to compete with IFS for two years after termination of his employment with IFS. In 2005, Kelly made distributions to FAH members, setting aside several million dollars to cover potential tax or legal liabilities and other costs. Kelly resigned from IFS in 2005 and started a competing business in 2007. In 2008, State Street filed suit against Kelly in New York alleging claims that included breach of the sale agreement’s non-competition provision. After settling with State Street in 2009, Kelly made a distribution to all FAH members other than the plaintiffs, claiming he was entitled to the withheld amount as indemnification pursuant to the indemnification provision of FAH’s LLC agreement and that he could choose from which members to seek such indemnification. The plaintiffs (each of whom was an FAH member, a senior IFS executive before the sale, and a State Street employee after the sale) filed this suit and Kelly counterclaimed, seeking a declaration that the plaintiffs were responsible under the indemnification provision for costs associated with the New York action and this action, claiming breach of a non-disparagement provision in FAH’s LLC agreement based on the plaintiffs’ alleged role in inducing State Street to bring the New York action against Kelly, and seeking either a declaration that the plaintiffs’ claims fell within the release provision in FAH’s LLC agreement or specific performance of the release. FAH’s LLC agreement indemnified Kelly against claims “relating to or arising out of the activities of the Company, or activities undertaken in connection with the Company, or otherwise relating to or arising out of” the LLC agreement except for “bad faith” acts. The plaintiffs argued that the indemnification provision was limited to Kelly’s role as the managing member of FAH and did not apply to the conduct at issue in the New York action, i.e., wrongful acts as CEO of IFS after the sale and as CEO of the competing business formed after the sale. The defendants argued that Kelly’s position as CEO of IFS allowed him to maximize distributions to FAH members and thus was inextricably intertwined with his role as managing member of FAH. The court described the issue as whether an indemnification clause addressing one role of many held by an executive can be expanded to include actions taken in other roles with some relation to the role subject to indemnification. Although the court was skeptical of the defendants’ “expansive reading” of the clause, it held that the indemnity clause was susceptible to two different, yet reasonable, interpretations. Thus, the court refused to grant the plaintiffs’ motion to dismiss. The court likewise found that the ambiguities as to the scope of the indemnification clause precluded dismissal of the defendants’ counterclaim for indemnification with respect to this action. Additionally, assuming indemnification was not granted for the New York action, the court noted that questions of fact might remain as to whether Kelly’s reliance on a broad interpretation of the indemnification clause in withholding funds from the plaintiffs constituted bad faith. The plaintiffs sought dismissal of the defendants’ claims for breach of the non-disparagement provision on a number of grounds. First, the plaintiffs contended that criticism of Kelly in his capacity as CEO of IFS fell outside the scope of the provision, which required the members to refrain from disparagement or criticism of the “Managing Member.” Because the LLC agreement defined “Managing Member” as “James P. Kelly” but did not facially restrict the non-disparagement provision to his role as FAH’s managing member, the court found the clause to be ambiguous and thus declined to dismiss the defendants’ counterclaim on this basis. Next, the plaintiffs argued that the time period prescribed in the non-disparagement provision, which was one year following the member’s “Effective Termination Date,” had expired by the time of the New York action. The court rejected this argument, noting that because the plaintiffs were still FAH members and IFS employees, their respective “Effective Termination Dates” had not yet occurred. Finally, the plaintiffs contended that their disclosures were exempt under the provision’s “legal process” exception, which excepted disparaging or critical statements or conduct “to the extent required by law or legal process.” The plaintiffs argued that they were fiduciaries of State Street under agency law principles and thus obligated to disclose relevant information that could affect the decisions of their principal. The court, however, concluded that the plaintiffs failed to meet their burden of establishing that “legal process” should be read that expansively. The court also noted that inclusion of the word “required” suggested “mandated disclosure.” The plaintiffs also attempted to take advantage of the absolute privilege afforded to trial witnesses, but the court declined to recognize such a privilege at this point in the litigation, noting that many factual questions were relevant to application of the privilege. The release provision in FAH’s LLC agreement provided that each member released Kelly from all claims “relating to or arising out of the activities of [FAH], or activities undertaken in connection with [FAH], or otherwise relating to or arising out of” the LLC agreement except for “bad faith” acts. The defendants argued that this clause required the plaintiffs first to obtain a declaratory judgment that Kelly had acted in bad faith before the plaintiffs could argue that the release clause did not apply to that conduct. Considering the LLC agreement as a whole, the court could not accept that the parties intended to employ a “two-stage litigation process.” The court thus granted the plaintiffs’ motion to dismiss the defendants’ counterclaim based upon the release clause of the FAH LLC agreement.

In re Lovell’s American Car Care, LLC

483 B.R. 355 (10th Cir (BAP) 2010)

(dissolved LLC as entity and thus “person” for purposes of proceeding in bankruptcy).

Milton Investments, LLC v. Lockwood Brothers, II, LLC

Civil Action No. 4909-VCP, 2010 WL 2836404 (Del. Ch. July 20, 2010)

(scope of arbitration clause in LLC agreement; arbitrator not disqualified by conflicts of interest where conflicts were known when arbitrator was designated in LLC agreement).

Nash v. Roberts Ridge Funding, LLC

699 S.E.2d 100 (Ga. App. 2010)

(ambiguity of operating agreement as to whether required contribution of interests in another LLC required transfer resulting in full membership status versus assignee status).

High Valley Concrete, L.L.C. v. Sargent

234 P.3d 747 (Idaho 2010)

(effect of transfer of individual’s units to another member to allow member to take advantage of tax losses; no fiduciary duty owed by member to individual who had transferred units to member and thus was not co-member).

Shirley v. JED Capital, LLC

724 F.Supp.2d 904 (N.D. Ill. 2010)

(application of Howey test to determine whether member’s interest was security under federal securities laws; futility of pre-suit demand under Illinois LLC statute in context of member’s derivative claim for breach of fiduciary duty of manager).

Moede v. Pochter

701 F.Supp.2d 997 (N.D. Ill. 2009)

(fact question as to reasonableness of member’s delay in making required capital contribution; ownership percentages not affected by failure to contribute).

Medford v. Lavergne

727 F.Supp.2d 515 (W.D. La. 2010)

(unambiguous clause in insurance policy referring to “a member of a corporation’s board of directors” not applicable to individual who was manager of LLC even if manager was functional equivalent of corporate director).

Ross v. Thomas

728 F.Supp.2d 274 (S.D.N.Y. 2010)

(cash distributions required by LLC operating at loss under unambiguous terms of operating agreement requiring distributions when LLC had taken in more capital than expended).

Woods v. Resnick

725 F.Supp.2d 809 (W.D. Wisc. 2010)

(LLC member distinguished from employee for purposes of work-for-hire doctrine).

Felton v. Teel Plastics, Inc.

724 F.Supp.2d 941 (W.D. Wisc. 2010)

(discussion of whether claims for breach of operating agreement belonged to member or LLC; interpretation and application of exculpatory provision and notice and accounting requirements of operating agreement).