recent case law developments 2015-17 · an llc, unilaterally transferred for no consideration...
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Recent Case Law Developments
2015-17 Thomas E. Rutledge
Stoll Keenon Ogden PLLC
500 W. Jefferson Street
2000 PNC Plaza
Louisville, Kentucky 40202
KJentuckyBusinessEntityLaw.blogspot.com
© June 24, 2019
Aurelia Skipwith*
AVC Global
20 F Street, N.W.
Suite 700
Washington, D.C. 20001
* After the preparation and submission of these materials, Ms. Skipwith was appointed to the office of Deputy
Assistant Secretary in the Department of the Interior.
This case law review has an inception date of January, 2015 and continues
through the first weeks of 2017. It is a selection of decisions rendered,
primarily in Kentucky, over that period. No assertion is made that it is
comprehensive
Fiduciary Duties .............................................................................................................................1
Conlon v. Haise
Griffin v. Jones
Patmon v. Hobbs
Farmer v. Miller
Liberty Rehabilitation v. Waide
In re Nine Systems Corporation Shareholders Litigation
The Direct Versus Derivative Distinction ..................................................................................11
(2015) adoption of KRS § 275.337
Gross v. Adcomm
Lani v. Schiller Kessler and Gomez
El Paso Pipeline GP Company, L.L.C. v. Brinckenhoff
Keller v. Estate of Richard Steven McRedmond
MFB Realty LLC v. Eichner
Pagtakhan-So v. Queto
King Fa, LLC v. Cheung
Environmental Trust, LLC v. Hi Tech Rubber, Inc.
Scarfo v. Snow
Quadrant Structured Products Company, Ltd. v. Vertin
Griffin v. Jones
Piercing the Veil ...........................................................................................................................34
In re Howland
Lee v. Lee
Sky Cable LLC v. Coley
ii
Balintulo v. Ford Motor Co.
WRK Rarities LLC v. United States
Kentucky Petroleum Operating Ltd. v. Golden
Roscoe v. Angelucci Acoustical, Inc.
Diversity Jurisdiction...................................................................................................................51
Americold Realty Trust v. Conagra Foods, Inc.
Bissell v. Graverly Brothers Roofing Corp
Lincoln Benefit Life Co. v. AEI Life, LLC
Singh v. Diesel Transportation, LLC
Fairfield Castings, LLC v. Hofmeister
Errant Gene Therapeutics, LLC v. Sloan-Kettering Institute
Landowner’s Responsibility ........................................................................................................61
Phillips v. Touchtone Properties, LLC
Shirrell v. The Kroger Company
Substantive Consolidation ...........................................................................................................65
In re The Archdiocese of St. Paul and Minneapolis
In re Howland
Judicial Expulsion of LLC Members .........................................................................................71
I.E. Test, LLC v. Carroll
All Saints University of Medicine Aruba
Corporification .............................................................................................................................76
Obeid v. Hogan
Richardson v. Kellar
iii
Administrative Dissolution ..........................................................................................................82
CF SBC Pledgor I 20-12-1 Trust v. Clark/School, LLC
In re: Reinstatement of S&D Roofing, LLC
In re Carlisle Etcetera, LLC
Member Disassociation ................................................................................................................87
Inteliclear, LLC v. Victor
Clark v. Butoku Karate School, LLC
Intra-member Transfers .............................................................................................................92
Huang v. Northern Star Management LLC
LLC as Entity Distinct From Members .....................................................................................96
Ceres Protein, LLC v. Thompson Mechanical & Design
Arbitration ....................................................................................................................................98
Gatliff v. Firestone Industrial Products Co., LLC
Watkins v. PNC Bank, N.A.
Economic Loss Doctrine ............................................................................................................102
Biszantz v. Stevens Thoroughbred, LLC
The Cinelli Rule ..........................................................................................................................104
Rose Mary Hubbs Brewer v. John M. Parsons 2007 Rev. Trust
Contract Architecture ...............................................................................................................106
Dixon v. Daymar College Group, LLC
C.A.R.S. Protection Plus, Inc. v. Mamrak
Sole Proprietorships...................................................................................................................110
Kentucky Employees Mutual Ins. v. Ellington
Sparkman d/b/a In-Depth Sanitary Service Group v. Console Energy, Inc.
iv
Fraudulent Conveyance.............................................................................................................115
Kentucky Petroleum Operating Ltd. v. Golden
UCC ..........................................................................................................................................119
Forcht Bank, NA v. Gribbins
Products Liability.......................................................................................................................122
Faesy v. JG 1187, Inc. d/b/a McDonald’s restaurant
LLC Assignees ............................................................................................................................124
Styslinger v. Brewster Park, LLC
Bourbon Investments, LLC v. New Orleans Equity LLC
Employment Law .......................................................................................................................130
Brown v. Outback Steakhouse
Uninsured Employers’ Fund v. Crowder
Armstrong v. Martin Cadillac, Inc.
Bankruptcy Remote ...................................................................................................................135
In re: Lake Michigan Beach Pottawattamie Resort LLC
In re: Intervention Energy Holdings, LLC
Good Faith & Fair Dealing .......................................................................................................140
Dieckman v. Regency GP LP
1
Fiduciary Duties
2
Kentucky Court of Appeals Holds That Shareholders Are Not
As To One Another Fiduciaries
In Conlon v. Haise the Kentucky Court of Appeals squarely held that shareholders in a
corporation do not as such owe fiduciary duties to one another. No. 2014-CA-001581-MR, ___
S.W.3d ___, 2016 WL 5485531 (Ky. App. Sept. 30, 2016).
Stoll Keenon Ogden represented Haise and the Corporation in this action.
This dispute arose out of a two shareholder corporation in which the shareholders were
Steve Haise and Jim Conlon, respectively 53% / 47% owners. A dispute arose out of the
adoption of a new buy/sell agreement. Haise, as president, terminated Conlon’s employment.
Conlon then put his shares to the corporation for redemption pursuant to an existing buy/sell
agreement. Ultimately Conlon would file this action.
The action was initially a direct and derivative action. The derivative aspects were
dismissed early in the litigation for the plaintiff’s failure to satisfy the requirements of the
derivative action statute (KRS § 271B.7-400).
Conlon alleged that:
(1) his termination by Haise was in violation of a fiduciary duty owed by Haise as
a majority shareholder to Conlon as a minority shareholder;
(2) Haise breached an agreement that Conlon would be a 50% shareholder;
(3) the price of his shares under the buy/sell agreement was improperly
calculated;
(4) the offset against the buyout price under the buy/sell agreement of certain
indebtedness of Conlon to the company was improper; and
(5) the trial court (Judge Edwards) abused his discretion in not permitting the
filing of a third amended complaint.
Breach of Fiduciary Duty
In holding that shareholders in a Kentucky corporation do not stand in a fiduciary
relationship with one another, the Court of Appeals wrote:
This case requires us to squarely confront an issue that to date no appellate
court in this Commonwealth has explicitly ruled upon: whether shareholders in a
privately owned corporation owe one another common-law fiduciary duties.
Having reviewed the nature of fiduciary relationships in conjunction with the
applicable business statutes and our prior case law, we have concluded that our
common law does not support imposing fiduciary duties on shareholders. Slip op.
at 7.
3
…
It would do violence to normal corporate practice and our corporation law to
impose a duty on the majority to vote their shares in the minority’s interests as
opposed to their interests. Slip op. at 13.
There being no duty, there could be no breach thereof. This determination was
acknowledged as being consistent with that rendered earlier this year in Griffin v. Jones, 2016
WL 1092879 (W.D. Ky. March 21, 2016), referenced in footnote 4 (Slip op. at 14).
Breach of Contract
The dismissal of the claim for breach of contract to make Conlon a 50% shareholder was
affirmed based upon (i) the written documents relied upon by Conlon to evidence a written
agreement to that effect did not support the existence of an agreement and (b) the alleged oral
agreement failed under the Statute of Frauds. Slip op. at 15-16.
Valuation of Shares under the Buy/Sell Agreement
The agreement provided that the shares would be valued by the company’s CPA unless
there was disagreement as to the CPA; if there was disagreement as to who was the CPA there
would be a three arbitrator determination of the price. Conlon objected to the company’s CPA
doing the necessary appraisal. The Court of Appeals (as had the trial court) parsed the
agreement and found that there was agreement as to who was the company’s CPA.
Raymond Lindle had been All Safe’s CPA for about four years when this
dispute arose. .… Haise and Conlon jointly interviewed Lindle and another
candidate in 2008 and the jointly selected Lindle. Conlon has not objected to
these facts. Instead, Conlon merely objected to Lindle performing the valuation
when he tendered his shares.
There is no evidence to support a conclusion that the CPA was anyone other
than Lindle. Conlon cannot manufacture a deadlock. Slip op. at 18.
Offset of Conlon Indebtedness Against the Redemption Price
The Court of Appeals quoted the provision of the buy/sell agreement that “required the
application of Conlon’s debt to the purchase price.”, observing that “Conlon fails to make any
real argument or provide any legal support for his argument that the trial court erred.” Slip op. at
19.
Amended Complaint
Holding that the trial court had not abused its discretion in denying the motion to file a
third amended complaint, the Court of Appeals observed:
We are somewhat perplexed by Conlon’s assertion surrounding the “additional
claims” he sought to add to his prior complaint. The majority of the proposed
4
“amendment relates to the inclusion of facts to support the already asserted
claims.” Slip op. at 20.
The Court of Appeals panel was Judges Jones, Maze and Stumbo, with Jones authoring
the opinion. The opinion was designated “To be published.” The Kentucky Supreme Court
denied discretionary review, but ordered that the opinion of the Court of Appeals not be
published.
5
Diversion Of Business Opportunity:
Patmon v. Hobbs III
The Kentucky Court of Appeals has issued its third decision in the Patmon v. Hobbs, No.
2014-CA-001411-MR, 2016 WL 3886831 (Ky. App. July 15, 2016). This third opinion
acknowledges certain of the errors made in Patmon v. Hobbs I, clarifies the measure of damages
upon the diversion of an opportunity and perhaps most importantly adopts a strict test as to the
defense that a venture was financially unable to act upon the opportunity. In doing so, the Court
of Appeal cited Thomas E. Rutledge and Thomas Earl Geu, The Analytic Protocol for the Duty
of Loyalty Under the Prototype LLC Act, 63 ARKANSAS LAW REVIEW 473 (2010).
Grossly oversimplifying the dispute, Hobbs, purporting to act as the managing member of
an LLC, unilaterally transferred for no consideration certain contract rights and other assets of
the LLC. Hobbs was a co-owner of that transferee company. Patmon, another member of the
original LLC, brought an action charging Hobbs with having breached his fiduciary duties to the
LLC. In the first Patmon v. Hobbs decision, Patmon v. Hobbs, 280 S.W.3d 589 (Ky. App. 2009),
it was ultimately held that he might have done so, but that Patmon would have the burden, on
remand, showing that the LLC could have performed on the transferred contracts. While the
ultimate conclusion that Hobbs was bound by fiduciary obligations was (and is) normatively
correct, the analytic path used in the decision was hopelessly flawed. Those errors were reviewed
in the Analytic Paradigm article. Also, since Patmon I was decided, the LLC Act has been
amended to cut off further misinterpretation of the Act as to both the statutory definition of the
fiduciary duties in LLCs and the availability of a “fairness” defense to the appropriation of
company assets. See KRS §§ 275.170(1), (2), as amended by 2010 Ky. Acts, ch. 133, § 32
(expressing labeling the various provisions is the duty of care and the duty of loyalty owed in
LLCs); KRS 275.170(2) as amended by 2012 Ky. Acts, ch. 81, § 106.
After remand and another appeal, the Court of Appeals considered the further actions of
the trial court. See Patmon v. Hobbs, 2014 WL 97464 (Ky. App. Jan. 10, 2014.) Finding that the
trial court did not resolve necessary issues, the Court of Appeals criticized the measure of
damages it had employed.
After that remand and another appeal, now this case comes to the Court of Appeals for a
third time. Cutting to the chase, it continues to be unhappy with the work done by the trial court,
and the case has for the third time been remanded.
The first substantive portion of the opinion calls the trial court to task for not providing,
as it had been previously directed to do so, specific findings of fact and conclusions of law. On
that basis the reversal and remand was granted. Slip op. at 11. “Nevertheless, we find it helpful
to further explain the trial court’s on remand as described in Patmon I.” Id.
From there, the Court of Appeals (Judges Dixon, Lambert and Thompson) first addressed
who had the burden of proof on the question whether the LLC had the financial wherewithal to
perform on the leases that had been transferred. Hobbs had defended on the basis that the LLC
could not perform, so it was in effect deprived of nothing by the transfer of the leases. “Hobbs
defended his actions opining that American Leasing did not have the financial ability to take
advantage of the O’Reilly.” Slip op. at 4. Patmon asserted that the burden should be upon Hobbs
6
to prove the absence of the ability to perform, while Hobbs responded that Patmon I had
allocated that burden to Patmon and that under the “law-of-the-case” that allocation could not be
revisited. Over several pages the Court all but said that this allocation of the burden should have
been upon Hobbs, but under the law-of-the-case rule it must in this case be as set forth in Patmon
I. “There is some appealing logic to the reasoning that the inability of the Corporation (sic - this
case involves an LLC) to undertake the diverted opportunity as an affirmative defense to be
proven by the defendant.” Slip op. at 14, but:
we agree with Hobbs that the law-of-the-case doctrine applies to the holding in
Patmon I that Patmon had some burden to demonstrate that American Leasing
had the financial ability to take advantage of the O’Reilly leases to prevail under
the doctrine of diversion of business opportunity.
Although we must apply the legal principles pronounced in Patmon I to the facts
as stated in that opinion, the law-of-the-case doctrine applies only to the extent
that an issue was actually resolved…. Although Patmon I placed the burden of
proof on Patmon on remand to demonstrate American Leasing had the financial
ability to perform the O’Reilly leases, Patmon I did not address the proof
necessary to meet that burden. We now do so. Slip op. at 14.
The Court would require that Patmon demonstrate (presumably in further disputes this
burden will be upon the defendant) that the LLC was able to utilize the opportunities. Crucially,
at this juncture the Court would also define what is the standard for insolvency such that it will
release a fiduciary from the charge of having diverted an opportunity.
The Court began by reviewing foreign law to the effect that only actual insolvency as a
defense to the diversion of what is otherwise a company opportunity. Slip op. at 14-15. Quoting
Klinicki v. Lundgren, 678 P.2d 1250 at 1253-54 (Or. App. 1984), the Patmon III Court wrote:
To allow a corporate fiduciary to take advantage of a business opportunity when
the fiduciary determines the corporation to be unable to avail itself of it would
create the worst sort of temptation for the fiduciary to rationalize an inaccurate
and self-serving assessment of the corporation’s financial ability and thereby
compromise the duty of loyalty to the corporation if a corporate fiduciary’s duty
of loyalty conflicts with his personal interest, the latter must give way. Unless a
corporation is technically or de facto insolvent, a determination whether a
business opportunity is corporate or personal does not depend on the
corporation’s relative financial ability to undertake the opportunity. Slip op. at 15.
It went on to state:
We hold that unless American Leasing was insolvent or legally prevented from
performing the O’Reilly leases, Hobbs must compensate it for his diversion of the
O’Reilly leases. The trial court is instructed to make the requisite finding. Slip op.
at 16-17 (emphasis added).
The Court then turned to how damages are to be measured. Previously the trial court had
in effect awarded Patmon a percentage interest in the net proceeds realized by Hobbs from the
7
disposition of the leases transferred from the LLC. That measure was rejected. Rather, first
Hobbs is liable to the LLC for the full measure of the benefits and the gains generated from the
use of those assets. “KRS 275.170 requires that Hobbs completely disgorged himself of any
benefits received.” Slip op. at 18. Those benefits are to go to the LLC, rather than directly to
Patmon. Further, “in addition to statutory damages, if the trial court finds on remand the
American Leasing is not financially insolvent, the measure of damages is the lost profits the
corporation (sic - LLC) would have received had the opportunity not been diverted.” Slip op. at
18-19. The Court noted as well that pre-judgment interest may be in order. Slip op. at 19.
Then, returning to Patmon I and Patmon II, the LLC is to be dissolved, and in the course
thereof the trial court may reset the sharing ratios between the members. Slip op. at 9.
This decision is important for a variety of reasons including:
Recognition of the separation of LLCs from the common law of corporations and
partnerships (Slip op. at 13);
Recognition of the prior error in the allocation of the burden of demonstrating
inability to perform, strongly hinting that in the future the burden is upon the
person alleging the inability to perform;
Defining actual insolvency as the threshold for an inability to perform;
Giving teeth to the statutory directive that, in the event of the diversion of
company assets from an LLC, the person effecting the diversion is obligated to
remit to the LLC all gains and benefits derived therefrom;
Specifying, on remand, that the trial court is not to accept the price at which
Hobbs ultimately transferred the LLCs assets, but rather to independently
determine their fair market value;
Affirmation of the rule that, upon dissolution of the LLC, sharing ratios may be
reset in order to, on an equitable basis, account for Hobbs’ a breach of duty; and
Raising, with respect to the award of damages to the LLC, the possibility of an
award of prejudgment interest.
8
No Claim for Breach of Duty Against Court Appointed Receiver
In a decision by the Kentucky Court of Appeals it was held, inter alia, that the owners of
a business undergoing dissolution have no claim for breach of fiduciary duty against a court-
appointed receiver. Rather, the receiver is an officer of the court and enjoys quasi-judicial
immunity. Farmer v Miller, No. 2014-CA-000330-MR (Ky. App. July 15, 2016).
John Farmer and Dennis Boehm had been the co-owners of a company named Bluegrass
Recovery & Towing, LLC. The company was subject to a series of both financial difficulties and
disagreements between Farmer and Boehm, leading to several pieces of litigation between them.
At one juncture, Farmer and Boehm agreed to the appointment of a receiver, Stephen Miller.
Miller was charged to “work with the parties to liquidate the business,”, and both Farmer and
Boehm were charged to “cooperate with Mr. Miller so that he can appropriately perform his
work.” Slip op. at 4. But then:
Pursuant to the directives of the trial court, Miller took control of the remaining
assets of Bluegrass and attempted to assist the parties in finalizing dissolution and
liquidation. However, the parties continue to quarrel and did not cooperate with
Miller’s efforts. Miller ultimately liquidated all of the assets of Bluegrass except
the real property encumbered by the National City Bank mortgage. Id.
After additional litigation, including in connection with the bank’s foreclosure on the real
property, Farmer filed this lawsuit against Miller alleging negligence, breach of fiduciary duty
and breach of contract. Slip op. at 6. Filed against Miller in his individual capacity rather than in
his role as the court-appointed receiver:
The Complaint alleged Miller had acted outside the scope of his court-order duties
as receiver for Bluegrass, resulting in substantial negative financial implications
for Farmer. Specifically, Farmer alleged Miller failed to make regular mortgage
payments to National City Bank, real property taxes, insurance and property
maintenance expenses although he had sufficient Bluegrass assets from which to
do so. Farmer contended these actions resulted in foreclosure, imposition of tax
liens, seizure of his personal funds, and reduction in value of the real property.
Slip op. at 7.
In response, Miller filed a motion to dismiss on the basis of quasi-judicial immunity.
Farmer responded by asserting that the actions of which he complained were ministerial in
nature, and that no immunity should attach for the negligent performance thereof.
The trial court granted the motion to dismiss, treating it as a motion for summary
judgment, and this appeal followed.
Adopting the reasoning of the trial court, the Court of Appeals found that Miller, as a
court-appointed receiver, was entitled to quasi-judicial immunity. The court held that a receiver
is obligated to do only those things that the court has directed them to do, and that efforts such as
that of Farmer to impose additional duties, if enforced, “would result in sanctioning an
inappropriate expansion of Miller’s duties beyond the trial court’s explicit directives.” Slip op. at
12.
9
Jury Finds Breach of Fiduciary Duties Where Corporation Used as Personal
Piggy-Bank of 51% Shareholder
As reported in the Kentucky Trial Court Review, a jury found that a corporate director
and 51% shareholder violated his fiduciary obligations by, inter alia, using the corporation’s
assets as his personal piggy-bank. Liberty Rehabilitation v. Waide, 19 KTCR 10 at 7 (October
2015).
Forrest “Ben” Waide was the the 51% shareholder in Liberty Rehabilitation; Lawrence
Holmes and Jason Myers were the minority shareholders therein. Waide was elected to the
Kentucky General Assembly in 2010 and reelected in 2012. Also in 2012 Holmes and Myers
became concerned about how corporate funds were being used. For example, the company paid
for Waide to attend the Republican National Convention, a trip to St. Louis with his wife, and
some $20,000 went to Waide’s reelection campaign. Ultimately Waide’s diversion of corporate
funds to his campaign led to his indictment for campaign finance violations; he pled guilty and
resigned from the General Assembly. See KRS § 121.025 (forbidding corporate contributions to
political campaigns); see also http://state-journal.com/local%20news/2015/04/14/forrest-ben-
waide-pleads-guilty-avoids-jail-sentence.
Holmes and Myers initiated a derivative action on behalf of Liberty Rehabilitation
seeking to recover $504,304 of diverted funds. Waide argued that (a) there were benefits to the
corporation at least sought in the trip to St. Louis and (b) while there were errors, they were not
sufficient to justify a finding that he violated his fiduciary obligations. The jury was apparently
having none of that. It awarded compensatory damages in the amount of $456,500 and punitive
damages of $225,000.
No appeal was filed, and Waide filed for bankruptcy.
10
Fair Process and Fair Price, Except When Fair Price Is Enough
Under Delaware law, with respect to a conflict of interest transaction, it is required that
there be (a) a fair process and ultimately that (b) there be a fair price. This pair of requirements
is referred to as the “entire fairness” test. The combination of procedural and substantive
safeguards is intended to protect the interests of minority participants in the transaction. By way
of example, if the 51% shareholder of a business corporation desires that the company undergo a
merger in which the 49% shareholder will be cashed out, the fair process/fair price requirements
should ensure that the minority shareholder receives the appropriate value for his or her shares. A
recent decision from the Delaware Chancery Court considered the treatment of a situation in
which the process was manifestly flawed from a prototypical “fair” process, but objectively a
price that was more than a fair price was achieved. In re Nine Systems Corporation Shareholders
Litigation, Consol. C.A. No. 3940-VCN, 2014 WL 4383127 (Del. Ch. Sept. 4, 2014).
The Court neatly summarized the challenge presented as follows:
The board decisions and stockholder actions at the heart of this
lawsuit present one of the long-standing puzzles of Delaware
corporate law: for a conflicted transaction reviewed by this Court
under the entire fairness standard, “[t]o what else are shareholders
entitled beyond a fair price?” The entire fairness standard of
review has long mandated a dual inquiry into “fair dealing and fair
price” that this Court should weigh as appropriate to reach a
“unitary” conclusion on the entire fairness of the transaction at
issue. Delaware courts have contemplated this issue before. What
unites the resulting range of explications of this area of Delaware
law is the principle that the entire fairness standard of review is
principally contextual. That is, there is no bright-line rule on what
is entirely fair.
Here, the Court concludes that a price that, based on the only
reliable valuation methodologies, was more than fair does not
ameliorate a process that was beyond unfair. At least doctrinally,
stockholders may be entitled to more than merely a fair price, but
the difficulty arises in quantifying the value of that additional
entitlement. A more challenging question thus arises: what
damages may stockholder plaintiffs receive where the transaction
at issue was approved and implemented at a fair price? This
memorandum opinion contemplates one practicable—and
contextual—answer to that question. (Slip op. at 1 (footnotes
omitted)).
In a subsequent decision, the Chancery Court would award $2,000,000 to the plaintiff’s
attorneys. See In re Nine Systems Corporation Shareholders Litigation, C.A. No. 3940-VCN,
2015 WL 2265669 (Del. Ch. May 7, 2015). Admittedly, plaintiff’s counsel did request nearly
$12,000,000.
11
Derivative Actions; the Direct vs. Derivative Distinction
12
The 2015 General Assembly amended the LLC Act to add an
express derivative action statute. See KY. REV. STAT. ANN. §
275.337. See also Rutledge, The 2015 Amendments to the
Kentucky Business Entity Statutes, 43 NORTHERN KENTUCKY
LAW REVIEW 129 (2015-16)
13
Suit Dismissed; Plaintiff Hoist on the Petard of the Direct versus Derivative Distinction
A 2015 decision from the Kentucky Court of Appeals reinforces the importance of
understanding and properly pleading a derivative (as contrasted with a direct) action In this
instance the efforts of one shareholder/director to bring a direct action against the other
shareholder/director were set aside because the cause of action was in fact derivative. Gross v.
Adcomm, Inc., No. 2014-CA-001031-MR, 2015 WL 8488900 (Ky. App. Dec. 11, 2015).
Sam Gross and Christopher Pearson formed Adcomm in 2001; each was a 50%
shareholder and a director. Gross was appointed president while Pearson was elected vice
president. In 2004 Pearson submitted to the Secretary of State documents identifying himself as
the corporation’s president and as well changing the corporation’s registered agent to himself. In
2005, a complaint by Adcomm as the plaintiff was filed against Gross alleging financial
misconduct, seeking an accounting, and seeking as well an order removing Gross from all
positions with Adcomm. This suit was initiated “at the direction and upon the authority of
Pearson as its ‘director and vice-president.’” I guess Pearson forgot about his 2004 filing saying
he was the corporation’s president.
In response,
Gross moved to dismiss Adcomm’s complaint for lack of standing. Specifically,
Gross pointed out that no resolution from the board of directors had appointed
Pearson as the president of Adcomm; authorized Adcomm to engage in litigation
that was effectively against half of the directors on its own board; or authorized
Adcomm to hire an attorney to prosecute its suit. Gross would later reassert this
argument, or variations of it, in several other motions to dismiss Adcomm’s suit
or to disqualify Adcomm’s counsel from prosecuting its suit over the course of
the next several years of litigation that would follow. Nevertheless, on the only
occasion that the circuit court made a ruling upon one of Gross’s motions to this
effect, the circuit court denied it without further explanation. Slip op. at 2-3.
Various counter-claims were as well filed, and eventually the matter was referred to a master
commissioner to effect an accounting. This appeal was from that master commissioner report.
On appeal, Gross argued two points, namely:
(1) Adcomm lacked standing to file suit against him so this litigation should have
been dismissed at its inception; and (2) Adcomm’s counsel, Jeffrey Stamper, has
had a irreconcilable conflict of interest from the inception of this twelve-year-long
litigation and should have been disqualified. Slip op. at 6.
After classifying the various claims and counter-claims as belonging to Adcomm and its
assets and noting that corporate officers and directors owe their fiduciary obligations “to the
corporation, not the shareholders,” (Slip op. at 60 it was observed that a corporation may initiate
legal action on its behalf pursuant to to vote of a majority of the board of directors. From there
the Court of Appeals characterized the question as:
14
Who is entitled to assert and litigate the rights of an aggrieved corporation when,
as here, the party who allegedly injured the corporation is a 50% shareholder,
controls half of the corporation’s board of directors, and does not want the
corporation to pursue litigation? Slip op. at 7.
Pearson/Adcomm claimed that Pearson had the capacity to initiate the suit in the basis
that Gross had a conflict of interest as to whether or not the suit should be brought against
himself which precluded him from taking part in that determination. As Pearson was the only
non-conflicted director, so went the argument, he acting unilaterally was a majority of the board
and could direct the corporation. In support thereof there was cited KRS § 271B.8-310(4), which
precludes an interested director from voting as to whether to approve a related party transaction.
After noting that KRS § 271B.8-310 relates to the ability of a corporation to avoid a
conflict of interest transaction, the Court of Appeals wrote that the statute is not mandatory and
has no impact upon the decision making structure of a corporation:
Nothing in KRS 271B.8-310 alters the manner in which a corporation decides to
exercise and vindicate such a right (i.e., through a majority vote of its directors at
a meeting of its board). Likewise, nothing in KRS 271B.8-310 disqualifies any
director-self-interested or otherwise-from voting against the corporation
exercising such a right. Slip op. at 9 (footnote omitted).
From there the Court considered an argument based upon the futility of making a demand
upon the board for it to bring suit against Gross, noting that he would never endorse a suit being
filed against himself. All of that may be well and good, but the Court of Appeals observed in
response that “the most noticeable flaw of Adcomm’s argument is that it misunderstands the
posture of this case.” Slip op. at 11. Rather, this was a direct action by Adcomm against Gross,
not a derivative action.
With this in mind, Sahni and its interpretation of the rule regarding the “futility”
of making a demand for suit upon a board of directors have no bearing upon
whether Adcomm had standing to sue Gross. This is because the “futility” rule
applies to derivative actions, not direct actions. And, despite Adcomm’s
insinuation that “Pearson” had a “position regarding [Gross’s] Motion to
Dismiss,” Pearson did not file a derivative action against Gross on behalf of
Adcomm. Rather, Adcomm purported to file a direct claim on behalf of itself, and
Pearson (as reflected in his several depositions, his testimony before the master
commissioner, and in Adcomm’s multitude of pleadings in this matter) repeatedly
stated that he was acting at all times as Adcomm’s authorized representative in
causing Adcomm to file the instant litigation. Further underscoring this point are
the facts that (1) “Adcomm, Inc.” has always been the sole individual plaintiff
suing Gross during the twelve years of this litigation; and (2) Adcomm hired its
own attorney to prosecute its case against Gross and to defend this appeal.
Consequently, this argument also does not support that Adcomm had standing to
directly sue Gross. Instead, as italicized above, it demonstrates that Adcomm does
not appreciate the difference between a direct corporate action and a derivative
corporate action. Slip op. at 13 (footnote omitted).
15
Which brings us to the culmination of this dispute, namely:
Who is entitled to assert and litigate the rights of an aggrieved corporation when,
as here, the party who allegedly injured the corporation is a 50% shareholder,
controls half of the corporation’s board of directors, and does not want the
corporation to pursue litigation? Id.
Which was answered as follows:
[T]his action purported to be a direct corporate action. There is no resolution of
Adcomm’s board of directors that authorized Adcomm to file the instant litigation
against Gross, or to hire and pay any attorney to prosecute it. In light of Gross’s
twelve years of objections to this litigation; his 50% interest in Adcomm; and his
role as the second of Adcomm’s two directors, it is also obvious that no such
resolution would have ever been forthcoming. Absent such a resolution, Adcomm
lacked authorization to file this litigation, was never properly a party to it, and its
claims should have been dismissed as a matter of law. Slip op. at 14-15.
16
LLC Derivative Action Dismissed For Lack of Standing; An Assignee Is Not A Member
In a recent decision by Judge Simpson, it was held that a former member of an LLC, now
an assignee consequent to resignation, lacks standing to pursue a derivative action. Lani v
Schiller Kessler & Gomez, PLLC, Civ. Act. No. 3:16-CV-00018-CRS, 2016 WL 4250452 (W.D.
Ky. August 9, 2016).
Lani, who had been a member of Schiller Kessler & Gomez, PLLC, a Kentucky
professional limited liability company, resigned from the Company effective not later than
November 30, 2015. On December 1, in state court, he filed a purported derivative action with
respect to that Kentucky LLC. The action was then removed to federal court on the basis of
diversity jurisdiction, which removal was accompanied by motions to intervene and realign and
thereafter a motion to dismiss on a variety of grounds, including standing.
Lani sought remand of the action on the basis that it involved matters of particular
importance to the state administrative scheme (i.e., Burford abstention), namely the regulation of
attorneys. That request was rejected by Judge Simpson in that Lani “has not explained why an
erroneous federal court decision could impair the Commonwealth Kentucky’s effort to
implement the Rules of Professional Conduct or procedures for lawyer discipline,” especially
where the only party to the action licensed in Kentucky was Lani himself. 2016 WL 4550452,
*2.
After granting a motion of the Kentucky LLC to intervene as a defendant in the action (in
the initial pleadings, the LLC had not been named as either a plaintiff or a defendant), the court
considered the impact of that intervention on diversity jurisdiction.
Applying the well-settled rule that a LLC has the citizenship of each of its members,
Judge Simpson turned to what he characterized as “the most difficult citizenship question; the
citizenship of the Company [i.e., the Kentucky LLC].” 2016 WL 4250452, *4. After noting that
the Company was antagonistic to Lani and is aligned as a defendant, the court considered the
application of KRS § 275.280, which identifies the circumstances upon which a member is
dissociated from the LLC. Finding that Lani’s resignation had been effective November 30, and
on that date he ceased to be a member of the Company, Lani’s citizenship would not be
considered in determining the LLC’s citizenship as of December 1.
From there, the court considered the motion to dismiss on the grounds that Lani, as a
former but not current member, did not have capacity to bring a derivative action. In reliance
upon KRS § 275.337(3) and Bacigalupo v. Kohlhepp, 240 S.W.3d 155 (Ky. App. 2007), the
action was dismissed on the basis that Lani was not a member when he purported to commence
the derivative action on December 1, 2015. With respect to Lani’s assertion that he continued
working for the firm for several days thereafter, the court noted that “the Kentucky Limited
Liability (sic - Company) Act says that a derivative action can only be maintained by a member,
implying that one must be a member throughout the litigation, and not just at the moment of
filing suit.” 2016 WL 4250452, *7 (emphasis an original.) Therefore:
17
The Court finds that Lani lacks standing to bring this derivative action on
behalf of the Company because he was not a member when he filed suit on
December 1, 2015. 2016 WL 4250452, *8.
In a subsequent decision, attorney fees exceeding $43,000 were awarded the defendants
consequent to Lani’s lack of a legitimate basis for bringing this derivative action. See 2016 WL
7401790 (W.D. Ky. Dec 19, 2016).
An effort to have these determinations set aside on a Rule 60 motion was denied. See
Lani v. Schiller, Kessler and Gomez, PLC, Civ. Act. No. 3:16-CV-00018-CRS, Memorandum
Opinion (March 17, 12017)
18
Delaware Supreme Court Holds That Breach of Limited Partnership Agreement is a
Derivative, and Not a Direct, Claim
In a decision from the Delaware Supreme Court, it reversed a holding of the Chancery
Court and found that claims by a limited partner challenging a drop-down transaction were
derivative and not direct. Consequent to that classification, a subsequent merger deprived the
limited partners of continued standing to pursue a derivative action. El Paso Pipeline GP
Company, LLC v Brinckerhoff, No. 103, 2016, 2016 WL 7380418 (Del. Dec. 20, 2016).
El Paso Corporation (“El Paso”) was the sole member in El Paso Pipeline GP Company,
LLC (“GP LLC”), which company in turn served as the sole general partner of El Paso Pipeline
Partners, L.P. (the “LP”). El Paso sold certain assets to the LP in a master limited partnership
drop-down transaction. Brinckerhoff, a limited partner in the LP filed a derivative action
challenging that drop-down transaction. While that matter remained in dispute, El Paso was
acquired and the LP was merged out of existence. Thereafter, the defendants moved to dismiss,
arguing that Brinckerhoff’s claims were exclusively derivative and that standing was lost
consequent to the merger. The Chancery Court issued an opinion holding that GP LLC was liable
for a breach of the partnership agreement on the basis there was not a reasonable belief that the
drop-down transaction was in the best interest of the partnership; damages of $171 million were
assessed. The Chancery Court rejected this claim that the injuries were derivative, finding that
the limited partners were individually harmed.
That classification was rejected by the Delaware Supreme Court, it finding that the
injuries were suffered exclusively by the limited partnership and then only derivatively by the
partners therein. No longer being partners in the LP, the former limited partners lacked standing
to continue to pursue the derivative action.
This is an important decision in that it adds to the line of authority standing for the
proposition that the breach of the organizational documents of a limited partnership/LLC will
typically given rise to a derivative, and not a direct, claim.
19
Tennessee Adopts New Standard for the Direct Versus Derivative Distinction
On July 11, the Tennessee Supreme Court adopted a new test, it based on Delaware law,
for when a lawsuit is direct versus derivative. Keller v. Estate of Edward Stephen McRedmond,
No. M2013-02582-SC-R11-CV (Tenn. July 11, 2016).
Professor Joan Heminway’s review of this decision is as follows:
Direct v. Derivative under the Tennessee Business Corporation Act
By joanheminway
In a recent decision of the Tennessee Supreme Court, Keller v. Estate of
Edward Stephen McRedmond, Tennessee adopted Delaware’s direct-
versus-derivative litigation analysis from Tooley v. Donaldson, Lufkin, &
Jenrette, Inc., 845 A.2d 1031 (Del. 2004), displacing a previously
applicable test (that from Hadden v. City of Gatlinburg, 746 S.W.2d 687
(Tenn. 1988)). Although this is certainly significant, I also find the case
interesting as an example of the way that a court treats different types of
claims that can arise in typical corporate governance controversies
(especially in small family and other closely held businesses). This post
covers both matters briefly.
The Keller case involves a family business eventually organized as a for-
profit corporation under Tennessee law (“MBI”). As is so often the case,
after the children take over the business, a schism develops in the family
that results in a deadlock under a pre-existing shareholders’ agreement. A
court-ordered dissolution follows, and after a bidding process in which
each warring side of the family bids, the trustee contracts to sell the assets
of MBI to members of one of the two family factions as the higher bidder.
These acquiring family members organize their own corporation to hold
the transferred MBI assets (“New MBI”) and assign their rights under the
MBI asset purchase agreement to New MBI
Prior to the closing, the losing bidder family member, Louie, then an
officer and director of MBI who ran part of its business (its grease
business), solicited customers and employees, starved the MBI grease
business, diverted business opportunities from MBI’s grease business to a
corporation he already had established (on the MBI property) to compete
with MBI in that business sector, and engaged in other behavior disloyal
to MBI. Louie’s actions were alleged to have contravened a court order
enforcing covenants in the MBI asset purchase agreement. They also were
allegedly disloyal and constituted a breach of his fiduciary duty of loyalty
to MBI. Finally, they constituted an alleged interference with New MBI’s
business relations.
Before granting relief on any of these claims, the court had to determine
whether the actions were properly brought before it--namely, in this case,
20
whether the proper plaintiffs had raised each of these claims for resolution
by the court in this case (a matter earlier, but not initially, brought to the
court’s attention by the defendant). Because only individual family
members (the acquirors in the MBI asset purchase) were plaintiffs in the
action, the court was required to focus on whether these individual
plaintiffs could bring all of the legal actions identified in the complaint. It
was important, as part of this analysis, to understand whether the claims
were the subject of direct or derivative actions.
After setting out the facts in some detail and describing extant standards
for distinguishing direct from derivative actions, the court determined to
adopt Delaware’s Tooley standard to clarify the various factors involved
in distinguishing direct from derivative claims and the way in which those
factors are evaluated. The court found the Hadden rule, while not vastly
different in its overall coverage, less clear in application. Both cases focus
on the nature of the wrong, the party entitled to relief, and a direct injury
to the plaintiff(s) independent of any corporate harm. Procedurally, “[t]he
stockholder must demonstrate that the duty breached was owed to the
stockholder and that he or she can prevail without showing an injury to the
corporation.” Tooley, 845 A.2d at 1039.
To decide the case, the Keller court took each claim before it individually.
With respect to the violation of the trial court’s order, the court found that:
the Buyers were injured individually [by Louie’s conduct]
to the extent that they signed agreed orders and contracts
regarding the purchase price of the original MBI‟s grease
business assets, including its goodwill and business
relationships. . . . Protection of the status quo, so that the
Buyers would receive the benefit of their bargain, was the
express premise of the trial court’s orders.
With respect to the breach of fiduciary duty claim, the court concluded
that:
under Tooley, the Buyers’ claim that Louie breached his
fiduciary duty to MBI through mismanagement and self-
dealing is derivative in nature and must be asserted
derivatively on behalf of the corporation itself.
Consequently, the Buyers do not have standing to recover
individually for any harm resulting from Louie‟s breach of
his fiduciary duty to the original MBI.
Query, however, whether any of Louie’s actions also constituted a breach
of fiduciary duty as among the shareholders of MBI as a closely held
corporation. Tennessee incorporates the Massachusetts close corporation
rules from Donahue v. Rodd Electrotype Company of New England and
21
Wilkes v. Springside Nursing Home. That cause of action would be
brought as a direct claim. This may be a bit of a stretch in this case, and it
likely wasn’t adequately pleaded. But it would be worth some thought,
with the right facts to support the claim . . . .
Finally, as for the claim of intentional interference with business relations,
the court found that the claim belonged to the New MBI, not the
individual plaintiffs:
[T]he Buyers did not themselves have business relations
apart from their investment and involvement in [New
MBI]. From our review of the Buyers’ allegations, we
agree with the Court of Appeals that the claim of
“intentional interference with business relations” belongs to
the Buyers’ corporation . . . , not to the Buyers individually.
Three claims--two direct and one derivative; three separate plaintiffs--
individuals and two different corporations--MBI and New MBI. All of
this seems right.
There is a lot of good doctrinal information in the Keller opinion. But a
big (yet exceedingly simple) lawyering lesson to be learned from all this is
that plaintiffs’ counsel must ensure that the appropriate plaintiffs are in
front of the court for each of the claims made in the complaint. And in
that connection, in the context of Tennessee corporate fiduciary duty
claims (where the legal action is likely to be derivative in nature),
plaintiffs’ counsel must pay attention to the Tooley standard in making the
assessment as to the proper plaintiff.
The Keller opinion may even be worth a read for folks outside Tennessee
for this reason. Regardless, folks inside Tennessee surely should give it
some attention.
22
New York Court Holds that Transferee of Membership Interests
Does Not Have Standing to Bring a Derivative Action
In a decision from New York, it was held that a transferee of a membership interest who
was never admitted as a member did not have standing to bring a derivative action on the LLC’s
behalf. MFB Realty LLC v. Eichner, 2016 NY Slip Op 31242(U) (Sup. Ct. New York County,
June 24, 2016).
The allegations in this purportedly derivative action are based upon assertions that certain
members used one LLC in order to support another while at the same time depriving the first
LLC of various opportunities. Ultimately, the substance of those allegations is irrelevant in that
the suit was dismissed for lack of standing.
Under the subject LLC’s operating agreement, a transfer of the economic rights of
membership required the consent of 95% of the members (apparently this 95% threshold was
applied on a disinterested basis). Separately, there was a requirement of 95% of the members
(again, it appears that this was to be applied on a disinterested basis) in order to effect the
admission of a transferee as a member. On the basis that MFB, the purported member bringing
the derivative action, was a mere transferee, dismissal was sought.
As an initial matter, the court reviewed the various allegations and determined them to be
derivative (and not direct) in nature. In this case, while the first step, namely consent to the
assignment of the economic rights, had been granted, there had been no satisfaction of the
second step, namely written consent to the admission of the transferee as a member. With respect
to the consent that was given:
Significantly, however, the consent letter is completely devoid of any express (or
implied) reference to the transfer of a membership interest in T. Park, and nothing
in that letter may be interpreted as a consent to the transfer of membership. From
there, applying the rule that “only a member of an LLC at the time of the alleged
wrong to the LLC has standing to bring a derivative claim on behalf of that
company,”, citing Cordts-Auth. v. Crunk, LLC, 815 F. Supp. 2d 778, 786-787
(S.D. N.Y. 2011) (citing New York Law), aff’d 479 Fed. Appx. 375 (2d Cir.
2012), it was held that:
Because it has failed to show that 95% of the members of T. Park
gave written consent to MFB becoming a substituted member of T.
Park, MFB lacks standing to sue on T. Park’s behalf.
23
Significant Attorney’s Fees Awarded the Defendants In a Failed Derivative Action
Earlier this year, of the federal court for the Eastern District of Kentucky dismissed, on
the grounds of a lack of standing, a derivative action purportedly brought on behalf of a
Michigan nonprofit corporation. Pagtakhan-So v. Cueto, Civ. Act. No. 5:14-370-DCR, 2016 WL
617429 (E.D. Ky. February 16, 2016). That decision has now been appealed to the Sixth Circuit
Court of Appeals. However, even while that appeal is pending, the trial court has ruled with
respect to a motion for attorney’s fees filed by the defendants in that action, and a significant
award of attorney’s fees has been made. Pagtakhan-So v. Cueto, Civ. Act. No. 5:14-370-DCR,
2016 WL 4094877 (E.D. Ky. August 1, 2016).
In the initial decision, the derivative action that was filed on behalf of the nonprofit
corporation had been brought by persons who were no longer directors of the corporation. No
longer being directors, they lacked standing to bring a derivative action. In addition, it was found
that they had failed to comply in any manner with Federal Rule of Civil Procedure 23.1, it
governing derivative actions filed in federal court. On that basis, the claims were dismissed with
prejudice.
The second opinion involved the consideration of the defendant’s motion for attorney’s
fees. Under the Michigan Nonprofit Corporation Act, an award of attorney’s fees to the
defendants is permissible, the statue providing:
In an action brought in the right of a corporation by a record holder or beneficial
owner of shares of the corporation or a member, the court having jurisdiction,
upon final judgment and finding that the action was brought without reasonable
cause, may require the plaintiff to pay to the parties named as defendants the
reasonable expenses, including fees of attorneys, incurred by them in the defense
of the action.
Initially exhibiting what can only be described as chutzpah, the plaintiffs first asserted
that this was not and was never intended to be a derivative action, a treatment that was evidenced
by the failure to comply with Rule 23.1. This argument was rejected on the basis that the
character of the action is derivative or direct is based upon the nature of the relief sought. Here,
as the only alleged injury was to the corporation, the action must have been derivative on its
behalf. Further, the court relied upon portions of the plaintiffs’ pleadings in which they, while
not using the word “derivative,” indicated they were acting on the corporation’s behalf. In that
the claims were derivative, the question was whether they were brought “without reasonable
cause.” On bases including the complete failure to comply with the requirements of Rule 23.1,
attorney’s fees were awarded. With respect to one defendant, those fees are in the amount of
$40,805.84, and with respect to another individual defendant the attorney’s fees awarded are
$50,623.00. As to the nonprofit corporation itself, it received attorney’s fees in $100,364.14. In
total, the plaintiffs are responsible for attorney’s fees in the amount of $190,792.98.
24
Failure to Distinguish Between LLC and its Members Dooms Appeal
A decision from the North Carolina Court of Appeals emphasizes the importance of
properly distinguishing between an LLC and its members. In this case, suit was brought under a
lease signed by the members, but on behalf of the LLC, against the landlord. Because the LLC
was not a party to the lease, its appeal of an adverse verdict was rejected. King Fa, LLC v.
Cheung, 788 S.E.2d 646 (N.C. Ct. App. 2016).
Tse and Cheung (collectively the “Tenants”) leased certain commercial property from
Cheung for use as a restaurant. While roof leak issues were identified in the property inspection,
the lease was silent as to who had responsibility for making those repairs. After another leak
developed, the tenants paid for a repair, which was ultimately unsuccessful in mitigating the
leak. The tenants did reduce a lease payment to Cheung in the amount paid for that repair.
Ultimately, as the leak continued, King Fa, LLC filed a complaint against Cheung on the basis of
breach of contract and breach of the covenant of quiet enjoyment. King Fa is a North Carolina
LLC with the Tenants as its members; it operated the restaurant. Importantly, this LLC was not
organized until after the lease had been entered into between the Tenants and Cheung. After
some tortured motion practice with respect to who should be the parties to the action, the court
awarded Cheung damages in the amount of $1,800. Importantly, these damages were assessed
against the Tenants, and not King Fa, LLC.
Thereafter, King Fa, LLC filed an appeal. That appeal was dismissed on the basis that
King Fa was not a “real party in interest” to the matter. Rather, judgment had been entered
against each of Cheung and Tse. They were the real parties to the appeal. However, they were
not named in the notice of appeal. In that the parties actually impacted by the trial court’s
decision had not brought an appeal, the appeal was dismissed.
25
Another LLC Case Dismissed For Failure to Name the Injured Parties to the Suit
In a recent decision from Minnesota, an appeal was dismissed on the basis that the
alleged injury was suffered not by the LLC plaintiff, but rather by its individual members.
Environmental Trust, LLC v. Hi-Tek Rubber, Inc. No. A15-1942, 2016 WL 4421191 (Minn. Ct.
App. Aug. 22, 2016).
Gordon Cell, the majority owner of Hi-Tek Rubber, Inc., had been pushing the company
for a number of years to develop various products. It was, however, never successful. In 2007,
it was offered a $1 million line of credit by Guaranty Bank of Iowa provided the line of credit
was guaranteed. A number of Hi-Tek’s shareholders agreed to guarantee that line of credit.
Environmental Trust LLC was organized with those guarantors as its members. Cell, while a
“governor” of Environmental Trust, was not a member thereof. As recited by the court:
According to its Member Control Agreement (MCA),
Environmental “was created as a financing tool for Hi-Tek.” The
only members of Environmental were the personal guarantors of
the line of credit to fund Hi-Tek. Each guarantor guaranteed
$55,000 as a “contribution.” The MCA provided that the
guarantors had no right against Environmental to return any of the
funds paid pursuant to the personal guarantees.
As you can anticipate, things did not go well. Hi-Tek never developed a marketable
product, and eventually it suffered an uninsured fire that destroyed portions of its inventory and
equipment. Thereafter, theft and vandalism caused further damage to its facility. Through all
this time, Hi-Tek never executed and delivered to Environmental an otherwise called for
promissory note and security agreement. As such, Environmental, as to Hi-Tek, was an
unsecured creditor. Then:
In 2011, Hi-Tek could not pay the interest payments and
announced he was going to default on the line of credit. To
prevent default, the guarantors use their personal funds to make
interest payments on the loan and to pay off the line of credit. The
total amount of the loan plus interest repaid by Environmental’s
members was $675,730.39. In 2014, Environmental sued Cell for
breach of contract, unjust enrichment, breach of statutory and
common-law fiduciary duty, conversion, fraud, and intentional and
negligent misrepresentation. A jury found in favor of
Environmental on all counts.
This appeal followed, with Cell arguing that “Environmental lacked standing to sue him
in his personal capacity and because Environmental did not suffer an injury.” The court would
find this reasoning persuasive.:
Environmental was never a party to the loan agreement or personal
guarantees and never experienced harm or injury related to Cell’s
failure to secure the line of credit. Environmental was not required
26
to pay on the line of credit, and there is no evidence in the record
that Environmental experience any negative consequences relating
to high Hi-Tek’s ultimate failure to repay the line of credit.....
Because Environmental was not a party to the relevant agreements,
and because Environmental did not experience and injury-in-fact,
Environmental lacked standing to sue Cell.
In addition, the court discussed Minnesota Statutes § 322B.88, which provides in part that
a LLC’s member “is not a proper party to a proceeding by or against [and LLC] except when ….
the proceeding involves a claim of personal liability or responsibility of that member and that
claim has some basis other than the member’s status as a member.” Environmental argued this
statute should give it standing to pursue the claims on behalf of its members. The argument was
not successful. Applying the statute, the court found:
Here, Environmental’s members signed personal guarantees
relating to their Environmental membership, but not as
Environmental members. The claims pursued by Environmental
involve personal liabilities or responsibilities of the guarantors, and
were based on the executed personal guarantees, not on their
Environmental membership. Thus, in Minn. Stat. § 322B.88 does
not prevent Environmental’s members from suing, and does not
grant Environmental standing to sue on their behalf.
27
Notwithstanding Fiduciary Duties Amongst Members, Direct Suit Dismissed;
Complaint Should Have Been Brought as a Derivative Action
In a decision from Connecticut, the court considered and applied the direct versus
derivative distinction in a dispute between two equal members of an LLC. Notwithstanding the
fact that the two members of the LLC stood in a fiduciary relationship with one another, the
court found that the plaintiff’s claims should have been brought as a derivative action on behalf
of the LLC. In that it had been brought as a direct action, the suit was dismissed. Scarfo v.
Snow, No. AC37794, 2016 WL 5037389, ___A.3d ___ (Conn. Ct. App. Sept. 27, 2016).
Scarfo and Snow formed Cider Hill Associates, LLC as the vehicle through which to
develop certain real property into a subdivision. Snow devoted his full-time efforts to the
development while Scarfo was passive. Ultimately, the project was both over budget and a loss,
an outcome no doubt facilitated by the Great Recession. Ultimately, Scarfo sued Snow, alleging
a variety of claims including breach of fiduciary duty.
On appeal, the parties were directed to submit supplemental briefings addressing
“whether the plaintiff has standing to maintain this suit in his individual capacity.” The court
would find that, notwithstanding the fiduciary duties that might exist amongst members in LLC,
the claims were derivative. Rather, notwithstanding the fact that Snow pointed to specific
provisions of the operating agreement that he says were violated:
We conclude that the plaintiff did not have standing in his
individual capacity to maintain his various causes of action and
that the trial court should have dismissed his case.
In support of this determination, the court relied upon the fact that an LLC is legally
distinct from its members and that, like a corporation, a derivative action is the proper means for
redressing injury to the entity.
In the present case, the plaintiff brought a direct action against the
only other member of Cider Hill, again Cider Hill itself, and
against other companies in which Snow had an interest. He alleges
various causes of action flowing from an alleged breach of
fiduciary type duty and a breach of the amended operating
agreement, which was signed by the plaintiff and Snow.
….
The plaintiff contends that Snow essentially mismanaged the
Evergreen Project. Although the plaintiff contends that he suffered
direct injury by the alleged action or inaction of Snow, any benefit
he would have received from the Evergreen Project, were it not for
the alleged improprieties of Snow, would have flowed to him only
through Cider Hill, first benefiting Cider Hill. Accordingly, if
there was an injury, that injury was sustained by Cider Hill and
then sustained by the plaintiff. Thus, the plaintiff’s injury is not
direct, and he has no standing to sue in his individual capacity.
….
28
The form of the judgment is improper, the judgment is reversed,
and the case is remanded with direction to dismiss the case for lack
of subject matter jurisdiction.
29
Delaware Chancery Court Addresses When a Corporation is “Insolvent” for Purposes
of a Creditor Derivative Action
In this decision the Delaware Chancery Court defined the test to be employed in
determining whether or not a corporation is insolvent such that a creditor will have standing to
bring a derivative action. Quadrant Structured Products Company, Ltd. v. Vertin, C.A. No.
6990-VCL, 2015 WL 2062115 (Del. Ch. May 4, 2015).
Quadrant held debt securities issued by Athilon Capital Corp. Premised upon Athilon’s
insolvency, Quadrant brought a derivative action alleging that certain Athilon transactions were
approved by the Athilon on Board of Directors in violation of its fiduciary duties, as well as
alleging that those transactions violated the Delaware Fraudulent Transfer Act. Under Delaware
law:
[T]he creditors of an insolvent corporation have standing to
maintain derivative claims against directors on behalf of the
Corporation for breaches of fiduciary duties. North American
Catholic Education Programming Foundation, Inc. v Gheewalla,
930 A.2d 92, 101 (Del. 2007).
Athilon resisted, asserting that a high bar is necessary with respect to insolvency to exist,
and further positing that that high bar had not been met. Specifically, Athilon asserted that
insolvency required all of:
(i) that the corporation was insolvent at the time the derivative
action was filed;
(ii) that the corporation continues to be insolvent throughout the
pendency of the derivative action; and
(iii) with respect to insolvency, such should be more than a mere
balance sheet or cash flow analysis, as well satisfy the requirement
for the appointment of a receiver, “namely that the corporation has
no reasonable prospect of returning to solvency.”
The Chancery Court rejected this three facter test, finding it sufficient that the plaintiff
demonstrate the corporation was insolvent at the time the suit was filed with insolvency
measured under either the balance sheet or the cash flow test.
In explaining its decision, the Court began with an analysis of the purpose of the
derivative action:
The derivative action exists to prevent injustice by facilitating a
lawsuit that otherwise would not have been or could not be
pursued, and stockholders have standing to assert a corporation’s
claim derivative because they can be regarded as the ultimate
beneficial owners of the corporate assets, including litigation
assets, and therefore have an interest in pursuing the claim.
30
Rejecting the assertion that the corporation must remain insolvent throughout the
pendency of the action, the Court observed that this “attempt to impose a continuous insolvency
requirement tries to build by analogy on the contemporaneous ownership requirement”
applicable with respect to shareholder derivative action. This the Court rejected in favor of a
requirement that the creditor bringing the action continue to hold the debt claim against the
corporation throughout the action.
With respect to the sought requirement that the corporation remain insolvent throughout
the course of the action, it was observed that a corporation could, during the term of the
proceeding, move back and forth across the line of insolvency. Recognizing this could give rise
to fact situations in which both the shareholders and the creditors could bring derivative actions,
it was concluded that a court under its general supervisory authority of the derivative action
would be able to weigh and balance the conflicting interests of the claims of equity holders
versus creditors.
The Court then turned its attention to determining whether Athilon was actually
insolvent, ultimately determining that the balance sheet test was the most appropriate measure.
Based upon the facts put forth by the plaintiffs, the Court determined that Athilon was insolvent
as of the time the derivative action was filed, and on that basis it was allowed to proceed.
31
Court of Appeals Disposes of Derivative Claims Brought on Individual Basis
In an August 14 decision, the Kentucky Court of Appeals dismissed, under the rubric of
lack of standing, a series of what were determined to be derivative claims that had been brought
individually by a shareholder. Ultimately, the court determined that the shareholder lacked
standing to bring claims based upon fiduciary duties that, to the extent they existed, were owed
to the business organization and not the individual investor. Griffin v. Jones, No. 2014-CA-
000402-MR (Ky. App. Aug. 14, 2015).
David Griffin invested, at the solicitation of Charles Jones, husband to defendant Sarah
Jones, $2,000,000 for a 50% ownership interest in Integrated Computer Solutions, Inc. There
followed thereafter a series of investments in additional entities organized and controlled by
either Charles or Sarah Jones, that total investment, a combination of loans and equity, coming to
approximately $29,000,000. It was alleged, however, that Charles and Sarah Jones, in their
control of these various entities, caused them to co-mingle their assets and ultimately transfer
them to a LLC, CA Jones Management Group LLC, a company in which Charles Griffin was the
sole member. Griffin ultimately brought suit against Sarah (this decision does not discuss any
claim made against Charles Jones) alleging:
1. breach of fiduciary duty owed to him, personally;
2. fraud by omission;
3. misappropriation; and
4. unjust enrichment.
The trial court dismissed all of these claims without explanation, and the Court of Appeals would
review them under the assumption that the Circuit Court adopted the reasoning employed by
Sarah Jones in her motion to dismiss.
Foreshadowing the theme of the decision, the Court of Appeals wrote that “a proper
ground for dismissing the balance of Griffin’s claims was his lack of standing.” Slip op. at 4.
Breach of Fiduciary Duty
With respect to the claim for breach of fiduciary duty, Griffin alleged that Sarah Jones, in
her capacity as a officer of the corporations in which he invested, owed to him a fiduciary duty.
For example, he alleged that:
As Secretary of ICS, Sarah Jones owed fiduciary duties to ICS and
its shareholders - including Griffin. It is black letter law that
corporate officers owed to the corporation and to its shareholders
fundamental duties of care and loyalty… Slip op. at 5.
Responding to this assertion, the Court of Appeals wrote that “Kentucky law does not
support that Sarah owed Griffin fiduciary duties under the facts alleged in his complaint.” Slip
op. at 7.
32
Rather, the court noted that both the common law and statutory fiduciary obligations imposed
upon members of the board of directors and corporate officers run to the benefit of the
corporation. In the context of an LLC, court noted that, by statute, the duty of loyalty owed in a
limited liability company is to “‘account to…the company.’” Slip op. at 8, n. 1.
Ultimately, in that any alleged breach of fiduciary duty, if indeed it took place, involved a
breach of an obligation owed to the business entity, and not to Griffin individually, he lacked
standing to bring those claims.
Another interesting point raised in this decision is the deference to be afforded a
plaintiff’s assertion that a fiduciary duty existed. As recited by the Court of Appeals:
It appears Griffin is arguing the Circuit Court was required to
believe Sarah owed him direct fiduciary duty in the contexts he
describes above because his complaint alleged that she did, and
because factual allegations in a complaint must be taken as true
whenever a court considers the propriety of granting a CR 12.02
Motion to Dismiss. Slip op. at 7.
This assertion was categorically rejected by the Court of Appeals. Rather, the assertion
that a legal duty exist is a legal conclusion and therefore “any statements in Griffin’s complaint
regarding legal duties Sarah may have owed him under the facts of this case are entitled to no
deference whatsoever, the court observing that, “[W]hether a legal duty exist is purely a question
of law [.]”, Bartley v. Commonwealth, 400 S.W3d 714, 726 (Ky. 2013) and “It is the duty of
courts to declare conclusions, and of the parties to state the facts from which legal conclusions
may be drawn.”, Rosser v. City of Russellville, 208 S.W.2d 322, 324 (Ky. 1948).
Fraud by Omission
Having determined that no fiduciary duty existed for the benefit of Griffin, the court was
able to dismiss the fraud by omission claim on the basis that there existed no obligation to make
disclosure. “Griffin has premised the first element of his fraud by omission claims, once again,
upon the notion that Sarah owed him a direct fiduciary duty of disclosure by virtue of her status
as an officer and by virtue of his status as a shareholder, member, or creditor of those entities. As
previously discussed, however, she did not.” Slip op. at 11-12 (footnote omitted).
In addition, the court commented upon Griffin’s implication that the funds invested
remained somehow his and that he had a right to be advised as to the disposition of same.
Rejecting that notion, the Court of Appeals wrote:
First, he appears to assume that he has a direct interest to assert to
a fraud by omission claim because the money he either invested in
or loaned to ICS, SEB, and CBR remained his money. But it did
not remain his money. Rather, it became an asset of those entities.
C. Owens v. C.I.R., 568 F. 2d 1233, 1238 (6th Cir. 1977) (“[S]tock
in a corporation represents an ownership interest in a going
business organization; the stockholders do not own the
corporation’s property.”). Slip op. at 11.
33
Misappropriation
With respect to a claim that Jones had misappropriated Griffin’s assets, the court
reiterated that the funds allegedly misappropriated belonged to the business organizations and
not to Griffin, and as well the fact that, if funds were misappropriated from the corporation, it is
to the corporation that any redress is owed.
Unjust Enrichment
With respect to Griffin’s claim for unjust enrichment against Jones, finding that this
claim “Laid bare, this is simply an impermissible attempt to convert a derivative claim into a
direct claim to nothing more than an exercise in semantics; it is another way of asserting that
Sarah, in her role of corporate officer, indirectly injured him (an investor in shareholder) by
misappropriating corporate assets.” Slip op. at 15. This assertion was rejected on the authority of
2815 Grand Realty Corp. v. Goose Creek Energy, Inc., 656 F. Supp.2d 707, 716 (E.D. Ky.
2009), which stands for the proposition that the diminution in the value of stock consequent to an
injury to the corporation is a direct injury only to the corporation and, as to a shareholder, is
derivative in nature.
34
Piercing the Veil
35
Sixth Circuit Confirms that Piercing is a Remedy; In re Howland
Last week the Sixth Circuit Court of Appeals issued its opinion in In re Howland,
addressing whether a trustee could assert piercing the veil as a mechanism for merging the assets
of an LLC into the bankruptcy estate of its members. As did the Bankruptcy and the District
Courts below, the Sixth Circuit rejected this effort. Phaedra Spradlin v. Beads and Steeds Inns,
LLC (In re Howland), ___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, 2017 U.S. App.
LEXIS 222 (6th Cir. Jan. 3, 2017).
Stoll Keenon Ogden and particularly Adam Back represented the defendants in this
action.
The facts underlying the dispute, as set forth by the Sixth Circuit, were as follows:
Matthew and Meagan Howland are the debtors in this personal bankruptcy case.
In June 2007, they entered into a contract to buy a 133-acre farm in Lancaster,
Kentucky, for $1.6 million. One month later, the Howlands assigned their interest
in the purchase agreement to Meadow Lake Horse Park, a limited liability
corporation they had recently formed under Kentucky law. They also personally
guaranteed the loan Meadow Lake later obtained in order to purchase the farm.
For the next three years, the Howlands operated a horse farm and bed and
breakfast on the property. In November 2010, the Howlands made a $760,000
payment on Meadow Lake’s mortgage for no consideration. Then, a month later,
Meadow Lake sold the property to Beads and Steeds Inns, LLC, a corporation
formed by a third party for the sole purpose of purchasing the farm. The purchase
price was $800,000, roughly half of what Meadow Lake paid just three years
earlier. Along with the sale, the two parties entered into a $1,000-a-month lease
agreement (about one-fourth the market rate), which allowed Meadow Lake and
the Howlands to continue operating the horse farm and bed and breakfast.
Two years later, saddled with unmanageable debt, the Howlands filed for personal
bankruptcy. The bankruptcy court appointed plaintiff, Phaedra Spradlin, as trustee
of the debtors’ estate. In her role as trustee, Spradlin filed this adversarial action
against Beads and Steeds. Spradlin alleged that the December 2010 transfer from
Meadow Lake to Beads and Steeds was fraudulent, done to evade the Howlands’
creditors.
Beads and Steeds moved for judgment on the pleadings, observing that the trustee
alleged that Meadow Lake—not the debtors, personally—engaged in the 2010
transfer. It argued that the trustee therefore failed to state a claim under the
governing fraudulent transfer provisions, both of which required a “transfer of an
interest of the debtor in property.” See 11 U.S.C. § 544(b)(1) (emphasis added);
see also 11 U.S.C. § 548(a)(1)(B). The trustee responded that she could pierce the
corporate veil in reverse and thereby treat Meadow Lake and the debtors as a
single entity.
The Sixth Circuit began by reviewing piercing law generally and noting that the states
fall into one of two categories:
36
• “identity,” in which piercing “expands the debtor’s estate to include the
property of its alter ego” by “deeming a corporation and its alter ego to be a single
entity.”; or
• “vicarious liability” which “shifts liability from the debtor to its alter ego.”
2017 WL 24750, *3 (citations omitted).
Finding that Kentucky utilizes the “vicarious liability” theory (2017 WL 24750, *7), the
effort to utilize piercing to enlarge the assets in the bankruptcy estate was doomed.
The fact that Kentucky endorses the vicarious liability approach to veil piercing,
as opposed to the identity approach, dooms the trustee’s fraudulent transfer claims
against Beads and Steeds under a veil piercing theory. The Bankruptcy Code
permits the trustee to avoid a transfer of property only if the debtor had an interest
in the property. 11 U.S.C. §§ 544(b)(1), 548(a)(1)(B). Under the vicarious
liability approach, however, veil piercing does not give the pierced entity (i.e., the
debtor) an interest in its alter ego’s assets—it gives the pierced entity’s creditor
(i.e., the trustee) an interest in the alter ego’s assets in order to satisfy its judgment
against the pierced debtor. Compare Garvin, 74 P.2d at 992 (under vicarious
liability approach, “[t]he doctrine of alter ego does not create assets for or in the
corporation”), with In re Am. Int’l Refinery, 402 B.R. at 744–45 (stating that
identity approach to veil piecing gives the debtor “an equitable interest in the
assets of its alter ego”) (citation omitted). Under § 544 and § 548, that is not
enough. Because Kentucky veil piercing does not transform the alter ego’s
property into the property of the debtor, but rather simply allows a creditor to
pursue the alter ego under a vicarious liability theory, the trustee has not stated a
claim under § 544 and § 548, both of which require that the debtor have an
interest in the transferred property. 2017 WL 24750, *5.
The decisions below, even while they rejected the effort to enlarge the estate via piercing,
had addressed at length the question of whether Kentucky would recognize either “insider-
reverse” or “outsider-reverse” piercing. Initially determining that piercing was not here possible,
it was able to avoid that issue, a point discussed in footnote 2 to the decision:
The parties spend a significant portion of their briefs jockeying over whether
Kentucky would recognize “reverse” veil piercing. However, based on the
foregoing, we need not address this issue because, regardless of the answer,
Kentucky’s approach to traditional veil piercing makes clear it would not use
reverse veil piercing to consolidate two entities. We therefore leave for another
day the question whether the Kentucky Supreme Court would recognize reverse
veil piercing.
This decision is another square declaration that piercing the veil is a remedy and is not
itself a cause of action, a point already made in numerous decisions cited by the Howland court.
2017 WL 24750, *4.
Still, I have two small quibbles with and a broader observation as to the decision. First, it
refers to Meadow Lake Horse Park as a “limited liability corporation,” (it is actually a limited
liability company), and refers to Beads and Steeds Inns, LLC as a corporation (likewise, it is
actually a limited liability company). 2017 WL 24750, *1.
37
Of greater import, the Sixth Circuit presumed, without analysis, that the law of piercing
that has developed in the context of the law of corporations is equally applicable with respect to
LLCs. On this point there is conflicting authority. In Turner v. Andrew, 413 S.W.3d 272, 277
(Ky. 2013), the Court wrote “The doctrine [of veil piercing] can also apply to limited liability
companies.” Turner was not, however, a piercing case, so this statement is dicta. Conversely, in
Pannell v. Shannon, 425 S.W.3d 58, 2014 WL 1101472, *7 (citations omitted), the Supreme
Court observed:
In fact, “limited liability companies are creatures of statute,” controlled by
Kentucky Revised Statutes (KRS) Chapter 275,” not primarily by the common
law. To the extent that common law doctrines could arguably govern limited
liability companies, the Kentucky Limited Liability Company Act “is in
derogation of common law,” KRS 275.003(1), and the traditional rule of statutory
construction that “require[s] strict construction of statutes which are in derogation
of common law shall not apply to its provisions.” Id. Thus, to the extent the
statutes conflict with common law, the common law is displaced.
This Court must therefore first look at the controlling statutory law. The obvious
place to start, then, is the source of limited liability in the LLC context, KRS
275.150.
Although this issue was raised in the lower court briefs, it was not briefed before the
Sixth Circuit. Both lower courts summarily found there to be no issue based on Tayloe, 2014
Ky. App. LEXIS 131, and Turner v. Andrew. Whether and on what terms an LLC may be
pierced remains a topic to be addressed by the Kentucky Supreme Court. The fact that the Sixth
Circuit did not undertake that analysis is worth noting only to make clear that In re Howland is
not cited as authority that Kentucky LLCs are subject to the common law of piercing.
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Alter Ego Applied to “Reverse Pierce,” But We Don’t Know on What Grounds
A July 15, 2016 decision of the Court of Appeals upheld the treatment of an LLC as
being the alter ego of its sole member, in effect reverse piercing the LLC to make its assets
available to satisfy a debt of the sole member. Unfortunately, the decision does not detail the
basis for the alter ego determination. Lee v. Lee, No. 2014-CA-000387-MR, 2016 WL 3886884
(Ky. App. July 15, 2016).
This dispute had its inception in the Lee’s divorce. John Lee was held liable for Jill’s
attorney fees to the sum of $70,000. In December, 2011, John’s company, Lee Development
Group d/b/a Acceleris, was found to be jointly and severally liable on that $70,000 judgment.
The opinion is silent as to the basis on which that determination was made. In May, 2012, the
Acceleris bank account was garnished. In May, 2012, John formed a new company, Acceleris
LLC. Learning of it, the Plaintiffs sought to garnish its accounts on the basis that it was John’s
alter ego. That order of garnishment was entered.
The substance of the decision was upon whether the trial court properly complied with
the garnishment statute, KRS § 425.501, and not upon the finding of alter ego. Rather:
On appeal, the Appellants do not challenge any of the court’s factual findings
regarding “alter ego” liability; rather, they contend the garnishment order was
void ab initio because Appellees did not have a final judgment against Acceleris,
LLC, before obtaining the order of garnishment. Slip op. at 3 (footnote omitted).
Upholding the garnishment against Acceleris, LLC on the basis it was John Lee’s alter
ego, the Court of Appeals quoted the trial court’s findings of fact.
Mr. Lee testified that he was the sole member of Acceleris, LLC, and that he
alone made all the managerial decisions.
Mr. Lee acknowledged that he used money from Acceleris, LLC, to pay personal
debt. Introduced as an Exhibit is a copy of a check on an Acceleris, LLC, account
made payable to the Internal Revenue Service, which he acknowledged was used
to pay his personal back taxes. Mr. Lee also testified that he used Acceleris, LLC,
funds to fund his son’s baseball team. Mr. Lee contended that Acceleris, LLC,
funds that were used to pay personal debt was salary. He further acknowledged
that funds from Acceleris, LL, were used to pay his personal providers.
Mr. Lee acknowledged that he opened a checking account with a bank located in
Indiana. When questioned as to whether he opened the account to avoid
garnishment, he stated that he did business with his business associates. As to the
Acceleris, LLC, bank account, Mr. Lee testified that he used his personal social
security number to identify the account even though Acceleris, LLC, has its own
Federal ID number.
It would be comforting to have more details as to why the finding of alter ego was
justified. For example, being a single member LLC is by statute not a basis for piercing the veil.
See KRS § 275.150(1). As for paying personal expenses out of the LLC, were the examples
39
given typical or atypical versus all company activities? Is any use of company funds to pay
personal expenses sufficient to support a finding of alter ego, or must there be some higher
threshold? That point was not addressed. Even though alter-ego finding was not appealed, why
this quotation as to why alter-ego treatment was appropriate?
This decision is one of only a few that have addressed reverse piercing in Kentucky. I
submit it deserved a more detailed analysis, especially as it is designated “to be published.”
40
Federal District Court in Virginia Reverse Pierces Delaware LLC
Based if nothing else upon the outrageous facts of the case, a recent decision from the
Federal District Court in Virginia is worth rending. Substantively, the Court reverse pierced three
Delaware LLCs in order to access their respective assets to satisfy a judgment debt of the sole
member. Sky Cable, LLC v. Coley, Civ. Act. No. 5:11cv00048, 2016 U.S. Dist. LEXIS 93537
(W.D. Va. July 18, 2016).
A judgment had been entered in favor of DirectTV, LLC against Coley and East Coast
Cable Vision in the amount of $2,393,000. In post-judgment collection actions, in language
detailed by the court, Coley engaged in a pattern of recalcitrance including failing to produce
documents by set deadlines, the apparent submission of fraudulent documents, and giving
inconsistent answers with respect to a number of matters, including whether he is the sole
member, or in contrast is a member with his wife, of three Delaware LLCs, they being Its
Thundertime, LLC, East Coast Sales, LLC and South Raleigh Air, LLC. There was in addition
comingling of funds between Coley and these three LLCs. In depositions, he was either unable
or unwilling to explain how the money moved between these three companies and his personal
account. Also, his personal residences were held by one of these LLCs, even as Coley and his
family lived in them rent-free. DirectTV, in order to collect on a judgment, petitioned the court
to reverse pierce the three LLCs.
Finding that Delaware law is controlling as to whether these three LLCs may be pierced,
it collected and reviewed the laws with respect to whether or not outsider reverse piercing would
be permissible under Delaware law. Ultimately concluding that outsider reverse piercing would
be permissible, that determination being based upon hints in certain Delaware decisions as well
as the long list of other states that have allowed outsider reverse piercing on appropriate facts,
reverse piercing was ordered. In addition, the court pointed a receiver for each of the LLCs,
finding this to be a “extraordinary case.” Specifically:
Randy Coley’s deception and efforts to evade judgment have plagued this
litigation. Based on this history, there is a probability that Coley’s
deceitful tactics will continue in an effort to frustrate DirectTV’s valid
claim as a judgment creditor in this case, and that the corporate assets are
in imminent danger of being “concealed, lost, or diminished in value.
For that reason, the receiver was justified.
41
Basic Principle of Parent/Subsidiary
Separation Applied to Strike Claims Under Alien Tort
Claims Act
The Second Circuit Court of Appeals handed down a decision to the effect that the U.S.
parent corporations of foreign subsidiaries who were alleged to have facilitated apartheid in
South Africa could not be sued under the Alien Tort Claims Act. Balintulo v. Ford Motor Co.,
2015 BL 238790 (2nd
Cir. July 27, 2015).
The plaintiffs sought to hold Ford and IBM responsible for having, through their foreign
subsidiaries, facilitated apartheid. Pursuing the claims and the jurisdictional requirements of the
ATCA, it was found that they were deficient. While, in the case of Ford, a South African
subsidiary may have done so via the assembly of vehicles used by the S.A. Defense Forces, it
was not Ford which did so.
[H]olding Ford to be directly responsible for the actions of its
South African subsidiary, as plaintiffs would have us do, would
ignore well-settled principles of corporate law, which treats parent
corporations and their subsidiaries as legally distinct entities.
(citation omitted).
The Court of Appeals continued with a discussion of piercing the veil, noting it is done
only in “extraordinary circumstances” and that the plaintiff had not plead any basis for doing so.
42
IRS Successfully Argues that One Corporation is the “Alter Ego” of the Other,
Holding the Newly Created Company Liable for the Tax Debts of the Former
From time to time the question is presented, on behalf of a business entity that it owes
significant liabilities, including liabilities to the IRS, about the option of simply shutting down
that venture, using the net assets to satisfy, typically on a pennies on the dollar basis, the existing
creditors, and then starting up essentially the same venture in a new corporate or LLC shell. As is
identified in a recent decision, this methodology has significant problems. WRK Rarities LLC v
United States, No.4:13-cv-00791, 2016 WL 775422 (N.D. Ohio February 29, 2016).
It is important to note that this is not a case about “piercing the veil.” In a piercing case,
the plaintiff, holding a judgment against the corporation or LLC, seeks to hold the shareholders
or members, who otherwise enjoy limited liability, liable upon that obligation. Here, the effort
was to hold one company liable for the debts and obligations of the other, even though there was
no ownership relationship between them. That this is not a “piercing” case is specifically noted
in footnote 1 to the decision. Rather, this analysis involves “alter ego” as that doctrine has been
applied under the Internal Revenue Code.
William R. Kimple, through a pair of acquisitions from the founders, by 1994 was the
sole shareholder of Kimple’s Jewelry & Gifts (“KJG”). Apparently (the opinion is nowhere
express as to the point), KJG was a C-corporation. In 2005 KJG filed for Chapter 11 bankruptcy.
In that proceeding, the IRS filed a proof of claim for unpaid federal taxes including corporate
income taxes and employment taxes. Notwithstanding the approval of a plan of reorganization in
2007, KJG failed to perform thereunder, and the bankruptcy was subsequently dismissed. In
addition, from 2007 forward, KJG ceased to make quarterly deposits of federal employment
taxes, and federal tax liens were ultimately filed. On December 31, 2010, KJG “allegedly”
ceased operations.
However, even as KJG was still in operation, Kimple formed a new LLC, WRK Rarities,
LLC, with a d/b/a of Kimple’s Fine Diamonds (“WRK”). WRK would go on to operate a jewelry
store from the same location they KJG had operated from since 1957, with Kimple as its sole
manager and member. Further, WRK utilized KJG’s signage, furniture and fixtures and
continued to utilize the services of the same employees, they having the same titles and salaries
they had when working for KJG. WRK even use the same bank as had KJG.
When, in 2011, the IRS levied on the accounts of KJG, there was little recovery as those
accounts contained only minimal funds. Later in 2011, the IRS determined that WRK was “the
nominee, alter ego, and/or fraudulent conveyee of KJG,” and proceeded to levy on WRK’s
accounts in order to collect on the taxes owed by KJG. Ultimately the IRS would seize WRK’s
assets. Thereafter, suit was filed, alleging wrongful levy. From there, this decision was rendered
to the government’s motion for summary judgment.
After determining that it is Ohio law that would govern whether alter ego liability
applies, and recognizing the general rule of Ohio that successor liability does not attach in the
instance of an asset acquisition, it noted as well that there are at least four exceptions to this rule,
and that “a successor corporation may be held liable when (1) the buyer expressly or impliedly
agrees to assume such liability, (2) the transaction amounts to a de facto consolidation or merger,
43
(3) the buyer corporation is merely a continuation of the seller corporation, or (4) the transaction
is entered into fraudulently for the purpose of escaping liability.” (Citation omitted).
The court would find it WRK was merely a continuation of KJF
Citing law to the effect that common ownership is crucial as it would indicate an
inadequacy of consideration, in this instance Kimple was the sole owner of both KJG and WRK.
Further, the government was able to demonstrate that inadequate consideration was paid for any
assets transferred from KJG to WRK.
With careful and conscientious planning, sometimes it is possible to abandon a failed
venture and start a new one. That is possible only with, however, careful planning. In the absence
of that planning, successor liability for taxes, and potential successor liability for other claims,
should not be treated as a surprise.
44
Fraudulent Conveyance and Piercing the Veil
In this 2015 decision, the Federal District Court found (a) that certain mortgages and
security interests were fraudulent conveyances and (b) that the veils of a variety of entities
should be pierced in order to hold the control person liable for an arbitration award against two
of those companies. Kentucky Petroleum Operating Ltd. v. Golden, Civ. No. 12-164-ART, 2015
WL 927358 (E.D. Ky. March 4, 2015).
Two LLCs, 7921 Energy LLC and Macar Investments, LLC (collectively the “Macar
parties”) sold gas and oil well properties and equipment to Kentucky Petroleum Operating, LLC
and Kentucky Petroleum Operating, Ltd. (collectively the “KPO debtors”). Disputes arose over
performance under those agreements, and that dispute went to arbitration. Between the
arbitration hearing and the rendering of the decision, the KPO debtors, working in concert with
affiliated companies, mortgaged/pledged their assets to those same affiliated companies,
particularly Kentucky Petroleum Limited Partnership (“KPLP”). The mortgage allowed KPLP
to foreclose on the leases in the event of a transfer by operation of law, described by Judge
Thapar as:
Taking a page out of playground negotiation, KPLP essentially called “dibs” in
the event they ever left the KPO debtors’ possession.
The Macar parties prevailed in arbitration, and were awarded against the KPO debtors a
judgment of $466,187. With the assets of the KPO debtors fully encumbered, the Macar parties
(i) argued that the mortgages/pledges between the KPO debtors and the related companies were
fraudulently transferred and (ii) the KPO debtors, KPLP and other entities are actually alter-egos
of one another and their veils should be pierced to reach Mehran Ehsan, their common controller.
Fraudulent Conveyance
Kentucky law voids any conveyance of property made with the intent to “delay, hinder,
or defraud creditors,” KRS § 378.010; subsequent creditors are likewise protected. Myers Dry
Goods, Inc. v. Webb, 181 S.W.2d 56, 59 (Ky. 1944). There was in this case no dispute that one
“badge of fraud” existed, namely that the mortgages/pledges were given during the pendency of
a lawsuit. 2015 WL 927358, *4. With that badge of fraud the burden shifted to the KPO debtors
to show that the mortgages/pledges were given in good faith. This they failed to do. In response
to the position that the KPO debtors did not think the Macar parties to be creditors at the time of
the mortgages/pledges, the Court found that their subjective view is largely irrelevant. Rather:
Even if the KPO debtors did not consider the Macar parties their
“creditors” when they recorded the UCC–1 and mortgage, the law did: “A person
who has a claim for damages against a grantor is a creditor within the meaning of
[the fraudulent conveyance statute].” Lewis, 49 S.W. at 329; Hager, 208 S.W.2d
at 519–20 (finding a debtor-creditor relationship where the debtor had “reason to
believe and anticipate” that the creditor would take action against him).
Moreover, section 378.010 protects both then-existing and subsequent creditors
from a debtor’s fraudulent conveyances. Myers, 181 S.W.2d at 59. Thus, section
45
378.010 applies even if the KPO debtors did not believe the Macar parties were
creditors at the time they executed the mortgage and UCC–1. Id.
The Court rejected the assertion that good faith is a fact question requiring a jury trial on
the basis that they failed, in the face of an admitted badge of fraud, to “present any evidence
disputing that they harbored intent to defraud.” Id. There was also rejected (on grounds that are
not entirely clear) the claim that the mortgages/pledges were given in satisfaction of an existing
indebtedness. Id. at *6.
The Macar parties were granted summary judgment on their claims for fraudulent
conveyances.
Piercing the Veil
The decision recites the piercing test adopted by the Kentucky Supreme Court in Inter-
Tel Technologies, Inc. v. Linn Station Properties, LLC, 360 S.W.3d 152, 165 (Ky. 2012), noting
that:
In Kentucky, alter ego liability boils down to “two dispositive elements: (1)
domination of the corporation resulting in a loss of corporate separateness and (2)
circumstances under which continued recognition of the corporation would
sanction fraud or promote injustice.”
As for the lack of separateness, it was found that the KPO debtors and the related
companies share common leadership in Mehram Ehsan, there was inadequate capitalization of at
least one of them, formalities were ignored and the entities comingled their funds. Id. at *7.
The fact that Mehram Ehsan was not named as a party in the suit, that raised as a bar to
the Court piercing the veil, was described as “mistaken.”
Having found a lack of separateness, the Court turned its attention to the second prong of
the piercing analysis, namely whether or not piercing would sanction fraud or promote injustice.
While acknowledging that the injustice needs to be more than the creditor is not paid, the
Court determined:
[O]ne such injustice is a parent corporation or director causing a subsidiary’s
liability and then rendering the subsidiary unable to pay that liability. Ehsan, who
controls and directs all of the KPO entities, incurred liability on behalf of the
KPO debtors by executing both the Macar and 7921 PSAs on behalf of the KPO
debtors. An arbitrator found that the KPO debtors breached the PSAs and
awarded damages to the Macar parties. Ehsan then rendered the KPO debtors
unable to meet their PSA obligations. As the Court explained in section II, the
KPO entities—at the direction of Ehsan—stripped assets from the KPO debtors,
meaning that the Macar parties could not collect their arbitration award.
Accordingly, continued recognition of the separate corporate forms of the various
KPO entities would sanction an injustice.
46
A second injustice is a scheme to shift assets to a liability-free corporation while shifting
liabilities to an asset-free corporation. In this case, all of the liabilities fell on the KPO debtors
because they are the only parties named in the arbitration award. Meanwhile, non-debtor KPLP
took all of KPO, LLC’s assets and all of the KPO debtors’ revenue under the PSAs. On these
facts, the continued recognition of the KPO entities’ supposedly “separate” corporate forms
would sanction injustice. Because the Court finds that the KPO entities lack corporate
separateness and that recognizing separate corporate forms would sanction an injustice, the Court
will pierce the corporate veil and treat the KPO entities as a single entity. Id. at *8 (citations
omitted).
From there the conclusion was a foregone, namely:
Because the Court finds that the KPO entities lack corporate separateness and that
recognizing separate corporate forms would sanction an injustice, the Court will
pierce the corporate veil and treat the KPO entities as a single entity. Id.
47
Kentucky Court of Appeals Affirms Piercing the Veil
In a decision rendered last Friday, the Kentucky Court of Appeals affirmed the
determination that the veil of an LLC should be pierced, primarily on the basis, it would appear,
that the company was undercapitalized. Roscoe v. Angelucci Acoustical, Inc., No. 2012-CA-
001933-MR, 2014-CA-000536-MR, 2017 WL 655488 (Ky. App. Feb. 17, 2017).
In 2006, Lexhold Partners II Lot 14-A Exclusive, LLC (“Lexhold Partners”) was awarded
the contract to construct a building now occupied by Hewlett-Packard. Although, apparently, the
property is owned by the University of Kentucky, Lexhold Partners holds the lease vis-a-vis
Hewlett-Packard. In order to affect this project, another LLC, Lexhold Premier Commercial
Contractors, LLC (“Premier”), was formed. Upon completion of the project, Premier was
dissolved. Roscoe, one of the defendant in this action, was one of the two “managing partners”
of each of Lexhold Partners and Premier. It should be noted that, throughout this opinion,
partnership and corporate terminology is intermixed even as the decision is about an LLC.
Premier subcontracted with Angelucci Acoustical, Inc. (“Angelucci”) for the installation
of drywall and acoustical ceilings. That subcontract had a price of $396,240.30. The building
was completed, and occupancy undertaken, even as Angelucci continued to complete certain
tasks. Angelucci alleged that it incurred an additional $88,053.70 in completing those additional
task, while Roscoe alleged that they were simply additional punchlist items included in the
original purchase price. Angelucci filed suit against Premier, Lexhold Partners and Roscoe
seeking those additional amounts. Angelucci sought and was awarded partial summary
judgment; that ruling became final, and Roscoe did not appeal.
Nearly a year later, on bases not fully identified in this decision, the trial court pierced the
“corporate” veil of Premier (the general contractor) to hold Roscoe liable on the $88,053.70 (plus
interest) judgment. This appeal followed. However, in connection therewith, Roscoe did not file
a supersedeas bond. Roscoe thereafter failed to comply with requirements as to judgment
discovery and, notwithstanding having entered into a settlement agreement in the amount of only
$30,000, he failed to discharge that obligation. After hearing, the trial court issued a judgment
against Roscoe totaling $334,785.34, which amount included compensatory and punitive
damages and attorney’s fees. Roscoe then filed this appeal.
With respect to the piercing claim, the decision of the Court of Appeals is somewhat
cryptic as to why that was permitted. It appears that facts justifying piercing were as follows:
• “the two managing members of the Lexhold Partners are the same
to managing members of Lexhold Premier, Roscoe and Oliver.
They developed Lexhold Premier Commercial Contractors, LLC
solely for the purpose of serving as the general contractor for the
project. This construction project was the only asset of Lexhold
Premier.”; and
• in two instances, Lexhold Partners was identified as the “owner” of
the property (Angelucci was not a party to either of these
agreements).
48
Quoting from the trial court, the Court of Appeals observed that:
As in Inter-Tel, Lexhold Partners caused Lexhold Premiere to be
obligated to pay Angelucci for work performed on the subject
property and then rendered it unable to pay. Lexhold Partners
limited the value of the sole asset of Lexhold Premiere and caused
it to bear the brunt of the failure to pay subcontractors while
Lexhold Premiere derive the benefit of the improvements to real
property by its lease agreement with the landowner and agreement
with HP.
Similarly, it appears that the second scenario identified in Inter-Tel
applies as all assets that could or should have been part of Lexhold
Premiere were moved beyond the reach of legitimate creditors and
have been retained largely by Lexhold Partners. Roscoe concedes
that Premiere was formed for the sole purpose of trying to escape
the hassles and liabilities associated with being a general
contractor[,] and he and Oliver wanted to keep the money “in
house.” Premiere had no assets other than the $5,247,000 contract
with Lexhold Partners and was in Roscoe’s terms a “pass-
through.” Moreover, Partners has reaped all of the benefits from
this construction project and currently receives revenue from its
lease with the sole tenant of the building, Hewlitt-Packard. That
was the purpose of its original lease with “Commonwealth of
Kentucky for the use and benefit of the University of Kentucky
acting by and through the Board of Trustees of the University of
Kentucky.” To allow Partners and Roscoe to escape liability under
these circumstances would, in fact, sanction fraud and promote
injustice against Angelucci and the other subcontractors.
What steps were undertaken by Roscoe in order to render Lexhold
Premier unable to satisfy its obligations, thereby effectuating a
fraud, was not detailed by the Court of Appeals. In the underlying
opinion and order issued by the Fayette Circuit Court (Judge
Goodwine), it had been found that:
[B]oth Lexhold Premier and Lexhold Partners worked on the same
project and had no other business. Lexhold Premier’s sole asset
was its contract with Lexhold Partners. The two companies have
the same member-managers and nearly identical operating
agreements. Minutes were not kept for company meetings. Bill
Boshong performed work for both entities but Lexhold Partners
paid the entire amount of his bill. Derek Roscoe only performed
work for Lexhold Partners but was paid by Lexhold Premier as
well. Lexhold Partners paid cost attributable to Lexhold Premier,
and vice versa. Slip op. at 8.
49
Then, after reciting a number of other circumstances in which the companys’ assets were
apparently intermingled, it was observed that:
It is clear to this Court that Lexhold Partners and/or Roscoe
exercise complete dominion and control over Lexhold Premier.
Roscoe and/or Oliver provided for or guaranteed 100% of the
startup costs to fund Lexhold Premier. They set the contract
amount of $5,247,000 that they would pay Lexhold Partners, i.e
themselves. There is no evidence that Lexhold Premier followed
any corporate formalities; Roscoe and/or Oliver used the
companies’ that funds interchangeably and funds from one paid the
expenses of the other. Whether premier was paid the $5,247,000
due under its contract with Partners was solely within the
discretion of Partners. Roscoe conceded that Premier paid him
certain “expenses which connected to his work” on the project. He
also conceded that he directed Premier to pay his son sums that he
believed were due him. Slip op. at 10.
The court would go on to find that the assets of Lexhold Premier, the general contractor,
had been “moved beyond the reach of legitimate creditors and have been retained largely by
Lexhold Partners,” with the result that “Partners has reaped all of the benefits of this construction
project and currently receives revenue from its lease with the sole tenant of the building,
Hewlett-Packard. … to allow Partners and Roscoe to escape liability under these circumstances
would, in fact, sanctions fraud and promote injustice against Angelucci and the other
subcontractors.” Slip op. at 11-12. Again, how the assets were moved so as to be unavailable to
Angelucci and other creditors is not detailed.
From that same order it becomes clear that the question of the name of the property
owner relates to a challenge to Angelucci’s mechanics lien.
From the perspective of the law of piercing, this decision is in several respects disturbing.
First, while on the facts piercing may have been justified, the Court of Appeal’s affirmance
without a detailed recitation of those facts leaves the reader wondering what truly happened.
Second, the continued reference to the “corporate” veil in the context of an LLC is simply
incorrect and as well glosses over the problem that the courts have not identified whether and to
what extent the Inter-Tel Technologies test for piercing will be different for LLCs versus
corporations. Third, justifying, at least in part, the piercing of an LLC based upon the failure to
satisfy “corporate formalities” is at best confusing. While corporations are obligated to have
meetings and keep minutes, the LLC Act does not require either meetings or minutes. If, in this
particular case, the operating agreement dictated that meetings would be held and minutes kept,
then there may have been a failure to follow a contractually assumed obligation. If that was the
case, it was not detailed by either the Court of Appeals or the trial court. Conversely, if there was
no such contractual obligation, supporting a ruling on piercing based upon the failure to do what
is not required is nonsensical.
More broadly, the courts’ language with respect to related special-purpose business
organizations is troubling. Blanket statements to the effect that the companies were related and
50
had the same members/management structure, and on that basis piercing was justified,
dangerously simplifies proper piercing analysis. It has long been the law that the organization of
various business ventures for the purpose of limiting liability (i.e., partitioning various asset
pools into different ventures with the intent and objective of exposing each to only a certain class
of creditor claims) is an accepted business practice. There is no question that the utilization of
these structures in an abusive manner should not be allowed and that piercing should be a
possible remedy for that abuse. The structures themselves are not, however, ab initio abusive or
improper, and flippant language to the effect that related ventures should, for that reason, be
pierced is unjustified. Rather, while related, special-purpose entities may be particularly at risk
for violating the rules as to when piercing is justified, there should not be any implication that
piercing is justified because of relatedness.
51
Diversity Jurisdiction
52
US Supreme Court Addresses the Citizenship, for Purposes of Diversity
Jurisdiction, of a Business Trust
The US Supreme Court has addressed and resolved the question of how the citizenship of
a business trust is to be resolved. Cutting to the chase, it is at least that of the beneficial owners
in the trust. Americold Realty Trust v. Conagra Foods, Inc., No. 14-1382 (March 7, 2016).
The decision, written by Justice Sotomayor, was unanimous. It also had a quick
turnaround. The case was only argued on January 19.
The question presented in this case is relatively straightforward, namely whether in
determining the citizenship of a business trust for purposes of diversity jurisdiction (28 U.S.C. §
1332), the trust will be deemed to have citizenship of only the trustees, only of the beneficiaries,
or other combination of the two. The ultimate decision needed to address the interface of the
Supreme Court’s 1980 decision rendered in Navarro Savings Association, in which suit was
brought by the trustees as the trustees and, on those facts, only their citizenship was relevant, and
Carden v Arkoma Associates, a 1990 decision in which it was held that the citizenship of every
“member” of an unincorporated association should apply to determine its citizenship.
Americold argued that the citizenship of only the trustees should be relevant in assessing a
trust’s citizenship. This argument is to the effect that a broadly held trust should be able to access
the federal courts through diversity jurisdiction. In contrast, ConAgra Foods is seeking the return
of the suit to state court by its argument that the citizenship of all of the beneficiaries of
Americold is relevant to determine its citizenship.
The Court came down squarely on the side of Conagra and of the Carden decision.
Essentially, Navarro was limited to the traditional common law trust in which the trust is itself
not subject to being sued – in those cases on the trustees may sue or be sued, and in that
circumstance only the citizenship of the trustees will be considered. Otherwise, as is the case
here with respect to a “trust” that is organized under a law that affords it the capacity to sue and
be sued in its own name, then the Carden rule is applicable, and the citizenship of all
“members,” namely the beneficial owners/shareholders in the trust, will apply.
53
Plaintiff Allowed Jurisdictional Discovery with Respect to Partnership and LLC Defendants
In an action brought in federal court on the basis of diversity, the party asserting diversity
jurisdiction bears the burden of showing that it exist, i.e., that no defendant is a citizen of the
same state as is any plaintiff. This can be an especially daunting task when one of the defendants
is a partnership or LLC. A partnership or an LLC is deemed to have the citizenship of each of its
members, but who are those partnerships or members is not a matter of public record. On the
recent decision from Pennsylvania, the court allowed the plaintiff to undertake discovery as to
the membership of the defendant partnership and LLC in order to determine whether or not
diversity actually existed. Bissell v. Graverley Brothers Roofing Corp., Civ. Act. No. 15-04677,
2016 WL 3405455 (E.D. Penn. June 21, 2016).
Bissell brought suit against the various defendants after a house she owned was bulldozed
by the defendants. In response to that complaint, the defendants filed a motion to dismiss on the
basis that Bissell had not identified in the complaint who are all the partners of Graverley Family
Partnership, one of the defendants, or the members of Gerard Commons, LLC, also a defendant.
In response, the court first noted that those defendants had not advised the court of who are those
partners/members, from which the court could have made a factual determination. Second, based
upon Lincoln Benefit Life Co. v. AEI Life, LLC, 800 F.3d 99, 105 (3rd
Cir. 2015), “affirmative
allegations of citizenship for unincorporated associations are not required when a party can
allege in good faith that it is diverse from each member.” 2016 WL 3405455,*7. The court then
recounted the efforts made by Bissell to investigate the partners and members of the LLC, and
found that she had undertaken sufficient efforts of reasonable investigation.
From there, the court ordered that there will be jurisdictional discovery as to who are the
partners of the partnership and who are the members of the LLC.
Because members of the unincorporated associations are not within
Plaintiff’s reach, jurisdictional discovery is appropriate with regard
to the citizenship of the two disputed Defendants. Therefore,
plaintiff shall be afforded an opportunity to conduct discovery to
establish the existence of diversity jurisdiction with regard to the
unincorporated associations. This, however, is not an invitation to
Plaintiff to embark on a fishing expedition - discovery shall be
narrowly tailored to address the limited issues set forth herein.
2016 WL 3405455,*7.
54
Diversity Jurisdiction and Jurisdictional Discovery: The Third Circuit Holds That “Hiding
The Ball” Will Not Work
Federal diversity jurisdiction, 28 U.S.C. § 1332, requires that the dispute both involve
more than $75,000 and that there be complete diversity, i.e., that no defendant be a citizen of any
state of which a plaintiff is a citizen. While corporations, consequent to specific legislative
designation, are deemed to be citizens of the jurisdiction of incorporation and the jurisdiction in
which is located the corporation’s principal place of business, an unincorporated association such
as a partnership, limited partnership or LLC is deemed to be a citizen in which any of its
partners/members are citizens to the effect that, for example, if a member of an LLC is itself
another LLC or a partnership, citizenship must be tracked through all layers until there are
reached either natural persons or corporations. A plaintiff bringing an action in federal court, or a
defendant seeking to remove an action to federal court, is required to plead facts demonstrating
that diversity exists. This obligation can be, at best, difficult to satisfy when one considers that
the membership of partnerships and LLCs is almost never of public record. How then, can either
the plaintiff or the defendant seeking to enlist diversity jurisdiction adequately plead its
existence?
This dilemma was recently faced and addressed by the Third Circuit Court of Appeals. In
this case, the plaintiff brought an action in federal court against defendants including LLCs.
Those defendants moved to dismiss the action on the basis that diversity jurisdiction had not
been adequately pled. Of course, the information as to the membership of those defendant LLCs
was uniquely within their control. As such, the plaintiff had pled diversity jurisdiction on the
basis of “information and belief.” Ultimately, the Third Circuit would confirm that “information
and belief” pleading is, at least initially, sufficient. Lincoln Benefit Life Company v. AEI Life,
LLC, No. 14-2660, 2015 WL 5131423, ___ F.2d__ (3rd
Cir. Sept. 2, 2015).
Lincoln Benefit brought suit in order to have declared void two life insurance policies,
alleging they were procured by fraud or for the benefit of third-party investors (i.e., “Stranger
Originated Life Insurance” or “STOLI”). AEI Life, LLC and ALS Capital Ventures, LLC were
identified as the record owners and beneficiaries of those two policies. In its Complaint,
originally filed in New Jersey, Lincoln Benefit alleged that it is a citizen of Nebraska based upon
its organization and principal place of business. It alleged, “upon information and belief,” that
AEI Life, LLC and ALS Capital Ventures, LLC were citizens of, respectively, New York and
Delaware. In response:
The defendants filed motions to dismiss for, among other things,
lack of subject-matter jurisdiction. Their primary argument was
that Lincoln Benefit failed to adequately plead diversity
jurisdiction: an LLC’s citizenship is determined by the citizenship
of its members, and Lincoln Benefit had not alleged the citizenship
of the members of the LLC defendants.
Lincoln Benefit, in response, pointed out that none of the defendants had asserted that it
was a citizen of Nebraska and further that, as information as to the membership of an LLC is not
publicly available, it should be allowed to proceed on an “information and belief” basis or, in the
alternative, it should be afforded the opportunity to undertake limited discovery for the purpose
55
of confirming that diversity did exist. The trial court held against Lincoln Benefit, holding (a)
that pleading diversity on the basis of information and belief is insufficient and (b) that allowing
jurisdictional discovery would be inappropriate when it was not clear that the federal court did
not already have jurisdiction. It was from these determinations that Lincoln Benefit appealed to
the Third Circuit Court of Appeals.
The Third Circuit, after providing a brief review of the rules of diversity jurisdiction,
noted that there are two bases for challenging jurisdiction. First, there is a “facial attack,” which,
as was done in this case, alleges a deficiency in the pleadings. There is as well a “factual attack,”
which challenges whether the alleged facts justify jurisdiction. Distinguishing, in the setting of
this dispute, a facial from a factual attack, the Court, wrote:
If the defendants here had challenged the factual existence of
jurisdiction, Lincoln Benefit would have been required to prove by
a preponderance of the evidence, after discovery, that it was
diverse from every member of both defendant LLCs. Instead,
however, the defendants mounted a facial challenge to the
adequacy of the jurisdictional allegations in Lincoln Benefit’s
complaint. 2015 WL 5131423,* 3.
In reliance, at least in part, on the decision rendered in Lewis v. Rego, Co., 757 F.2d 66
(3rd
Cir. 1985), and as well limiting Chem. Leaman Tank Lines, Inc. v. Aetna Cas. & Sur. Co.,
177 F.3d 210, 222 n. 13 (3rd
Cir., 1999), for the proposition that “rather than affirmatively
alleging the citizenship of the defendant, a plaintiff may allege that the defendant is not a citizen
of the plaintiff’s state of citizenship.” To the effect that:
A State X plaintiff may therefore survive a facial challenge by
alleging that none of the defendant association’s members are
citizens of States X. Id. at *4.
provided that the plaintiff has undertaken reasonable inquiry in support thereof. To that end:
[B]efore alleging that none of an unincorporated association’s
members are citizens of a particular state, a plaintiff should consult
the sources at its disposal, including court filings and other public
records. If, after this inquiry, the plaintiff has no reason to believe
that any of the Association’s members share its state of citizenship,
it may allege complete diversity in good faith. The unincorporated
association, which is in the best position to ascertain its own
membership, may then mount a factual challenge by identifying
any member who destroys diversity. Id.
Explaining the rationale for its holding, the Court wrote:
We believe that allowing this method of pleading strikes the
appropriate balance between facilitating access to the courts and
managing the burdens of discovery. District courts have the
authority to allow discovery in order to determine whether subject-
56
matter jurisdiction exists. Rule 8(a)(1), however, serves a
screening function: only those plaintiffs who have provided some
basis to believe jurisdiction exists are entitled to discovery on that
issue. The corollary of this principle is that a plaintiff need not
allege an airtight case before obtaining discovery.
Depriving a party of a federal forum simply because it cannot
identify all of the members of an unincorporated association is not
a rational screening mechanism. The membership of an LLC is
often not a matter of public record. Thus, a rule requiring the
citizenship of each member of each LLC to be alleged
affirmatively before jurisdictional discovery would effectively
shield many LLCs from being sued in federal court without their
consent. This is surely not what the drafters of the Federal Rules
intended.
Moreover, the benefits of such a stringent rule would be modest.
Jurisdictional discovery will usually be less burdensome than
merits discovery, given the more limited scope of jurisdictional
inquiries. It seems to us that in determining the membership of an
LLC or other unincorporated association, a few responses to
interrogatories will often suffice. So long as discovery is narrowly
tailored to the issue of diversity jurisdiction and parties are
sanctioned for making truly frivolous allegations of diversity, the
costs of this system will be manageable. Id. at * 5.
This opinion was followed by a concurrence written by Judge Ambro that, while not
specifically commenting upon this dispute, urged the U.S. Supreme Court to in effect abandon
the rule of Carden v. Arkoma Associates, 494 U.S. 185 (1990), and allow at least limited liability
companies, notwithstanding the fact that they are unincorporated, to proceed under the rules for
determining citizenship that are applicable to corporations.
Assuming the reasoning employed in the Lincoln Benefit decision is followed by the
other circuits, this could be a most important decision. First, it significantly undercuts the large
number of decisions that, to date, have held that citizenship must be pled specifically and not on
information and belief. See, e.g., Principle Solutions LLC v. Feed.Ing BV, Case No. 13-C-223
(E.D. Wisc. June 5, 2013) (“It is well-settled that a plaintiff claiming diversity jurisdiction may
not do so on the basis of information and belief, only personal knowledge is sufficient.”);
Pharmerica Corp. v. Crestwood Care, LLC, No. 13C 1422, 2015 WL 1006683 (E.D. Ill. March
2, 2015) (“[I]t is not sufficient to assert jurisdiction based on information and belief.”); MCP
Trucking, LLC v. Speedy Heavy Hauling, Inc., 2014 WL 5002116 (D. Colo. Oct. 6, 2014)
(denying jurisdictional discovery and remanding action to state court even as it acknowledged
that further discovery in that forum could demonstrate that diversity exists, leading to subsequent
removal); Lake v. Hezebicks, 2014 WL 1874853 (N. D. Ind. May 9, 2014) (allegations of subject
matter jurisdiction must be based on personal knowledge and may not be based upon information
and belief and collecting cases to that effect). Further, it stands in direct challenges to those
decisions that have held that citizenship must be affirmatively pled and that negative statements
57
as to citizenship are insufficient. See, e.g., D.B. Zwirn Special Opportunities Fund, LP v.
Mehrotra, 661F.3d. 124 (1st Cir. 2011), citing Cameron v. Hodges, 127 U.S. 322 (1888). While it
may do nothing to address the fact that diversity jurisdiction may be unavailable consequent to
de minimis indirect ownership (see, e.g., Fadal Machining Centers, LLC v. Mid-Atlantic CNC,
Inc., 2012 WL 8669, 2012 U.S. App. LEXIS 48 (Jan. 3, 2012), Alphonse v. Arch Bay Holdings,
L.L.C., 2015 WL 4187585 (5th
Cir. July 13, 2015)), it does limit the ability of a defendant to
“hide the ball” as to its citizenship while objecting that the other side has not adequately pled
citizenship and therefore diversity.
58
Rule 11 Sanctions Imposed On Attorney Who Filed Diversity Suit That Was Not
In a recent decision from a Federal District Court in New Jersey, where a plaintiff’s
attorney filed a lawsuit in federal court based on diversity jurisdiction where it was manifestly
clear that diversity did not exist, Rule 11 sanctions were awarded. Singh v. Diesel
Transportation, LLC, Civil Action No. 15-7930 (JLL), 2016 WL 901834 (D. N.J. March 8,
2016).
This dispute arose out of a trucking accident that occurred in Nebraska. The plaintiff filed
an action alleging claims in negligence and seeking to impose liability by means of respondeat
superior. The complaint was filed on the basis of diversity jurisdiction, 28U.S.C. § 1332.
However, that complaint alleged that the plaintiff was resident in New Jersey even as identified
two defendants as likewise being resident in New Jersey. As such:
Plaintiff has alleged that he and two Defendants reside in New Jersey, thereby
negating any grounds for diversity jurisdiction. 2016 WL 901834, *2.
On that basis the Defendant’s motion to dismiss for lack of subject matter
jurisdiction was granted.
From there, the court turned its attention to a motion for sanctions under Rule 11 against
the attorney who filed the defective complaint. In determining that Rule 11 sanctions were
appropriate, it observed:
The Court finds that Plaintiff’s counsel failed to make the appropriate inquiry into
the law of diversity jurisdiction prior to filing the instant Complaint on Plaintiff’s
behalf.
As discussed above, the jurisdictional defect here-namely, the lack of complete
diversity-was apparent from a plain reading of the Complaint. The Court finds
that the obviousness of this error of law, in conjunction with Plaintiff’s Council’s
failure to withdraw the Complaint even after being apprised of its deficiencies by
Defense counsel, as well as Plaintiff’s counsel repeated failure to oppose the
pending Motions, necessitates the “fashioning [of] sanction[s] adequate to deter
undesirable future conduct.” 2016 WL 901834, *2 (citation omitted).
On that basis, the defendant’s motion for sanctions against that attorney was granted.
59
Diversity Jurisdiction and Tax Classification
In a recent decision, the court rejected the suggestion that the election by a particular
LLC, for purposes of the Federal Internal Revenue Code, to be classified as a corporation should
impact upon the mechanism by which the citizenship of the LLC is assessed for diversity
purposes. In effect, the LLC argued that, having elected to be taxed as a corporation, it should be
assessed for diversity purposes as a corporation. This argument was unsuccessful. Fairfield
Castings, LLC v Hofmeister, No. 4:15-cv-00059, 2015 WL 4105027 (S.D. Iowa July 2, 2015).
In rejecting the invitation to treat the LLC as a corporation for purposes of diversity
jurisdiction, the District Court wrote:
Similarly, Spara’s elective decision to be treated as a corporation
for tax purposes does not somehow transform its LLC status for
purposes of evaluating diversity jurisdiction. The motivations
behind a business entity’s choice to be taxed in a certain manner
have no bearing on the rationale for evaluating the citizenship of
each member of an LLC.
60
Erroneous Declaration of Diversity Jurisdiction Could Cost the Plaintiff
In the decision from earlier this month, the United States District Court for the Southern
District of New York opined with respect to a belated determination by the plaintiff that, in fact,
diversity jurisdiction did not exist in a lawsuit that has been pending for 19 months. While the
court dismissed the action without prejudice so that it could be re-filed in state court, it is
considering sanctions against the plaintiff. Errant Gene Therapeutics, LLC v. Sloan-Kettering
Institute, 15-CV-2004, NYLJ 1202777366266 (S.D.N.Y. Jan 18, 2017).
Errant Gene Therapeutics, LLC (“Errant Gene”) brought suit, based upon the existence of
diversity jurisdiction, against Sloan-Kettering. In connection therewith, Errant Gene made
certain representations to the court as to the existence of diversity jurisdiction. On that basis, the
suit proceeded for some 19 months. At the end of that period, Errant Gene advised the court that,
in fact, diversity jurisdiction was lacking because one of the members of one of its member
LLCs was in fact a New York resident. At the time of the prior representation of diversity
jurisdiction, that person was inaccurately identified as being a resident of Delaware.
Sloan-Kettering resisted the effort to dismiss the case on the basis of the lack of diversity,
but the court correctly determined that it must do so. “Under the circumstances, the Court has no
choice but to GRANT Errant Gene’s motion. Accordingly, this action is DISMISSED
WITHOUT prejudice to refile in state court.”
The court was not, however, done with this matter. Rather, noting that it has authority to
amongst other things impose sanctions under FRCP Rule 11, it directed that:
Particularly in light of Errant Gene’s somewhat imprecise descriptions of
both its original inquiry into its citizenship and its recent discovery of the
lack of citizenship (not to mention it’s rather sluggish presentation of the
pertinent facts to the Court, it is hereby ORDERED that Errant Gene and
its counsel show cause, within 14 days, why Errant Gene and/or its
counsel should not be sanctioned pursuant to Rule 11(c) for
misrepresenting to the Court, in sum and substance, that Errant Gene was
not a citizen of New York for purposes of diversity jurisdiction and
allowing the litigation to proceed for months on the basis of that
inaccurate statement.
What will happen in this particular case remains to be seen. Regardless, a court issuing a
show cause order of this nature is a good reminder of the importance of a detailed assessment of
the existence of diversity jurisdiction.
61
Landowner’s Responsibility
62
Kentucky Supreme Court Clarifies Responsibility of
Landowner Towards Party Crasher
In a recent case, the Court of Appeals held that a party crasher is to be treated as an
“licensee,” and for that reason the landlord was not responsible when she fell off the landing of a
fire escape, sustaining significant injuries. Phillips v. Touchstone Properties, LLC, No. 2014-
CA-001851-MR (Ky. App. July 1, 2016).
Touchstone Properties, LLC leased an apartment to Jason Orr and Gabriel Dent. The
apartment was comprised of the second and third floors of the house. Orr thereat held a party
with Dent’s knowledge. Madison Phillips was not invited to the party, but was rather invited by
someone who had been; in effect she crashed the party.
A fire escape ran up to the third floor of the building. At some point in the course of the
party, the window through which the fire escape could be accessed (the window itself had been
painted closed at some point in the past) was broken. Phillips followed a friend of hers out onto
the fire escape so that the friend could smoke a cigarette. Phillips, while holding both her cell
phone and a can of beer, stepped backwards and fell through the ladder opening of the fire
escape. Ultimately Phillips and her parents would file a suit against Touchstone, Orr and Dent
alleging negligence in the failure to keep the premises in a reasonably safe condition.
Under the law of real property, a person is upon real property either as an invitee, a
licensee or a trespasser. Different obligations are owed to the different classes, with the highest
obligations being owed to an invitee with minimal obligations owed to a trespasser. Touchstone,
Orr and Dent defended on the basis that Phillips was either a licensee or a trespasser to whom no
duty with respect to the fire escape was owed. Phillips maintained that she was an invitee and
that, if instead she was classified as a licensee, still a duty of care to her was breached. Summary
judgment was granted to Touchstone, Orr and Dent, to the effect that Phillips’ lawsuit was
dismissed. This appeal followed:
Phillips contends that the Circuit Court committed error by rendering
summary judgment dismissing her premises liability action against
Touchstone, Orr, and Dent. Phillips maintains that she was an invitee and
that under Shelton v. Kentucky Easter Seals Society, Inc., 413 S.W.3d 901
(Ky. 2013), granting defendant’s summary judgment was improper.
Alternatively, Phillips argues that even if she is classified as a licensee, the
precepts of Shelton, 413 S.W.3d 901, nevertheless are still applicable and
preclude the granting of summary judgment. Accordingly, whether being
an invitee or as a licensee, Phillips argues that Touchstone, Orr, and Dent
owed Phillips a duty of reasonable care to prevent foreseeable harm in the
premises liability action based upon Shelton, 413 S.W.3d 901. Shelton,
Phillips maintained that any issue of foreseeability are to be left to [sic]
fact-finder for resolution and that summary judgment was thus improper.
Slip op. at 4.
The Court of Appeals rejected that reading of Shelton and the suggestion that there is no
distinction between the obligations owed invitees versus licensees. Rather, those distinctions
63
continue to exist, so it was necessary for the court to determine whether Phillips was an invitee,
licensee or trespasser.
In reliance upon authorities including Shipp v. Johnson, 452 S.W.2d 828 (Ky. 1969), a
social guest is a licensee (and not an invitee). Notwithstanding the fact that Phillips had not been
directly invited to the party, but rather was invited to it by someone who had been invited,
“viewing the facts most favorable to Phillips, she was invited as a social guest to the party on the
evening of December 28, 2011, and thus, qualifies as a licensee.” Slip op. at 5.
From there, the court would determine that none of the defendants were aware that
anybody was using the fire escape on the night of the party. Likewise, none of them failed to
warn Phillips of an unreasonably dangerous condition known to them. While Phillips stepped
backwards and fell through the ladder opening in the fire escape, her fall was not caused by any
unreasonably dangerous “hidden peril” known to Touchstone, Orr, or Dent and not to Phillips.
Slip op. at 6.
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Open and Obvious Doctrine No Bar To Suit
In a decision recently rendered by the Kentucky Court of Appeals, it was held that the
Open and Obvious Doctrine is (i) a question of fact to be considered by the jury that (ii) goes to
the allocation of responsibility for the injury. For that reason, a lawsuit against Kroger and Coca-
Cola must be tried by a jury. Shirrell v. The Kroger Company, No. 2015-CA-000362-MR (Ky.
App. Aug. 12, 2016).
Shirrell slipped and fell in a Kroger store on posters that had been laid on the ground by
an employee of Western Kentucky Coca-Cola Bottling Company, presumably in preparation for
erecting them as part of the display. After Shirrell filed this action, both Kroger and Coca-Cola
filed for summary judgment on the basis that posters on the floor constituted an “open and
obvious hazard.” The trial court granted summary judgment to each of those defendants. This
appeal followed.
On appeal, Shirrell argued, inter alia, that the open and obvious doctrine does not go to
ultimate liability, but rather is a factual question to be considered in allocation of fault.
Specifically:
Shirrell believes that the Circuit Court misinterpreted the law as to open and
obvious hazards in relation to invitees. Even if the posters were an open and
obvious hazard, Shirrell maintains that the open and obvious nature of the posters
merely constitutes an issue of fact for the jury to consider when allocating fault
between him and appellees. Slip op. at 4.
After summary judgment had been granted in this case, the Kentucky Supreme Court had
issued an opinion in Carter v Bullit Host, LLC, 471 S.W.3d 288 (Ky. 2015), in which it clarified
the law regarding open and obvious hazards vis-a-vie the premises liability claims of the
invitees. Therein, the Kentucky Supreme Court held:
The open-and-obvious nature of a hazard is, under comparative fault, no more
than a circumstance that the trier of fact can consider in assessing the fault of any
party, plaintiff or defendant. Under the right circumstances, the plaintiffs (sic)
conduct in the face of an open-and-obvious hazard may be so clearly the only
fault of his injury that summary judgment could be warranted against him, for
example when a situation cannot be corrected by any means or when it is beyond
dispute that the landowner had done all that was reasonable.
In that the open and obvious doctrine was not, on the facts available in considering the
motion for summary judgment, a bar to the suit, the summary judgment was reversed, and the
case remanded for reconsideration.
65
Substantive Consolidation
66
Plaintiffs Fail in Effort to Substantively Consolidate Archdiocese With Various Parishes and
Other Organizations
In a decision rendered by the United States Bankruptcy Court for Minnesota, it denied an
effort by those representing alleged victims of clerical sexual abuse to substantively consolidate
the Archdiocese of St. Paul and Minneapolis with over 200 other Catholic, nonprofit (and not
debtors in bankruptcy) entities. In Re: The Archdiocese of St. Paul and Minneapolis, Case No.
15-30125 (Bankr. D. Minn. July 28, 2016).
In connection with allegations of clerical sexual abuse, on July 16, 2015, the Archdiocese
of St. Paul and Minneapolis filed for Chapter 11 bankruptcy. On May 23, 2016, the unsecured
creditors committee filed a petition to substantively consolidate with the Archdiocese in excess
of 200 Catholic entities, none of themselves parties to the bankruptcy. Those entities included
individual parishes, a foundation, various cemeteries and various high schools. Numerous of
those entities filed objections to the consolidation. Ultimately, the effort to achieve substantive
consolidation would be rejected.
After determining that the unsecured creditors committee did have standing to bring the
substantive consolidation motion, the bankruptcy court first found that it lacks the capacity to
effect the substantive consolidation of these numerous nonprofit corporations. The bankruptcy
Code at § 303(a) bars the involuntary bankruptcy of “a corporation that is not a moneyed
business, or commercial corporation.” In connection therewith, the Court cited the legislative
history, it stating that “Eleemosynary institutions, such as churches, schools, and charitable
organizations and foundations, likewise are exempt from the involuntary bankruptcy.” Finding
that all of the other entities that would be swept into the substantive consolidation are religious,
nonprofit organizations exempt from involuntary bankruptcy consequent to § 303(a), the court
wrote that “I conclude that I lack authority to substantively consolidate the debtor with the
targeted entities.”
The court continued its analysis from the legal bar to a granting substantive consolidation
to a factual basis, namely that the plaintiffs had failed to allege facts sufficient to justify
consolidation. Rather, notwithstanding generalized allegations of interrelationship, “The
committee failed to sufficiently establish that the interrelationship warrants consolidation.” The
court went on to observe:
Those allegations concerning generic actors are insufficient because they failed to
identify and show how each non-debtor’s characteristics or actions make them
individually subject to substantive consolidation. It is also unreasonable to infer
all the non-debtors are liable for the actions or characteristics of a few named non-
debtors because the plausibility standard generally does not allow holding
hundreds of non-debtors liable for the conduct of one. Facts demonstrating
grounds for substantive consolidation should have been alleged as to each and
every non-debtor individually, but the committee did not do so here.
From there the court would expand on its determination that there been no showing that
the finances of the various debtors and non-debtors had been inextricably intertwined, and as
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well found that the committee had failed to demonstrate the benefits of consolidation would
outweigh the harm to creditors of the to be consolidated entities.
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Sixth Circuit Denies Substantive Consolidation; In re Howland
Last week the Sixth Circuit Court of Appeals issued its opinion in In re Howland,
addressing whether a trustee could assert substantive consolidation as a mechanism for merging
the assets of an LLC into the bankruptcy estate of its members. As did the Bankruptcy and the
District Courts below, the Sixth Circuit rejected this effort. Phaedra Spradlin v. Beads and
Steeds Inns, LLC (In re Howland), ___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, 2017
U.S. App. LEXIS 222 (6th Cir. Jan. 3, 2017).
As a point of disclosure, Stoll Keenon Ogden and particularly Adam Back represented
the defendants in this action.
The facts underlying the dispute, as set forth by the Sixth Circuit, were as follows:
Matthew and Meagan Howland are the debtors in this personal bankruptcy case.
In June 2007, they entered into a contract to buy a 133-acre farm in Lancaster,
Kentucky, for $1.6 million. One month later, the Howlands assigned their interest
in the purchase agreement to Meadow Lake Horse Park, a limited liability
corporation they had recently formed under Kentucky law. They also personally
guaranteed the loan Meadow Lake later obtained in order to purchase the farm.
For the next three years, the Howlands operated a horse farm and bed and
breakfast on the property. In November 2010, the Howlands made a $760,000
payment on Meadow Lake’s mortgage for no consideration. Then, a month later,
Meadow Lake sold the property to Beads and Steeds Inns, LLC, a corporation
formed by a third party for the sole purpose of purchasing the farm. The purchase
price was $800,000, roughly half of what Meadow Lake paid just three years
earlier. Along with the sale, the two parties entered into a $1,000-a-month lease
agreement (about one-fourth the market rate), which allowed Meadow Lake and
the Howlands to continue operating the horse farm and bed and breakfast.
Two years later, saddled with unmanageable debt, the Howlands filed for personal
bankruptcy. The bankruptcy court appointed plaintiff, Phaedra Spradlin, as trustee
of the debtors’ estate. In her role as trustee, Spradlin filed this adversarial action
against Beads and Steeds. Spradlin alleged that the December 2010 transfer from
Meadow Lake to Beads and Steeds was fraudulent, done to evade the Howlands’
creditors.
Beads and Steeds moved for judgment on the pleadings, observing that the trustee
alleged that Meadow Lake—not the debtors, personally—engaged in the 2010
transfer. It argued that the trustee therefore failed to state a claim under the
governing fraudulent transfer provisions, both of which required a “transfer of an
interest of the debtor in property.” See 11 U.S.C. § 544(b)(1) (emphasis added);
see also 11 U.S.C. § 548(a)(1)(B). The trustee responded that she could pierce the
corporate veil in reverse and thereby treat Meadow Lake and the debtors as a
single entity.
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The trustee sought leave to file an amended complaint alleging substantive consolidation.
That motion was denied by the trial court on the basis that the tendered complaint failed to
adequately plead substantive consolidation. 2017 WL 24750, *2. The Sixth Circuit, in
considering the matter, began by noting that “[a]lthough similar in some ways to veil piercing,
substantive consolidation is a distinct concept unique to bankruptcy law.” 2017 WL 25750, *6.
Whereas veil piercing is a mechanism for imposing vicarious liability, substantive consolidation
“brings all assets of a group of entities into a single survivor. Indeed, it merges liabilities as
well.” and in effect “treats separate legal entities as if they were merged into a single survivor.”
Id.
In reliance upon In re: Owens Corning, the Howland court wrote that:
To state a claim for substantive consolidation, the trustee must
allege:
(i) prepetition [the entities sought to be consolidated]
disregarded separateness so significantly their creditors relied
on the breakdown of entity borders and treated them as one
legal entity, or
(ii) post-petition their assets and liabilities are so scrambled
that separating them is prohibitive and hurts all creditors. Id.
Looking to the proposed amended complaint, it was found that it fell “far short of
demonstrating a significant disregard of corporate separateness such that the debtor’s and
Meadow Lake’s creditors relied on the breakdown and treated them as one.” 2017 WL 24750,
*6. Specifically:
Missing are any allegations that the debtors or Meadow Lake
distributed misleading financial information to creditors, failed to
accurately record their transactions with creditors, or otherwise
misled creditors into believing they were dealing with them as one
indistinguishable entity. Id.
Having disposed of the first element of the Owens Corning test, it being focused upon
pre-petition activities, the Sixth Circuit turned its attention to the question of post-petition
scrambling of assets. In this instance, the trustee was hoist on the petard of the errors identified
by the trustee. Specifically:
Moreover, the proposed complaint simply does not allege that the
debtors’ and Meadow Lake’s assets are hopeless are “hopelessly
scrambled.” Paragraph fifteen alleges that the debtors listed
Meadow Lake’s debts as their own, the implication being that even
the debtors could not distinguish between their assets and Meadow
Lake’s. However, the very fact that the trustee can make this
allegation - i.e., highlight the debtors’ mistake of listing another
entity’s debt as their own - demonstrates that she can, in fact,
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distinguish the debtors’ assets from Meadow Lake’s. 2017 WL
24750, *7.
The court went on to note that substantive consolidation does not exist to address the
alleged harm that creditors will be injured because of a reduction in the distributions to them.
In footnote 3 to the decision, the court noted that the trustee argued for the application of
the test for substantive consolidation set forth in In re: Owings Corning, and that the defendants
responded thereto. On that basis, “Because the parties do not brief the issue, and because the
trustee’s claim fails under the standard she proffers, it is unnecessary to decide whether the
Owens Corning test sets forth the best articulation of the substantive consolidation elements.”
2017 WL 24750, footnote 3.
71
Judicial Expulsion of LLC Members
72
New Jersey Supreme Court Analyzes Widely Used Provision for Judicial Expulsion of
Member from LLC
In this decision, the New Jersey Supreme Court reversed both the trial court and the
appellate decision division, finding on the facts of this particular case that the standard for
judicial expulsion of a member from an LLC had not been satisfied. This decision has
ramifications in all states that have adopted either the Uniform Limited Liability Company Act
or the revised Uniform Limited Liability Company Act, both containing these same standards for
judicial expulsion. IE Test, LLC v. Carroll, A-63 Sept. Term 2014, 2016 WL 4086260 (N.J.
Aug. 2, 2016).
This case involves a three member LLC. All three, two different degrees, had been
involved in a predecessor organization in the same line of business; they entity went into
bankruptcy, causing one of the members, the defendant Carroll, to lose in excess of $2.5 million.
With respect to the new LLC, the three members did state their intention to enter into a full
operating agreement for the LLC, IE Test, LLC, acknowledging in the meantime that “the
Members of the Company and their LLC Percentage Interest have been and are: Kenneth Carroll
(33%), Pat Cupo (34%) [and] Byron James (33%).” It was with coming to agreement on that
full operating agreement that the relationship between the members broke down.
Cooper and James were actively involved in the management of IE Test. Carroll, in
contrast, was not involved in day-to-day management had minimal involvement with the
company beyond a single sales call. Cooper and James drew “salary” and “benefits” from the
LLC while Carroll was not similarly compensated. That said, Carroll was still feeling the sting
from the $2.5 million loss he had suffered with respect to the predecessor entity. While there was
agreement that IE Test LLC was not responsible on that loss, Carroll proposed an operating
agreement pursuant to which he would receive certain payments intended to at least in part make
him whole on the loss. Cooper and James, however, were unwilling to agree to those terms.
Believing that the relationship with Carroll would be irrevocably broken consequent to their
refusal to agree to those terms, they sought to judicially expel Carroll from the LLC.
Alleging all of breach of fiduciary duty of loyalty, breach of the fiduciary duty of care,
breach of contract in breach of the implied covenant of good faith and fair dealing, the LLC filed
an action against Carroll seeking his judicial expulsion. To provision of the New Jersey Limited
Liability Company Act at issue is N.J. Code § 42:2 B-24 (b)(3), which provides:
On application by the limited liability company or another member, the
member’s expulsion by judicial determination because:
(a) the member engaged in wrongful conduct that adversely and
materially affected the limited liability company’s business;
(b) the member willfully or persistently committed a material breach
of the operating agreement; or
73
(c) the member engaged in conduct relating to the limited liability
company business which makes it not reasonably practicable to carry on the
business with the member as a member of the limited liability company.
On motions for summary judgment, the trial court rejected the effort to expel Carol based
upon subsection (a) of the statute, finding that Carroll’s insistent upon compensation did not
constitute “willful misconduct” within the meaning of the statute. Well those demands may have
been unreasonable, they were not of themselves unlawful and they inflicted no harm on the LLC.
Slip op. at 8. The trial court did, however, find that Carroll could be expelled under subsection
(c) on the basis that was no longer “reasonably practicable” for the three members to coexist in
the LLC and that further controversy and litigation is likely to result. Slip op. at 9. The
determination would be affirmed by the Appellate Division. See 2014 WL 8132907. This case,
through the decision of the Appellate Division, has been reviewed by Peter Mahler in his blog
New York Business Divorce in a posting titled Involuntary Member Dissociation Under
RULLCA (September 28, 2015).
Looking first to the “not reasonably practicable” language of (c) in the statute quoted
above, the Court began by noting that “not reasonably practicable” is not defined in the LLC Act.
Still, as the conduct at issue must be “relating to the limited liability company business,” the
Court held that the “Legislature clearly did not intend that disagreements and disputes among
LLC members that bear no nexus to the LLCs business will justify a member’s expulsion under
subsection 3(c).” Slip op. at 18. Expanding on this theme, the Court wrote:
Significantly, the Legislature did not authorize a court to premise expulsion under
subsection 3(c) on a finding that it would be more challenging or complicated for
other members to run the business with the LLC member than without him. Nor
does the statue permit the LLC members to expel a member to avoid sharing the
LLC’s profits with that member. Instead, the Legislature prescribed a stringent
standard for prospective harm: the LLC member’s conduct must be so disruptive
that it is “not reasonably practicable” to continue the business unless the member
is expelled.” Slip op. at 19.
In applying this test, “the court [is] to evaluate the LLC member’s conduct relating to the LLC,
and assess whether the LLC can be managed notwithstanding that conduct, in accordance with
the terms of an operating agreement or the default provisions of the statute.” Slip op. at 21.
Detailing the factors to be considered in that analysis, the Court wrote:
In that inquiry, a trial court should consider the following factors, among others
that may be relevant to a particular case: (1) the nature of the LLC member’s
conduct relating to the LLC’s business; (2) whether, with the LLC member
remaining a member, the entity may be managed so as to promote the purposes
for which it was formed; (3) whether the dispute among the LLC members
precludes them from working with one another to pursue the LLC’s goals; (4)
whether there is a deadlock among the members; (5) whether, despite that
deadlock, members can make decisions on the management of the company,
pursuant to the operating agreement or in accordance with applicable statutory
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provisions; (6) whether, due to the LLC’s financial position, there is still a
business to operate; and (7) whether continuing the LLC, with the LLC member
remaining a member, is financially feasible. Id. (footnote omitted).
In this instance, as the New Jersey LLC Act has a default rule of majority rule, and as the
respective ownership percentages of the members had been determined, but for narrow actions
that by default require the unanimous approval of the members, the Court found that IE Test,
LLC could operate. Carroll’s conduct did not affect the LLC vis-à-vis third-parties, and it
continued to financially flourish. For those reasons, the trial court’s grant of summary
judgment to IE Test LLC was reversed.
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All Saints University of Medicine Aruba
The dispute arising out of All Saints University of Medicine Aruba has to date yielded
three decisions from the Appellate Division of the Superior Court of New Jersey. All Saints
University of Medicine Aruba v. Chilana, 2012 WL 6652510 (N.J. App. Div. Dec. 24, 2010)
(“Aruba I”); All Saints University of Medicine, Aruba v. Chilana, 2015 WL 6456117 (N.J. App.
Div. Oct. 27, 2015) (“Aruba II”); All Saints University of Medicine, Aruba v. Chilana, 2015 WL
11254290 (N.J. App. Div. Aug. 5, 2016) (“Aruba III”).
Without delving too deeply into the somewhat convoluted factual background of this
dispute, it essentially boiled down to the fact that two of the LLCs members, Paulpillai and
Yusuf, utilized its assets for individual purposes. In consequence to these and similar acts, the
LLC required significant cash contributions from Chilana in order to satisfy current obligations
including payroll withholding obligations. After a trial, the trial court determined that Paulpillai
and Yusuf had engaged in conduct justifying their dissociation from the company. Aruba I, 2012
WL 6652510,*9. The balance of the dispute has revolved primarily around the appropriate
remedy. The trial court, having dissociated each of Paulpillai and Yusuf, as well ordered a
redemption of their interest in the company, finding the value thereof to be zero, a value that was
consequent to their misconduct. Whether the statute, in addition to providing for dissociation, as
well provided for the redemption of the financial interest in the LLC, or rather left a dissociated
member as a mere assignee in the LLC, became the issue. It would ultimately be determined, in
Aruba III, that the court could order a liquidation of the financial interest in the LLC; doing
otherwise would allow the disloyal members, Paulpillai and Yusuf, to participate in any post-
turnaround value. Aruba III, 2015 WL 11254290, *__,
From All Saints University of Medicine Aruba there are at least two significant
takeaways. First, even in the face of clearly egregious conduct, it can take years to effectuate a
member’s expulsion. Second, the statutory remedy, namely disassociation, is clearly insufficient.
Merely stripping persons of the right to participate in management, but leaving them with
economic rights in the venture, permits a bad actor to share in the ultimate gain after turnaround.
While the All Saints Medical University of Aruba court, in Aruba III was able to come to the
conclusion that there was a right to compel a buyout, in this instance at a price of $0, that may
not always be the case. While, post dissociation, the remaining members likely have the right to
amend the operating agreement to create a buyout right with respect to the economic interest of
the now dissociated member,1 in many instances will simply engender another round of
litigation.
1 See also Thomas E. Rutledge and Katharine M. Sagan, An Amendment Too Far?: Limits on the Ability of Less
Than All Members to Amend the Operating Agreement, 16 FLORIDA STATE UNIVERSITY BUSINESS REVIEW ___
(forthcoming).
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Corporification of LLCs
77
More on Corporification
“Corporification” is the term, invented I believe by Steve Frost, to describe the
incorporation (pun intended) into limited liability companies of concepts and principles that have
arisen in the context of corporations. Oftentimes the utilization of concepts developed initially in
corporate law into an LLC leads to either confusing or unintended consequences as there exist
ambiguity as to the degree to which corporate law is intended to be incorporated. A recent case
out of Delaware provides a clear illustration of these problems. Obeid v. Hogan, No. 11900-V
CL, 2016 BL 185285 (Del. Ch. June 10, 2016).
This dispute arose out of a pair of limited liability companies, Gemini Equity Partners,
LLC and Gemini Real Estate Advisors, LLC. Each of these LLC was owned one third by
plaintiff William T. Obeid, one-third by Christopher S. La Mack and one-third by Dante
Massaro. Between the two LLCs, they held in excess of 1 billion in real estate assets, including
11 hotels and 22 commercial properties. Prior to the disputes addressed in this litigation, Obeid
managed the hotel properties while the La Mack and Massaro managed the commercial
properties. The defendant Hogan is a retired federal judge who was retained to serve as the
special litigation committee on behalf of each of the LLCs; La Mack and Massaro were not
parties to this action. The court throughout referred to Gemini Equity Partners, LLC as the
“Corporate LLC” while referring to Gemini Real Estate Advisors, LLC as the manager-managed
LLC.
The Corporate LLC, organized in Delaware, utilized a board of directors comprised of a
Obeid, La Mack and Massaro through July, 2014, at which time the La Mack and Massaro
removed Obeid. With respect to the Manager-Managed LLC, each of Obeid, La Mack and
Massaro served as a manager.
On July 1, 2014, La Mack and Massaro voted to remove Obeid as the president of the
Manager-Managed LLC, installing Massaro in his place. In effect, while Obeid remained a
manager, Massaro took on day-to-day control of the Manager-Managed LLC. After a flurry of
litigation ranging from North Carolina to federal and state courts in New York, the Corporate
LLC and the Manager-Managed LLC, under the control of the La Mack and Massaro, hired the
Brewer firm to serve as outside counsel. One of its recommendations was that a retired federal
judge be hired to serve as a special litigation counsel to respond to a derivative action filed with
respect to each of the LLCs in New York. After a meeting at which no formal resolutions were
adopted, the Brewer firm circulated the names of two retired federal judges it had identified as
being appropriate to serve as the special litigation committee. Hogan, one of those judges, was
ultimately retained pursuant to an engagement letter signed by La Mack and Massaro to serve in
that role. Crucially for the outcome of this decision, Hogan was not appointed a director of the
Corporate LLC nor appointed a manager of the Manager-Managed LLC. Upon learning that
Hogan had been so retained, Obeid filed this action in Delaware seeking a determination that
Hogan could not act as special litigation committee on behalf of either LLC or otherwise take
any action with respect to the derivative suit. In addition, Obeid sought a declaratory judgment
that his removal as a director of the Corporate LLC was invalid.
With respect to Hogan’s service as the special litigation committee for the Corporate
LLC, after setting forth its ultimate conclusion that he could not do so, the court began its
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analysis with a telling section heading, namely “The Implications Of Mimicking A Corporation’s
Governance Structure.” From there it observed that LLCs may design their inter-see
management structure as they see fit, citing ROBERT L. SYMONDS, JR. & MATTHEW J. O’TOOLE,
DELAWARE LIMITED LIABILITY COMPANIES § 9.01[B] at 9-9 (2015) for the principle that
“Virtually any management structure may be implemented through the company’s governing
instrument.” From there the Court wrote:
Using the contractual freedom that the LLC Act bestows, the drafters of an LLC
agreement can create an LLC with bespoke governance features or design an LLC
that mimics the governance features of another familiar type of entity. The
choices that the drafters make have consequences. If the drafters have embraced
the statutory default rule of a member-managed governance arrangement, which
has strong functional and historical ties to the general partnership (albeit with
limited liability for the members), the parties should expect the court to draw
analogies to partnership law. If the drafters have opted for a single managing
member with other generally passive, non-managing members, a structure closely
resembling and often used as an alternative to a limited partnership, then the
parties should expect a court to draw analogies to limited partnership law. If the
drafters have opted for a manager-managed entity, created a board of directors,
and adopted other corporate features, then the parties to the agreement should
expect a court to draw on analogies to corporate law. Depending on the terms of
the agreement, analogies to other legal relationships may also be informative.
(citation and footnotes omitted).
While going on to recognize that there are limitations in drawing analogies between
LLCs and other organizational forms, the Court, citing Elf Autochem, 727A.2d at 293, observed
that “the derivative suit is a corporate concept grafted onto the limited liability company form.”,
leading the conclusion that “absent other convincing considerations, case law governing
corporate derivative suits is generally applicable to suits on behalf of an LLC.” (footnote
omitted).
Having determined that the corporate law governing special litigation committees in
derivative actions would be applicable to the corporate LLC, the Chancery Court turned its
attention to the Zapata Corp. v Maldonado, 43 A.2d 779 (Del. 1981) decision.
After an extensive review of the Zapata decision and the role of the special litigation
committee, the Court noted an absence of situations in which the special litigation committee
was comprised of non-directors, observing that as derivative litigation does not fall into the
ordinary course, these matters would, in the corporate context, need to be resolved by the board.
It was observed that:
A board may not make a similarly complete delegation to an officer or a non-
director. Doing so would risk an improper abdication of authority. Hence the
requirement exists that a Zapata committee be made up of directors.
From there was ultimately concluded:
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Judge Hogan is not a director of the Corporate LLC. Consequently, under the
Corporate LLC Agreement, he cannot function as a one-man special litigation
committee on behalf of the Corporate LLC.
Turning to the Manager-Managed LLC, even as the Court acknowledged it was not
utilizing a board of director management model, it was concluded that the manager-managed
system employed was sufficiently analogous to a board structure to justify the application of
Zapata and the ultimate determination that Hogan could not, with respect to that LLC, serve as a
special litigation committee. “In my view, the resulting structure is sufficient to cause the
reasoning that governed the Corporate LLC to apply equally to the Manager-Managed LLC.”
The court had little problem, applying the operating agreement and the Delaware LLC
Act, to find that Obeid’s removal as a director was permissible.
Which brings us back to Corporification. The drafter of the limited liability company
agreement for the Corporate LLC wrote into the document significant aspects of the laws of
corporate derivative actions. From that utilization, the Chancery Court assumed that the entire
body of law governing derivative actions, including that developed exclusively through court
decisions, was intended to be applied in the context of this LLC. In effect, the Court read into the
express terms of the LLC agreement the common-law penumbra of derivative actions. Whether
that is what was actually intended by the drafter is unknown. Were they intending that the
common law of derivative actions be incorporated by a deemed incorporation by reference, or
rather where they intending that only so much of that law as was set forth in the agreement
would apply? Curiously, the Court did not reference the terms of the merger clause of either LLC
agreement.
Regardless, this decision well highlight the perils of utilizing in an LLC agreement
principles developed under corporate law. Absent particularly careful drafting, concepts not
intended to be applied with respect to that LLC may be found applicable.
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Incorporating Ambiguity Into the Operating Agreement
In a recent case decided by the North Carolina Business Court, it was called upon to
interpret an operating agreement which incorporated by reference the usual authority of the
president of a North Carolina corporation. In the course of its opinion, the court explained that
the authority of the president of a corporation is open to interpretation. Richardson v. Kellar,
2016 NCBC 60, 2016 WL 4165887 (Sup. Ct. N.C. Aug. 2, 2016).
This case arose out of an application by Richardson for a preliminary injunction, which
relief was ultimately granted. Richardson, through a wholly owned LLC, and Kellar, through
another wholly owned LLC, where the two 50% members of a North Carolina LLC named TW
Devices, LLC. Richardson and Kellar were the two directors of TW Devices, LLC. The organic
documents of that company were quite specific in detailing the purpose of the company, namely
the development of a variety of cardiovascular-related medical devices. Ultimately, TW Devices
would become a shareholder in a subsequently organize corporation, Cleveland Heart, Inc.
(“CHI”), which was also in part owned by the Cleveland Clinic Foundation.
Kellar would ultimately seek to marginalize Richardson, unilaterally voting the interest of
TW Devices, LLC in CHI, asserting that he could do so in his alleged capacity as CEO/President
of TW Devices, LLC.
At this juncture, the question would turn ultimately on whether TW Devices LLC was
merely a holding company with respect to an interest in CHI, or rather had other business
purposes. The court would hold ultimately that TW Devices, LLC was not a mere holding
company. On that basis, the voting of that LLCs interest in CHI was an extraordinary matter
which needed to be resolved by the LLC’s two member Board of Directors. On the basis that
Kellar was in effect stripping Richardson of his right to participate in those decisions, the
requested temporary injunction was granted.
But back to corporification. Initially, Kellar argued that as TW Devices LLC should be
viewed as a mere holding company, he, as the president/CEO thereof, would under the operating
agreement have the capacity to vote the shares. In furtherance thereof, he pointed to section
4.12(a) of the TW Devices LLC Operating Agreement, which provides:
Any officer… shall have only such authority and perform such duties as the
Board may, from time to time, expressly delegate to them…. unless the Board
otherwise determines, if the title assigned to an officer of the Company is one
commonly used for officers of the business corporation formed under the North
Carolina Business Corporation Act, then the assignment of such title shall
constitute the delegation to such officer of the authority and duties that are
customarily associated with such office, including the authority and duties that a
President may assigned to such other officers of the Company under the North
Carolina Business Corporation Act. 2016 WL 4165887, *2.
The only problem was that even as the operating agreement sought to incorporate the
authority of an officer, including the president, those are actually open questions under North
Carolina law. Rather:
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North Carolina law does not provide definitive guidance regarding the
“customary” authority possessed by corporate presidents. The Business
Corporation Act does not define the duties or powers possessed by officers. North
Carolina’s leading commentator on corporate law has noted that:
The allocation of authority and duties among corporate officers is
usually outlined to some extent, either specifically or generally, by
the corporate bylaws, and is then further defined in more detail by
the directors and by the officers themselves. To the extent that
these respective functions of corporate officers and agents are not
thus defined by the corporation, they may be defined by the law
and custom is developed by normal practices.
Russell M. Robinson, II, Robinson on North Carolina Corporation Law § 16.01
(7th
ed. 2015) (footnotes omitted).
A pair of observations. First, this operating agreement failed in that it did not clearly
delineate the scope of authority of the president and in so doing it failed to differentiate the
authority of the president versus the authority of the Board of Directors. Second, it failed in that
it was not amended at the time that TW Devices LLC became an owner of CHI as to whether the
authority to vote the interest in CHI would be vested in the president as an ordinary transaction
or in the Board of Directors as an extraordinary transaction. Had the operating agreement
addressed those points, this lawsuit could have been avoided.
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Administrative Dissolution
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Illinois Court Addresses Effect of Reinstatement of LLC, Gives Effect to the Fact That
Dissolution Did Happen
A recent decision from Illinois interpreted and placed certain limits upon the effect of the
statute providing that, upon reinstatement after administrative dissolution, it is as if it never took
place. In this case, the fact that it took place had legal effect. CF SBC Pledgor 1 2012-1 Trust v.
Clark/School, LLC, __ N.E.3d __, 2016 Il. App. (4th
) 150568, 2016 WL 4702589 (Ill. App. 4th
Dist. Sept. 8, 2016).
Clark/School LLC was the borrower pursuant to a mortgage that included as an event of
default the failure to maintain the LLC as an LLC. A default was declared under the mortgage
on the basis that the LLC had been administratively dissolved as well as other defaults in the
covenants. In response to a declaration of default and the appointment of a receiver, the LLC
asserted that there was no default in the existence covenants in that the LLC had been reinstated
by the Illinois Secretary of State pursuant to a statute that provides, inter alia, that the
reinstatement after administrative dissolution relates back to and in effect cures the dissolution.
The lender responded, inter alia, that the subsequent cure of the dissolution did not impact the
fact that it had taken place. Rather:
In this case, Section 4.14 of the party’s mortgage security
agreement plainly stated that the mortgage loan was made in
reliance on defendant’s continued existence as an LLC. Defendant
agreed to maintain its existence and ensure its continuous right to
carry on its business. The party’s agreement defined defendant’s
breach of Section 4.14 as an “Event of Default.” In its December
2013 complaint, plaintiff alleged defendant failed to maintain its
existence as an LLC because it was not in good standing with the
Secretary of State and dissolved in September, 2011. Defendant
acknowledges that, at the time plaintiff filed its complaint, it was
not in good standing and had been dissolved. Under these
circumstances, we hold the LLC Act’s relation-back provision
does not apply to prevent defendant’s dissolution from constituting
an “Event of Default under the party’s agreement.
In support of its ruling on the LLC Act, the court cited Virendra S. Visla M.D., Ltd. v.
Parvais, 884 N.E. 2d 790, 796 (Ill. App. 3d 2008), wherein an employment agreement was found
to be terminated by the administrative dissolution of the employer medical corporation.
This ruling should be considered in light of the provisions of the Kentucky LLC Act
which provide for the dissociation of certain business entity members upon the dissolution
thereof.
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Louisiana Court Denies Retroactive Reinstatement of Dissolved LLC
In a recent decision from the Louisiana Court of Appeals (Fifth Circuit), the court denied
retroactive reinstatement of an LLC that had been affirmatively dissolved by its members. In
denying retroactive reinstatement, in effect the court affirmed the application of an atypical
Louisiana statute which provides inter alia that upon voluntary dissolution the members of the
LLC are liable severally for the LLC’s debts and obligations. In re: Reinstatement of S & D
Roofing, LLC, ___So.3d___, No. 16-CA-85, 2016 WL 5231860 (La. Ct. App. Fifth Cir. Sept. 22,
2016).
Shane Dufrene and David Cain organized S&D Roofing, LLC as a Louisiana limited
liability company. S&D contracted to provide roofing services to 9029 Jefferson Highway, LLC.
Apparently the work was never done, because Jefferson sued S&D for breach of contract. Cain
received the service of process although Dufrene never did. Thereafter, a default judgment was
entered against S&D for $15,000. Apparently neither Cain nor Dufrene ever received that notice
of the default judgment. Some seven months after that default judgment was entered, Cain and
Dufrene voluntarily dissolved S&D, and in connection therewith submitted an affidavit which
provided in part that S&D owed no debts. This dissolution was pursuant to Louisiana Revised
Statute 12:1335.1, which provides in part:
In addition to all other methods of dissolution, if a [LLC] is no
longer doing business and owes no debts, it may be dissolved by
filing an affidavit with Secretary of State executed by the
members… attesting to such facts and requesting that [LLC] be
dissolved. Thereafter, the members… shall be personally liable for
any debts or other claims against the [LLC] in proportion to their
ownership interest in the company.
When Jefferson sought to enforce its default judgment against Dufrene and Cain, they
sought to reinstate the LLC pursuant to court order and as well to have that reinstatement be
retroactive to the effect that they would not be personally liable on Jefferson’s claim. This
reinstatement was sought pursuant to a statute that provides:
The Secretary of State shall reinstate a [LLC] that has been
dissolved pursuant to this Section only upon receipt of an order
issued by a court of competent jurisdiction directing him to do so.
While the court did grant reinstatement, it did not do so retroactively. When Dufrene and
Cain complained that the reinstatement was not retroactive, the court referenced a number of
other Louisiana LLC statutes that do provide for retroactive reinstatement. As the provision here
relied upon did not provide for retroactive reinstatement, the court found that that was outside the
statutory scope. In addition, the court recited a number of policy reasons why retroactive
treatment was not appropriate, including the ability of third parties to rely upon the public record.
85
Delaware Chancery Court Addresses Requirements for Admission of Assignee as a
Member, Standing to Bring an Action for Judicial Dissolution and Availability of Equitable
Dissolution
In a recent decision, Delaware’s Chancery Court addressed a variety of important issues
regarding limited liability companies and as well the equitable jurisdiction of the Chancery
Court. With respect to LLCs, the Court explained the requirements for admission of an assignee
as a member, holding that it requires a formal affirmative act. In addition, the Court affirmed the
statutory rule that standing to bring an action for judicial dissolution is restricted to a member or
manager, and an assignee is neither. Still, the underlying complaint was not dismissed as the
court found that the assignee may have standing to seek equitable dissolution. In re Carlisle
Etcetera. LLC, C.A. No. 10280-VCL, 2015 WL 1947027 (April 30, 2015).
Carlisle Etcetera, LLC (the “Company” or “Carlisle”) was formed and owned equally by
Well Union Capital Limited (“WU Parent”) and Tom James Company (“James”). The Company
was in turn managed by a four member board, half of whose members were appointed by WU
Parent and half by James. In addition, the Company had an executive staff including a CEO,
which position was filled by a James executive appointed by that Board. The relationship
between WU Parent and James ultimately soured, and despite some initial negotiations they were
unable to agree to a price by which one side would buy out the other. With the board deadlocked,
the Company CEO operated the Company essentially free of any oversight. In consequence,
“James did not see the deadlock as a problem and [felt] no urgency to alleviate it.” Also, on a
date not defined in the opinion vis-à-vis the organization of the company, but clearly early on,
WU Parent assigned its interest in Carlisle to a “wholly-owned subsidiary that would act as a
‘blocker’ entity for tax purposes.” There was no dispute that the James representatives in Carlisle
were aware of this transfer; whether they had consented to the substitution of the new WU
Subsidiary (“WU Sub”) as replacement member would be an important aspect of this decision.
Unable to agree as to a buyout of one party by the other, WU Sub filed an action in the
Delaware Chancery Court seeking the judicial dissolution of the Company. When James
challenged the capacity of WU Sub to bring an action for judicial dissolution, asserting it was not
a member, a WU Parent joined in the action. As is detailed below, that did not cure the
deficiency.
This opinion was rendered in response to the James’ 12(b)(6) motion.
Standing to Seek Judicial Dissolution
James asserted that neither of the WU entities had standing to seek judicial dissolution on
the basis that judicial dissolution is a right afforded the members, and neither was a member. In
furtherance thereof, while WU Parent may have initially been a member of the Company, it
transferred its entire membership interest in the Company to the WU Sub. While that constituted
WU Sub as a assignee of the interest, that assignment also terminated WU Parent’s position as a
member. In that WU Sub was never admitted as a substitute member, it could not exercise any
Rights of a member. Essentially, James asserted that it and it alone was a continuing member in
Carlisle. On this argument it would prevail.
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Under the Delaware LLC Act, when a member assigns all of their economic interest in a
venture, the assignor member ceases to be a member in the company. See DEL. CODE ANN. §
702(b)(3). [It should be noted that this rule under the Delaware LLC Act is different than the rule
under the Kentucky LLC Act.] In the face thereof, WU Sub argued that James had consented to
its admission as a substitute member, arguing for de facto status based upon it being listed in the
Carlisle tax forms and as well the identification of WU Sub as a member in the draft revised (but
never executed) operating agreement. “WU Sub argues that it became a member under the LLC
Act once his status as a member was “reflected in the records of the limited liability company.”,
citing DEL. CODE ANN. § 18-301 (b)(1).
Carefully parsing the statute, the Court found that was not the case. Rather, while the
timing of admissions as a member may be determined by when a member’s admission is
“reflected in the records of the limited liability company,”, that reflection does not of itself
constitute admission. Rather, a formal act of the other members to the admission is required.
Hence, WU Sub was not a member and could not move for judicial dissolution.
Equitable Dissolution
Notwithstanding that neither WU Sub nor WU Parent had capacity to move for judicial
dissolution of Carlisle, LLC, the Chancery Court consider whether they could do so on an
equitable basis. In consideration thereof, the Court provided several pages of analysis as to how
the equitable jurisdiction of the Chancery Court could be employed and when that jurisdiction is
limited consequent to the existence of a comprehensive legal regimen. Based upon the facts
presented, the Court determined that WU Sub, as the holder of equity in Carlisle even as it is not
a formal record owner, may seek equitable dissolution of the Company.
A few thoughts:
Notwithstanding the asserted certainty of Delaware law, decisions such as
this highlight the fact that Delaware law is often fact specific (as is the
right of a Court of Equity) and is far more fluid than many people would
think. In this instance, the statute affords a member the right to seek
judicial dissolution. A nonmember, who cannot seek judicial dissolution,
is still allowed to move for equitable dissolution.
One basis cited in support of the Court’s determination that equity should
intervene and possibly allow dissolution is that the parties had negotiated,
but never executed, an amended operating agreement which would have
substituted WU Sub as a member who, inter alia, would then have had the
capacity to move for judicial dissolution. If courts are going to allow such
reliance, parties negotiating amended agreements need to take great care
to legend their discussions so as to not give rise, based upon preliminary
documents, to new Rights.
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Member Disassociation
88
Disassociation of Member Pursuant to Operating Agreement Given Effect
A recent decision from Connecticut held that the provision of an operating agreement
providing that upon certain defaults a member would be disassociated would be enforced. The
immediate effect of this ruling is that a suit against the disassociated member for breach of
fiduciary duty and conversion of company assets may proceed in federal court pursuant to
diversity jurisdiction Inteliclear, LLC v. Victor, Civil No. 3:16cv1403 (JBA), 2016 WL 5746349
(D. Conn. Oct. 3, 2016).
Inteliclear, LLC had four members: Victor (30%), Powell (30%), Barretto (30%) and
DeVito (10%). Victor was the LLC’s “General Manager.” Prior to this suit they had been
involved in litigation as to the company. After the dismissal of that litigation (initiated by
Victor), the other members voted to remove Victor as the General Manager, and this suit was
filed against him.
The claims against Victor arose out of his operation for the LLC other than in compliance
with the operating agreement. For example, while it provided that a check exceeding $5000
could be issued only with the approval of a majority of the members, Victor was apparently
writing $5000 checks without that member consent. In addition, he was using company funds to
pay personal expenses. Consequent to that conduct, the members other than Victor advised him
that he was disassociated as provided in the operating agreement. The operating agreement of
Inteliclear, LLC provided in part:
The default by any Member in the performance of any Member’s covenants,
obligations, responsibilities, duties or undertakings set forth and provided for
under the provisions of the Operating Agreement, this Members Agreement, the
Members Confidentiality and Non-Compete Agreement or any amendment or
successor thereto, in which event, in addition to any remedy in law or at equity
available to the non-defaulting Members, the non-defaulting Members may elect
to treat such default as a withdrawal of the defaulting Member in connection with
such Member’s desire to no longer provide Member’s Services to the Company
under paragraph 8.B of this Members Agreement and may proceed with the
elections provided non-withdrawing Members in paragraphs 8.B(1) and (2) above
in regard the defaulting ember’s (sic) Interest.”Barretto, Powell and DeVito
advised Victor that his violations of the operating agreement would be treated as
effecting Victor’s disassociation from the LLC. Victor then moved the LLC’s
funds to a new bank. He as well withdrew $30,000 for himself. The suit sought a
declaration that Victor, having been disassociated from the LLC, could not act on
its behalf. 2016 WL 5746349, n. 7.
The thrust of this decision was whether the suit could be filed against Victor in federal
court. An LLC is treated, for purposes of diversity jurisdiction, as having the citizenship of each
of its members. If Victor was still a member of the LLC, there would be no diversity and the suit
would be dismissed. If, in the alternative, Victor was a disassociated (i.e., a former member) of
the LLC, the suit could proceed.
89
The court would hold that Victor was disassociated from the LLC (i.e., no longer a
member) and in consequence his citizenship would not be attributed to the LLC. In doing so it
had to resolve the question of whether it was making a determination on the merits, which it
could not due absent a trial on the merits, or rather resolving a jurisdictional question. In part on
the basis that there had been a hearing on the motion for a restraining order, that affording Victor
due process, the court said:
The Court is satisfied that the appropriate way to proceed is to hear and decide
the factual issues bearing on its subject matter jurisdiction, recognizing that they
also implicate elements of at least one of the substantive claims as well as the
basis for the injunctive relief sought. 2016 WL 5746349, *5.
Reviewing Victor’s conduct, the court found that injunctive relief keeping him from
alleging he had control of the LLC was warranted on the basis that he was no longer a member
of the LLC. Rather, he had been disassociated under the terms of the operating agreement
consequent to his own conduct.
The Court finds that Plaintiff has demonstrated that Barretto, Powell and
DeVito had legitimate justification for believing that Defendant defaulted in the
performance of his “covenants, obligations, responsibilities and undertakings”
under the Agreements. As early as the end of 2015, Barretto, Powell and DeVito
suspected Defendant was broadly misappropriating InteliClear funds and hired
Ram Associates, an accounting and financial consulting firm, to investigate
records that they became privy to as a result of the state court action but had not
been otherwise able to obtain from Defendant in the ordinary course of business.
Most significantly, as Plaintiff claims, Plaintiff’s American Express and bank
records appear to show that Defendant treated InteliClear’s accounts as his own
personal piggy bank. The evidence showed that Defendant used Plaintiff’s
American Express card to purchase personal items such as a guitar costing over
$500 for himself; airline tickets for his wife, daughter and even his daughter’s
former boyfriend, totaling well over $2,000; a gym membership costing over
$1,000 for his wife and that he used InteliClear funds to pay his personal credit
card bill. The evidence showed these charges and payments were not “reasonable
and necessary business, educational and profession expenses” permitted by
Paragraph 4(1) of the Members Agreement, nor reimbursable expenses under
Paragraph 8.1 of the Operating Agreement. Additionally, they were not
authorized by the other Members. Plaintiff characterizes Defendant’s actions as,
in effect, stealing from Plaintiff, demonstrating that he is a defaulting Member
under Paragraph 12 of the Members Agreement. 2016 WL 5746349, *5 (citations
to record deleted).
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Michigan Court Enforces Written Withdrawal From LLC
A recent decision from Michigan reviewed and in turn rejected the efforts by a former
member of an LLC who, after resigning therefrom, made claims including for reinstatement as a
member. The Michigan Court of Appeals upheld the application of the written resignation
documents. Clark v. Butoku Karate School, LLC, Docket No. 326638, 2016 WL 4419321
(Mich. Ct. App. Aug. 18, 2016).
Joby Clark and John Wasilina were the two equal members of Butoku Karate School,
LLC, a Michigan limited liability company. The company was formed in 2002 to operate a
karate studio. In June, 2010 and thereafter, Wasilina learned of a rumor that Clark was engaged
in a sexual relationship with an underage student of the LLC. While Clark denied the rumors, he
and Clark did agree that “even if meritless, [the rumors] would likely destroy the school because
most of the students were children and parents were likely to withdraw their children.” In light
thereof, Wasilina caused there to be drafted agreements providing, inter alia, that Clark was
withdrawing from the LLC and had no further claim on its assets. Those agreements were signed
and delivered by Clark. In connection therewith, Clark and Wasilina withdrew nearly all of the
company’s operating funds and evenly split them. Ultimately Wasilina would be twice charged
with criminal conduct involving the underage student. Both trials ended in a mistrial. Clark
thereafter entered a plea of no contest to a lesser charge.
At some point thereafter, Clark initiated this suit against the LLC and Wasilina, alleging
all of fraud, a failure to distribute and conversion of personal property. With respect to the
allegation of fraud, Clark:
[A]lleged that defendants had defrauded plaintiff because Wasilina had induced
plaintiff to sign the documents by misleading plaintiff into believing he would
later be reinstated in the company, and also by promising to pay plaintiff for his
membership interest.
The trial court granted summary judgment to the defendants, and this appeal followed.
With respect to the failure to distribute, the Court of Appeals first considered whether the
operating agreement served to override the statutory default rule that would otherwise provide
for the distribution to withdrawn member of the fair value of their membership interest. MCL §
450.4305. The court found that the written operating agreement did address the question of
rights to a distribution upon withdrawal, and therefor controlled over the LLC Act. Further, the
agreements signed by Clark and Wasilina in connection with Clark’s withdrawal from the
company provided in part:
The Company accepts immediate withdrawal and resignation of Member Joby
Clark from any and all aspects [of] the company … Joby Clark’s interest in the
company is extinguished in its entirety without a substitute or financial
compensation. …. nor does the Company owe any monies, duties, rights,
responsibilities, privileges, accountings, or any other items or tangible means of
remuneration in any way to the resigning Member, Joby Clark. (Bracketed
language and italics added by the court).
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With respect to the effect of this release, the court found that it constituted an amendment
to the operating agreement. As such, Clark had no claim against the LLC for a liquidating
distribution.
With respect to the allegation of fraud, and again reviewing the language of the release
agreement indicating that Clark had no further claim against the LLC, the court stated that “It is
difficult to imagine language more definite in ending a business relationship.” Applying as well
general contract rules as to the effect of an agreement, the court observed:
Rather, plaintiff admits that he understood the actions that the documents
authorize, but chose to believe that the opposite result would occur. If, as plaintiff
suggests, an oral statement was made contrary to the explicit language of the
documents that he signed, plaintiff’s reliance was not reasonable.
With respect to the claim of conversion, its dismissal was upheld on the grounds that the plaintiff
had not indicated what actions the defendants had taken to deprive the plaintiff of his property.
In addition, the consent to withdraw provided that he had already removed all of his personal
property from the company’s location, and anything that was left behind was to become
company property. As the company now had a right to possession to the property left behind,
there could be no claim for conversion.
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Intra-Member Transfers
93
No Implied “Disinterested” Limitation in Approving Transfers of LLC Interest
Peter Mahler, in his blog New York Business Divorce, has provided an excellent review
of the decision recently handed down in Huang v. Northern Star Mgmt. LLC, 2016 N.Y. Slip Op.
32194(u) (Oct. 24, 2016). I write as well to emphasize the question of whether a vote of the
members must be disinterested and the application of the rule of independent legal significance.
Tai Huang was a member in Northern Star Management LLC, a New York LLC, holding
a 13.5% interest therein. Ling Lian Huang held another 13.5% interest, while Jian Chai Qu held a
6% interest; those three comprised the “Minority Members.” The balance of the 67% interest in
Northern Star (“NSM”) was held by four unnamed and otherwise undifferentiated members (the
“Majority Members”).
After the settlement of litigation between the Minority Member and the Majority
Members regarding the financing of NSM property, the Majority Members effected a cash-out
merger of the Minority Members. This was accomplished by (i) the Majority Member casing to
be created NewCo; (ii) the Majority Members transferring to NewCo their respective interests in
NSM, receiving in return interests in NewCo; (iii) NewCo approving, as the Majority Member of
NSM, a merger of NewCo with and into NSM pursuant to which all other members of NSM (i.e.,
the Minority Members) would be cashed-out.
The Minority Members sought to set aside the merger on the basis that NewCo was not a
member of NSM because the Majority Members’ transfers of LLC interests to its violated § 9.3
of the NSM operating agreement. Section 9.3 of the NSM Operating Agreement provided that:
[a] Member may freely transfer his interest in [NSM] to another
person or entity…, only with the prior majority consent of other
Members either in writing or at a meeting called for such purpose.
If majority Members do not approve of the transfer, the transferee
shall have no right to participate in the management of the business
and affairs of [NSM] or become a Operating Member.
The Minority Members would assert that § 9.3 required the approval of a disinterested majority
of the members in order to effect a transfer of interests in NSM to NewCo. The court refused to
read into the operating agreement a limitation to the “disinterested” membership. Rather:
Despite the Huangs’s contentions, Section 9.3 of the NSM
Operating is completely devoid of the term “disinterested,” which
is the crux of the Huangs’s application. The plain language of the
provision the Huangs cite to clearly permits a member to transfer
their membership interest upon approval by a simple majority of
members. It does not state that a majority of the disinterested
members is required, as the Huangs assert (emphasis added by
court).
From there the court concluded:
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NSM and NewCo clearly established that for each of the four
Majority Members each obtained majority consent from the other
three Majority Members for their respective transfers. In each
instance, the three non-transferring Majority Members held over
33% of the NSM membership interests, which was the collective
NSM membership interest of the Minority Members.
Consequently, the Minority Members never held enough
membership interest in NSM to prevent or challenge the transfers.
The first takeaway is that absent the operating agreement requiring a disinterested vote,
one will not be implied. Nothing too surprising there, although it should be recognized that
where “unanimous” consent is required, courts have inserted a disinterested requirement to avoid
absurd results. See, e.g., Young v. Ellis, 172 Wash. App. 1014 (Wash. Ct. App. Div. 2, Dec. 4,
2012) (where managing member of LLC was named in the operating agreement, and amendment
of operating agreement required unanimous consent of the members, court rejected as “absurd”
suggestion that managing member could be removed only with his consent. Rather, the operating
agreement’s general rule of majority consent of the members would apply to removal of
managing member.).
Perhaps of greater import, the court did not aggregate the Majority Members in assessing
the transfer of the LLC interests in NSM to NewCo. Rather, each members’ assignment was
approved, inter alia, by the other members within the Majority Members; it was as if there were
four distinct transfers, each approved by the other of the Majority Members. Had there been
aggregation, none of the Majority Members could have voted to admit NewCo as a substitute
member, and only the Minority Members, they not participating in the capitalization of NewCo,
could have done so. Assuming disaggregation of members who are acting in concert is the
correct rule, it presents questions as to how an operating agreement should provide for
disinterested votes. Consideration needs to be given to whether and when aggregate treatment
will be provided for, being aware that on certain facts aggregation may have the effect of vesting
control in a minority.
The default rule under the Kentucky LLC Act is that the admission of an assignee
requires the approval of a “majority-in-interest” of the members. See KRS § 275.265(1). The
Act is express that the member seeking to assign a limited liability company interest may not
(unless there is a contrary provision in the operating agreement) vote with respect to the
admission of the assignee as a member. Id. It is, however, silent as to collective action by
several members, and is likewise silent as to an assignee’s ability to vote with respect to
admission as a member vis-à-vis an additional traunch of interests.
Assume there is an LLC with 8 equal (12.5%) members. Five of those members want to
transfer their interests to Laura (not already a member). In series, each of the five could transfer
their interests to Laura as follows:
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Assignor Laura’s Cumulative
Interest Pre-
Assignment
Assignment &
Admission of Laura
as a Member
Approved By:
Laura’s Cumulative
Interest Post-
Assignment
Member 1 0% Members 2, 3, 4 & 5 (57.14% of all interests
other than those held by
Member 1)
12.5%
Member 2 12.5% Laura and Members 3,
4 & 5
25%
Member 3 25% Laura and Members 4
and 5
37.5%
Member 4 37.5% Laura and Member 5 50%
Member 5 50% Laura 62.5%
Applying the rule of independent legal significance (see KRS § 275.003(5)), members 6,
7 and 8 have had no voice with respect to Laura’s admission as a member. If, however, that
result is not desired, then the operating agreement will need to: (i) waive the application of the
rule of independent legal significance; (ii) adopt a test for aggregation; and (iii) provide that no
participants in an aggregated transaction may vote with respect to the admission of the assignee
as a member.
96
LLC as Entity Distinct from Members
97
Court Incorrectly Treats Assets of Dissolved LLC as the Assets of the LLCs Members.
The procedure followed in Ceres Protein, LLC v Thompson Mechanical & Design, Civ.
Act. No. 3:14-CV-00491-TBR-LLK, 2016 WL 6090966 (W.D. Ky. Oct. 18, 2016) upon the
administration of dissolution of an LLC was simply incorrect. Therein, Ceres Protein, LLC, a
plaintiff in the action along with Shannon, one of its members, was administratively dissolved.
Thereafter the defendants moved to substitute Tarullo, the other of Ceres Protein, LLC’s
members, for the LLC. When, ultimately, the LLC was reinstated, it was substituted back in for
Tarullo, in effect returning the parties to the place they were at the initiation of the lawsuit.
The issue is that the LLC need never have been removed as a party to the suit. The
dissolution of an LLC does not limit its capacity to participate in litigation. See KRS §
275.300(4)(a). Furthermore, dissolution does not vest in the members the property, including the
legal rights, of the LLC. See KRS § 275.300(3)(a). But that is with the substitution of Tarullo
purported to do.
The error of treating the members of Ceres Protein LLC as the owners, upon dissolution,
of the LLC’s assets was ultimately corrected, but it should not have needed to be remedied in the
first place.
98
Arbitration
99
Court of Appeals Upholds Agreement to Arbitrate Employment Dispute
In a decision rendered by the Kentucky Court of Appeals, it determined that an
employee’s agreement to arbitrate disputes with his employer would be enforced. Gatliff v.
Firestone Industrial Products Company, LLC, No. 2013-CA-001568-MR (Ky. App. February 6,
2015).
Gatliff charged her employer, Firestone Industrial Products Company, LLC, with
violation of the Kentucky Civil Rights Act consequent to her termination from employment after
completing gender reassignment surgery and allegations of creating a hostile work environment.
The suit was initially removed to federal court, but then remanded to the Circuit Court on the
basis that the claimed damages were not sufficient to meet the requirements of diversity
jurisdiction. Firestone then sought to compel arbitration of the dispute, an effort which Gatliff
resisted.
According to the Court of Appeals, Gatliff had agreed to arbitrate all disputes in a series
of three separate documents. The first was signed when she applied for a full-time position with
Firestone in 1998. Also in 1998, she acknowledged receipt of a copy of the Firestone employee
dispute resolution policy, it containing an agreement to arbitrate. She as well, in 2003, signed a
document referencing the employee dispute resolution policy and acknowledging that she had
had opportunity to review it. Objecting to the enforcement of these agreements against her,
Gatliff asserted that: (i) no meeting of the minds occurred; (ii) no provision stated that she was
waiving her right to a jury trial; (iii) no consideration existed for the 2003 agreement as to the
revised employee dispute policy; and (iv) the agreement is so unconscionable.
In support of the assertion that no meeting of the minds occurred, Gatliff claimed that
“she did not read the plans referred to in the acknowledgments and the acknowledgments did not
contain a jury waiver provision.” The Court of Appeals rejected this assertion. Rather, the Court
found that the documents signed by Gatliff referred to the dispute resolution plan and represented
that the signatory acknowledged having had opportunity to review the plan, relying in part on the
rule that “a signor to a contract is presumed to know the contents of the contract.” Slip. Op. at 8
(citation omitted).
The Court of Appeals stated that arbitration agreements need not contain an explicit
waiver of the right to a jury trial as that waiver is an obvious consequence of an agreement
arbitrate. As to the argument for a lack of consideration, the court, in reliance upon Spears v.
Carhartt, Inc., 215 S.W.3d 1 (Ky. 2006), held that continued employment is itself sufficient
consideration to support an agreement to arbitrate. In connection therewith, the court did not
discuss the June, 2014 ruling of the Kentucky Supreme Court in Charles T. Creech, Inc. v.
Brown wherein it was determined that noncompete agreements require consideration to the
employee (i.e., something of value) above and beyond continued employment. Seeking to avoid
the agreement on the basis that it does not require that arbitration take place in Kentucky (see
Ally Cat, LLC v. Chauvin, 274 S.W.3d 451, 455 (Ky. 2009)), the Court of Appeals relied upon
the fact that the agreements with Firestone provided that they would be interpreted under the
Federal Arbitration Act, and as the Federal Arbitration Act imposes no requirement as to the
locale of the arbitration. Likewise rejected were assertions of substantive unconscionability
100
based on the failure to agree she would be provided a free record of the proceedings and for
attorney fees and costs. The Court’s rejection of these challenges is likely dicta in that first the
Court found that they were not timely in that they were not raised to the trial court below.
101
Court of Appeals Upholds Actions of Trustee Because
the Trustee Was Authorized To Do What It Did
In a recent decision, the Kentucky Court of Appeals considered certain criticisms as to
the investment of trust assets. Ultimately, it would determine that the actions of the trustee were
not subject to the asserted criticisms, essentially on the basis that the trustee was authorized to
engage in the complained of conduct. Watkins v. PNC Bank, N.A., No. 2013-CA-001457-MR
(Ky. App. Jan. 30, 2015).
Lowery Watkins a beneficiary of the Thomas W. Bullitt Fund 3 Trust, brought suit
against PNC Bank, trustee thereof (PNC was itself the successor to Citizens Fidelity Bank and
Trust Company, the original trustee) asserting that it had violated its duties as a trustee by (1)
retaining in the trust PNC stock in violation of the Prudent Investor Rule, (2) that the PNC stock
had be retained in violation of the duty of loyalty and (3) that PNC applied trust assets to
purchase Black Rock mutual funds in violation of the duty of loyalty. The trial court had granted
summary judgment to PNC Bank on all of these counts, and this appeal followed. The Court of
Appeals would ultimately affirm the trial court on all three theories of liability.
As to the Prudent Investor Rule of KRS § 386.3-277, it provides in part that the trustee
has a duty to conform the investments to the directions pursuant to the trust instrument. In this
instance, it had been directed that the trust assets would be shares of Citizens Fidelity Bank and
Trust, which ultimately became PNC. On this basis, it was determined that PNC did not violate
the Prudent Investor Rule. Separately, Watkins challenged the holding of the PNC stock as a
violation of the duty of loyalty. Again, consequently to the directive from the trust with respect
to holding the stock, when combined with KRS § 386.025, there was no violation of the duty of
loyalty. With respect to the purchase of the Black Rock mutual funds, with which PNC is
affiliated, and the charge of self-dealing, Kentucky law, specifically KRS § 386.3-272, allows it
to make such investments. As such, and a cursory basis, the Court determined that PNC did not
act improperly in making this investment.
In that PNC did what the law and/or the trust instrument authorized it to do, no viable
claims arose.
102
Economic Loss Doctrine
103
Federal District Court Enforce Exclusive Remedy Terms of Thoroughbred Horse Sale
Agreement, Applies Economic Loss Doctrine to Preclude Fraud Claim
In a recent decision from the Federal District Court, it held that the specific terms of the
conditions of sale utilized by Keeneland would be enforced to the effect that a horse purchaser
could not seek redress on a sale as he waited too long to bring a complaint. Further, the Court
found that allegations of fraud are barred by the economic loss doctrine. Biszantz v. Stevens
Thoroughbreds, LLC, No. 5:13-CV-348-REW, 2015 WL 574594 (E.D. Ky. Feb. 11, 2015).
Gary Biszantz, when first reading this decision, must have known it was not going to go well for
him when the first paragraph recited:
The case presents no genuine dispute of any material fact, and each of Plaintiff’s
claims fails as a matter of law. Mr. Biszantz, an experienced horseman who
voluntarily entered an arms’ length transaction covered by the highly predictable
and demanding Keeneland Conditions of Sale, seeks to evade the effect of those
conditions over just satisfaction with the results of the bargain; this he cannot do,
on this record, under Kentucky contract (or tort) principles.
While the factual record recited in the decision is long, suffice it to say that Stephens, in
connection with efforts to sell the thoroughbred Salina, deposited certain records with
Keeneland. There was a question as to whether everything that should have been deposited
actually was, and it is clear that certain records were missing. Still, Biszantz purchased Salina
and began training the horse; that training proceeded well for at least several months. When
medical issues arose Biszantz sought to set aside the transaction.
Notwithstanding failures in disclosure as to Salina, the Court reviewed and applied the
Keeneland Conditions of Sale (the “COS”). They afforded Biszantz certain rights available
within certain time limitations; the COS went on to provide that the remedies afforded under the
COS are exclusive. Finding that Biszantz had not acted within the time limitations of the COS,
the Court determined he had no right to have the sale set aside.
Biszantz also brought a claim for fraud. This claim was rejected based on the Economic
Loss Doctrine. Essentially, where the parties have by contract, in this case the COS,
comprehensively allocated the risks and rewards of the transaction, including remedies for
breach, they are restricted to an action in contract and cannot morph the complaint into one
arising in tort.
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The Cinelli Rule
105
Court of Appeals Holds Option Agreement Unenforceable for
Failure to Address Material Terms
In a decision rendered last week by the Kentucky Court of Appeals, it held that an option
agreement o purchase a business and the related real property from which it operated was
unenforceable in that it failed of itself to address all of the material terms of the purported deal.
Rose Mary Hubbs Brewer v. John M. Parsons 2007 Revocable Trust, No. 2013-CA-001309-MR
(Ky. App. March 27, 2015).
This dispute arose out of the question of whether there could be enforced in agreement
“for the purchase [sic - of] all of the stock and assets of Knox Body Shop, Inc. (Knox), along
with the real property that Knox was situated upon.” Consistent with other Kentucky law to the
effect that only an agreement which sets forth all of the material terms will be enforcable to
uncertainty (i.e., agreements to agree are not themselves enforceable) the court stated that an
option agreement will be enforceable only if the “material terms” are “fixed with reasonable
certainty. Citing Hisle v. Keltner, 495 S.W.2d 773, 775 (Ky. 1973), it was observed that:
An option contract must be complete and certain in its terms, that
is to say, the parties and its subject matter must be identified by it,
and the terms and provisions of the contract must be stated in
writing, if required to be in writing, or established by competent
evidence, if not required to be in writing, with that certainty and
definiteness which will enable a court to determine that the parties,
by an election thereunder, have concluded an agreement and also
what the exact terms of that agreement are.
Turning to the language of the agreement under consideration, the court determined that
the description of the real properly purportedly subject to the option was insufficient in that
parole evidence would be necessary to supply its description; under Hisle, reference to parole
evidence is not allowed with respect to the enforcement of an option. Further, the agreement was
found to be insufficiently definite in that there was no agreement as to how the option price
would be paid, including the terms of the promissory note that could be presented in payment.
On this basis, the trial court’s determination that the option agreement was unenforceable
was affirmed.
106
Contract Architecture
107
Kentucky Supreme Court Finds No Agreement to Arbitrate Disputes;
Document Architecture Matters
In a decision rendered last month, the Kentucky Supreme Court held that students
enrolling at Daymar College did not agree to arbitrate their disputes with the college. In part this
decision was based on the curious architecture of the agreement at issue. Dixon v. Daymar
College Group, LLC, __ S.W.3d ___, 2012-SC-000687-DG, 2015 WL 1544450 (Ky. April 2,
2015).
Certain students brought action against Daymar based on allegations of fraud in the
enrollment process, breach of contract, etc. They also sought class action status. Daymar sought
to refer the complaints to arbitration. In opposition to their efforts the students asserted, inter
alia, that there was no agreement to arbitrate.
Students enrolling at Daymar completed a variety of forms. One of those forms
contained, on its reverse side, an “agreement” to arbitrate all disputes. The signature block
appeared, however, on the front of the document, and it never provided above the signature that
the language on the reverse was incorporated by reference.
The trial court denied arbitration. On appeal, the Court of Appeals reversed that decision.
The Supreme Court would reverse the Court of Appeals and affirm the decision of the trial court.
Ergo, no enforceable agreement to arbitrate.
Kentucky has a statute, KRS § 446.060, which provides that the signature of a party to an
agreement must appear at or near the end of the agreement, a requirement applicable only to
agreements which must be in a signed writing. While an agreement to arbitrate need not be in a
signed writing, the programs for which the students enrolled all exceeded a year in length. As
such the enrollment documents needed to satisfy the Statute of Frauds (KRS § 371.010(7)).
From there KRS § 446.060 was applicable, and the agreement to arbitrate on the reverse of the
signed document would be effective only if it was incorporated by reference above the signature
block. The Supreme Court found there to be no such incorporation. Further, each student’s
acknowledgement that they had read the reverse could not be extended into an agreement to be
bound by the terms set forth on the reverse.
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Another Case on Contract Architecture and a Signature Not at the Bottom of the Writing
In a decision rendered on May 1, 2015, the Kentucky Court of Appeals considered the
enforceability of an agreement that was signed not at the end but above the final provisions of
the agreement. See C.A.R.S. Protection Plus, Inc. v. Mamrak, No. 2014-CA-000470-MR (Ky.
App. May 1, 2015) (not to be published).
Mamrak bought a used car and, in connection therewith, bought a vehicle service
agreement from C.A.R.S. Protection Plus, Inc. (“CARS”). At the time he bought the car, a used
BMW, the odometer read 130,269 miles. CARS issued a “warranty coverage card” reciting (a)
the coverage would begin on October 20, 2011 (nine days after the car was acquired) and end on
January 20, 2012, and (b) identifying the mileage range for which coverage was provided as
between 130,269 and 134,769. Essentially, the coverage period was the lesser of six months or
4,500 miles.
The day after the car was purchased, it exhibited trouble which was, at least temporarily,
resolved by a new thermostat. However, problems again arose, and the thermostat was replaced
again, as was the water pump. When problems continued the vehicle was towed to a garage,
where Mamrak was told that the motor would have to be replaced. Mamrak incurred cost of
$7,785.93, of which CARS paid $63.48. CARS defended any additional liability on the basis that
the engine problems manifested themselves on October 12, 2011, the day after the vehicle was
purchased but before the service contract’s effective date of October 20. Further, CARS would
rely upon the terms of the service agreement which provided: “component failures that occur
before [CARS] approves this limited warranty application are not covered.” Mamrak noted that
this language appeared in the contract below his signature line, and therefore the limitation did
not constitute part of the agreement. In response thereto:
CARS argued that the location of Mamrak’s signature on the application was
irrelevant to the operation of the vehicle service contract. It contended that even if
Mamrak’s signature had been required to make an enforceable contract, language
sufficient to incorporate all the terms of the agreement was immediately
proximate or adjacent to his signature. Finally, CARS contended that if Mamrak’s
position were accepted, and only those terms found above his signature are part of
the agreement, then the service contract is utterly meaningless since all of the
operative terms (including the coverage description) are included below his
signature on the application. It argued that no agreement could exist under the
circumstances.
Initially, the Oldham Circuit Court issue partial summary judgment in Mamrak’s favor to
the effect of the language under his signature was not part of the agreement. This determination
was based upon KRS § 446.060(1), which requires, inter alia, that any signature on a document
appear at close to the end of the document when the contract is otherwise required by law to be
signed by a party thereto. In response to a second motion for summary judgment, and here
limited by the prior determination striking the language below Mamrak’s signature, “CARS
argued the no valid contract had been created. It claimed that the document--as redacted by the
Court--lacked definite and essential terms and did not reflect any actual agreement between the
parties. CARS sought summary judgment on the basis that no contract had been formed between
109
the parties.” In turn the trial court determined that the language above Mamrak’s signature was
sufficient to create a contract. After further fact-finding based on affidavits, CARS was ordered
to pay $5,519.61 towards the powertrain repairs.
In my view, unfortunately, the Court of Appeals essentially sidestepped the
interrelationship of Kentucky’s rules as to the formation of the contract, including as set forth in
Cinelli, and the treatment of the language below a signature as being excluded from the contract.
Rather, resolving the question “without reference to the location of the signature line and [the]
dispute over terms appearing above or below it,” the Court found that the agreement was binding
on October 20, 2011, that the car was still operating on that date and that “the bulk of the
necessary repairs occurred on October 25 and again in November 2011.” From there the Court
was able to determine that “[T]he vehicle service agreement standing alone was in effect and
covered the cost of repairs.” Presumably this last clause was meant to apply as of the date the
repair costs were incurred.
In addition, albeit without analysis, the Court of Appeals determined that the service
contract is enforceable under the Magnuson-Moss Warranty-Federal Trade Commission
Improvement Act, it being simply stated that “Mamrak is entitled to enforcement of a vehicle
service contract under both the spirit and the letter of the Act.”
110
Sole Proprietorships
111
Sole Proprietor is Not Employee of Sole Proprietorship
In a decision rendered by the Kentucky Supreme Court on May 14, 2015, it clarified the
law governing sole proprietorships and the relationship of the sole proprietor thereto, a decision
which, in this instance, had a material impact upon the availability of workers compensation
coverage. Kentucky Employers’ Mutual Insurance v. Ellington, 2013-SC-000802-WC, 2015 WL
234-0284 (Ky. May 14, 2015).
Randy Ellington operated his business, R & J Cabinets, as a sole proprietorship (at one
time it had apparently been a partnership, but became a sole proprietorship some six years before
this case arose). The sole proprietorship maintained a workers’ compensation insurance policy
with Kentucky Employers’ Mutual Insurance. In December, 2010, presumably while rendering
services on behalf of R & J Cabinets, his sole proprietorship, Ellington slipped on ice at a job site
and broke his femur. Thereafter, he filed a claim for workers compensation benefits.
The insurance policy, in numerous instances, excluded Ellington from coverage. For
example, an endorsement with the heading SOLE PROPRIETORS, PARTNERS, OFFICERS
AND OTHERS EXCLUSION ENDORSEMENT “specifically stated that there was no bodily
injury coverage to any person” named on a certain schedule; it listed Ellington. In fact, on that
schedule, Ellington’s name appeared in a column with the heading “Excluded Individual Name.”
While both the ALJ and the Workers’ Compensation Board determined that coverage was
not available, the Court of Appeals reversed, holding there to be an ambiguity in the agreement
to the effect that while Ellington was excluded in his capacity as the owner of the business, he
could be included as an employee of his sole proprietorship. That determination would be
reversed by the Supreme Court. Explaining that the sole proprietor is not their own employer, the
Supreme Court wrote:
It is thus evident that the Court of Appeals’ reading
misunderstands the nature of a sole proprietorship. Unlike a
corporation or a limited-liability company, a sole proprietorship is
not an entity separate from the proprietor. They are one and the
same. Cf. Black’s Law Dictionary (10th
ed. 2014) (defining sole
proprietorship as “[a] business in which one person owns all the
assets, owes all the liabilities, and operates in his or her personal
capacity” (emphasis added)). Though we often speak of such
people as being self-employed, no one really contemplates that a
sole proprietor acts in two capacities, both as employer and
employee. The Court of Appeals’ confusion appears to stem from
the fact that Ellington operated his business under an assumed
name, rather than his own, as is allowed under KRS 365.015. But
again, that does mean that R & J Cabinets was a separate entity
from Ellington. Rather, the use of the assumed name for the sole
proprietorship further demonstrates that Ellington and the business
were one and the same.
112
The Supreme Court went on to undertake a “reasonable expectation” analysis of the
policy, concluding therefrom that Ellington could not have had a reasonable expectation that he
was covered by the policy.
This decision is important for a number of reasons. First, it clarifies the relationship of a
sole proprietor to their sole proprietorship. Second, it makes clear that the filing of a certificate of
assumed name does not of in itself create a distinct legal entity. Third and perhaps of greatest
import, it highlights the importance to sole proprietors who want workers’ compensation
insurance coverage to be sure that the policy they have purchased affords them coverage. As an
extension thereof, it needs to be recognized that, absent specific riders, members of an LLC are
typically not covered by workers’ compensation coverage. Where the LLC’s members are
rendering services on its behalf, it is important that they scrutinize their policy to ensure that
coverage, if desired, is available. Surprises in this area can be very expensive.
113
Kentucky Supreme Court Addresses Nature of Sole Proprietorship
In a recent decision that was focused upon whether the proper parties to an action had
been named, the Kentucky Supreme Court provided some useful guidance on the nature of a sole
proprietorship. This “organizational form” receives very little either academic or judicial
attention even as they are prominent in the economy. Sparkman d/b/a In-Depth Sanitary Service
Group v. Console Energy, Inc., Nos. 2013-SC-000119-DG and 2013-SC-000831-DG (Ky. Aug.
20, 2015). This opinion is designated as “To Be Published.”
This decision arose out of a question as to whether or not a verdict was legitimate in light
of confusion as to the designation of certain of the parties, they being an individual, Keith
Sparkman, his sole proprietorship for which no certificate of assumed name had apparently been
filed, In-Depth Sanitary Service Group, and a corporation that Sparkman ultimately formed with
his wife, In-Depth Sanitary Service Group, Inc. In the course of untangling the web of confusion,
and ultimately determining that there was no error, the Court discussed the relationship of a sole
proprietorship and the sole proprietor. Cutting to the chase, the Court observed:
Here Keith Sparkman and Group, his d/b/a entity, were essentially
synonymous, given the legal status of a sole proprietorship. Slip
op. at 7.
Differentiating a sole proprietorship from a wholly owned corporation, citing therefore
the decision rendered in Miller v. Paducah Airport Corporation, 551 S.W.2d 241 (Ky. 1977) for
the proposition that “individual was not proper plaintiff even though he was sole owner of the
corporation that was the real party in interest.”, the Supreme Court wrote:
A sole proprietorship is defined as “a business in which one person
owns all the assets, owes all the liabilities, and operates in his or
her personal capacity.” BLACKS LAW DICTIONARY (10th ED.
2014). A sole proprietorship, therefore, differs greatly from other
business organizations such as corporations or limited liability
companies (LLCs) even in cases where a business organization has
only one shareholder or member. For example, the sole member of
an LLC or sole shareholder of a corporation is not entitled to assert
in his or her individual capacity the rights of the business
organization. Turner v. Andrew, 413 S.W.3d 272 (Ky. 2013);
Miller, 551 S.W.2d 241. An owner of a sole proprietorship, on the
other hand, is liable in his or her personal capacity for the
liabilities of the sole proprietorship, and may assert the Rights of
the sole proprietorship in his individual capacity. Slip op. at 12-13.
In support thereof, the Court also cited WILLIAM BARDENWERPER, 4A KY. PRAC. METHODS OF
PRAC., PART III: BUSINESS ORGANIZATION, § 18:1.
Addressing Sparkman’s failure to file a certificate of assumed name for “In-Depth
Sanitary Service Group,”, the Supreme Court rejected the suggestion that the contracts entered
into were by reason thereof in any manner deficient. Rather, the Supreme Court that wrote that:
114
As a sole proprietorship, Group’s contracts are Sparkman’s
contracts; and Sparkman’s failure to comply with the assumed
name statute does not invalidate those contracts as the Court of
Appeals suggested. Slip op. at 15 (emphasis in original).
While not cited in this opinion, the treatment of the sole proprietorship as set forth in this
decision is consistent with the ruling issued in Kentucky Employers Mutual Insurance v.
Ellington, 2015 WL 2340284 (Ky. May 14, 2015), wherein the Court held that the sole
proprietor is not in turn an employee of his sole proprietorship.
I had a small quibble with the original opinion with respect to assumed name filings. As
set forth on page 13 of the slip opinion, it is stated that “To operate under an assumed name,
Kentucky Revised Statute (KRS) § 365.015(2) stipulates that a party must first file a certificate
of assumed name with the Secretary of State.” Strictly speaking, this is not true. All of business
corporations, partnerships, LLCs, etc. do file certificates of assumed name with the Secretary of
State. The exception to that rule is a sole proprietorship; certificates of assumed name for a sole
proprietorship are filed with (and only with, the county clerk. KRS § 365.015(2). It’s a
admittedly small quibble, but as the decision is focused upon the treatment of sole
proprietorship’s, it’s an important one. This opinion was subsequently revised to address this
point.
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Fraudulent Conveyance
116
Fraudulent Conveyance and Piercing the Veil
In a recent decision, the Federal District Court found (a) that certain mortgages and
security interests were fraudulent conveyances and (b) that the veils of a variety of entities
should be pierced in order to hold the control person liable for an arbitration award against two
of those companies. Kentucky Petroleum Operating Ltd. v. Golden, Civ. No. 12-164-ART, 2015
WL 927358 (E.D. Ky. March 4, 2015).
Two LLCs, 7921 Energy LLC and Macar Investments, LLC (collectively the “Macar
parties”) sold gas and oil well properties and equipment to Kentucky Petroleum Operating, LLC
and Kentucky Petroleum Operating, Ltd. (collectively the “KPO debtors”). Disputes arose over
performance under those agreements, and that dispute went to arbitration. Between the
arbitration hearing and the rendering of the decision, the KPO debtors, working in concert with
affiliated companies, mortgaged/pledged their assets to those same affiliated companies,
particularly Kentucky Petroleum Limited Partnership (“KPLP”). The mortgage allowed KPLP
to foreclose on the leases in the event of a transfer by operation of law, described by Judge
Thapar as:
Taking a page out of playground negotiation, KPLP essentially called “dibs” in
the event they ever left the KPO debtors’ possession.
The Macar parties prevailed in arbitration, and were awarded against the KPO debtors a
judgment of $466,187. With the assets of the KPO debtors fully encumbered, the Macar parties
(i) argued that the mortgages/pledges between the KPO debtors and the related companies were
fraudulently transferred and (ii) the KPO debtors, KPLP and other entities are actually alter-egos
of one another and their veils should be pierced to reach Mehran Ehsan, their common controller.
Fraudulent Conveyance
Kentucky law voids any conveyance of property made with the intent to “delay, hinder,
or defraud creditors,” KRS § 378.010; subsequent creditors are likewise protected. Myers Dry
Goods, Inc. v. Webb, 181 S.W.2d 56, 59 (Ky. 1944). There was in this case no dispute that one
“badge of fraud” existed, namely that the mortgages/pledges were given during the pendency of
a lawsuit. 2015 WL 927358, *4. With that badge of fraud the burden shifted to the KPO debtors
to show that the mortgages/pledges were given in good faith. This they failed to do. In response
to the position that the KPO debtors did not think the Macar parties to be creditors at the time of
the mortgages/pledges, the Court found that their subjective view is largely irrelevant. Rather:
Even if the KPO debtors did not consider the Macar parties their
“creditors” when they recorded the UCC–1 and mortgage, the law did: “A person
who has a claim for damages against a grantor is a creditor within the meaning of
[the fraudulent conveyance statute].” Lewis, 49 S.W. at 329; Hager, 208 S.W.2d
at 519–20 (finding a debtor-creditor relationship where the debtor had “reason to
believe and anticipate” that the creditor would take action against him).
Moreover, section 378.010 protects both then-existing and subsequent creditors
from a debtor’s fraudulent conveyances. Myers, 181 S.W.2d at 59. Thus, section
117
378.010 applies even if the KPO debtors did not believe the Macar parties were
creditors at the time they executed the mortgage and UCC–1. Id.
The Court rejected the assertion that good faith is a fact question requiring a jury trial on
the basis that they failed, in the face of an admitted badge of fraud, to “present any evidence
disputing that they harbored intent to defraud.” Id. There was also rejected (on grounds that are
not entirely clear) the claim that the mortgages/pledges were given in satisfaction of an existing
indebtedness. Id. at *6.
The Macar parties were granted summary judgment on their claims for fraudulent
conveyances.
Piercing the Veil
The decision recites the piercing test adopted by the Kentucky Supreme Court in Inter-
Tel Technologies, Inc. v. Linn Station Properties, LLC, 360 S.W.3d 152, 165 (Ky. 2012), noting
that:
In Kentucky, alter ego liability boils down to “two dispositive elements: (1)
domination of the corporation resulting in a loss of corporate separateness and (2)
circumstances under which continued recognition of the corporation would
sanction fraud or promote injustice.”
As for the lack of separateness, it was found that the KPO debtors and the related
companies share common leadership in Mehram Ehsan, there was inadequate capitalization of at
least one of them, formalities were ignored and the entities comingled their funds. Id. at *7.
The fact that Mehram Ehsan was not named as a party in the suit, that raised as a bar to
the Court piercing the veil, was described as “mistaken.”
Having found a lack of separateness, the Court turned its attention to the second prong of
the piercing analysis, namely whether or not piercing would sanction fraud or promote injustice.
While acknowledging that the injustice needs to be more than the creditor is not paid, the
Court determined:
[O]ne such injustice is a parent corporation or director causing a subsidiary’s
liability and then rendering the subsidiary unable to pay that liability. Ehsan, who
controls and directs all of the KPO entities, incurred liability on behalf of the
KPO debtors by executing both the Macar and 7921 PSAs on behalf of the KPO
debtors. An arbitrator found that the KPO debtors breached the PSAs and
awarded damages to the Macar parties. Ehsan then rendered the KPO debtors
unable to meet their PSA obligations. As the Court explained in section II, the
KPO entities—at the direction of Ehsan—stripped assets from the KPO debtors,
meaning that the Macar parties could not collect their arbitration award.
Accordingly, continued recognition of the separate corporate forms of the various
KPO entities would sanction an injustice.
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A second injustice is a scheme to shift assets to a liability-free corporation while shifting
liabilities to an asset-free corporation. In this case, all of the liabilities fell on the KPO debtors
because they are the only parties named in the arbitration award. Meanwhile, non-debtor KPLP
took all of KPO, LLC’s assets and all of the KPO debtors’ revenue under the PSAs. On these
facts, the continued recognition of the KPO entities’ supposedly “separate” corporate forms
would sanction injustice. Because the Court finds that the KPO entities lack corporate
separateness and that recognizing separate corporate forms would sanction an injustice, the Court
will pierce the corporate veil and treat the KPO entities as a single entity. Id. at *8 (citations
omitted).
From there the conclusion was a foregone, namely:
Because the Court finds that the KPO entities lack corporate separateness and that
recognizing separate corporate forms would sanction an injustice, the Court will
pierce the corporate veil and treat the KPO entities as a single entity. Id.
119
UCC
120
Bank Held Liable For Forged Checks Where Customer Acted Promptly
In a recent decision from the Kentucky Court of Appeals, on the facts there presented, the
bank was held liable on certain forged checks. In this instance, the customer against whose
account the forged checks were drawn was prompt in advising the bank that the checks were not
authorized. Forcht Bank, NA v. Gribbins, No. 2014-CA-000592-MR (Ky. App. July 2, 2015)
(not to be published).
Rene Gribbins maintained her checking account at Forcht Bank. Eight checks, which had
the effect of completely depleting her account, were prepared and presented by Andy Akers.
When contacted by the bank and told that the account had been depleted, Gribbins completed
and submitted affidavits of forgery for each of those eight checks. Gribbins was the only
authorized signature on the account, and “the signature on the eight checks was clearly not
Gribbins’s.” Slip op. at 3-4. Ultimately, Akers was charged with eight counts of criminal
possession of a forged instrument, to which he pled guilty.
When Forcht Bank did not return the improperly withdrawn funds to her account,
Gribbins filed suit. The trial court granted her summary judgment, which was then appealed by
Forcht to the Court of Appeals. Essentially:
The relationship between a customer and a bank is inherently
contractual and, thus, it has been held that banks have a duty to act
in good faith and to exercise ordinary care in dealing with their
customers and accounts. [Citation omitted]. Furthermore, KRS
355.1-203 and KRS 355.4-103 of the Uniform Commercial Code
(UCC) also impose a duty of good faith and fair dealing on banks.
Additionally, KRS 355.4-401(1) provides that “[a] an item is
properly payable if it is authorized by the customer and is in
accordance with any agreement between the customer and bank.”
Here, it is not disputed that Forcht Bank improperly made payment
on Gribbins’s account on eight forged checks. She established,
under KRS 355.4-401, that she did not sign the eight checks and,
thus, did not authorize the payment of the instrument. However,
despite the forgery and the lack of proper authorization, Forcht
Bank paid the checks without hesitation. In doing so, it failed to
use ordinary care in the disbursement of Gribbins’s funds resulting
in harm to her by the depletion of the deposited funds in the
account over the course of 21 days.
The next step in our analysis is to consider Gribbins’s duties as a
customer of the bank who had forged checks cashed in her
account. The duties are found in KRS 355.4-406. Keep in mind,
this statute applies only to claims based on checks with
“unauthorized signatures.” [Citations omitted]. These duties are
outlined in KRS 355.4-406(3), which elucidates that a customer
has a duty to exercise reasonable promptness in examining the
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bank statement to ascertain whether any payment was unauthorized
either because of an alteration or forged signature. If such a
discovery is made by a bank customer, the customer must
promptly notified the bank of the relevant facts. In the case at bar,
Gribbins actually completed the appropriate affidavits of forgery
prior to even receiving the bank statement. Thus, she exercised
ordinary core as delineated by the statute.
In sum, Forcht Bank failed in its duty to exercise ordinary care to
Gribbins when it honored eight forged checks drawn on her
account. [Citation omitted]. Under KRS 355.4-406(4), the bank
bears the burden of presenting evidence they Gribbins’s conduct,
under KRS 355.4-406(3), substantially contributed to its payment
or injury from the payment of the forged checks. It cannot do so -
Gribbins notified the bank about the forged checks even before the
bank statement was issued.
The Court of Appeals also found that the request in the prayer for relief of Gribbins’s
complaint for “all proper relief” encompassed a claim for the award of both prejudgment and
postjudgment interest.
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Products Liability
123
It’s Official: Hot Coffee is Hot
In this decision, the Kentucky Court of Appeals rejected a plaintiff’s claims that a
McDonald’s restaurant should be responsible after she tripped and spilled hot coffee on herself.
Faesy v. JG 1187, Inc. d/b/a McDonald’s Restaurant, No. 2014-CA-001367-MR (Ky. App. Sept.
4, 2015). This particular decision is designated as “not to be published.”
Margie Ann Faesy entered a McDonald’s restaurant in Lexington and purchased a
number of beverages, including a hot coffee. While leaving the restaurant with the drinks in a
carrier she tripped, spilling the hot coffee on herself. In response to burns she suffered from the
hot coffee, she filed a negligence action against the restaurant based upon, essentially, an
assertion that the coffee was excessively hot. In contrast, she made no allegations to the effect
that her fall could be in any manner be blamed upon this particular McDonald’s restaurant.
The trial court dismissed her lawsuit on the basis that, essentially, the fall was her own
fault and therefore the consequences thereof were likewise her fault. That determination would
be adopted and confirmed by the Court of Appeals. In addition, after discussing prior law dealing
with claims based upon firearms, it wrote that:
A hot cup of coffee is also, to a much lesser extent [than is a
firearm] inherently dangerous; as the circuit court indicated,
everyone understands or should understand that hot coffee (which
Faesy specifically ordered) is hot, and hot things cause burns.
However, it does not necessarily follow that a restaurant that
serves such beverages is liable in damages to each person burned
by such beverages. Here, despite Faesy’s allegation that 195 to 205
degrees was an excessively hot temperature for her cup of coffee,
there is nothing of record illustrating that Faesy’s cup of coffee
was any hotter than the temperature of coffee she would have
received in any other restaurant, or hotter than the industry
standard for coffee temperatures in general.… Moreover, hot
beverages are most certainly not within the category of those
substances or chattels which by their very nature are not only
inherently dangerous, but unsafe for general use. Slip op. at 7-8.
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LLC Assignees
125
Assignee May Not Move for Dissolution of LLC
In a recent decision from Connecticut, it was affirmed that an assignee of an interest in an
LLC does not have the rights afforded a member to move for its dissolution, winding up and
termination. Styslinger v Brewster Park, LLC, 321 Conn. 312 (Conn. Sup. Ct. May 17, 2016).
This case was succinctly summed up in the first paragraph of the decision, it providing:
In this appeal, we must determine whether the assignee of a membership interest
in a Connecticut limited liability company (“LLC”) has standing to seek a court
order forcing the winding up of the affairs of an LLC in the absence of the LLC’s
dissolution. We conclude that the assignee does not have standing to do so.
Brewster Park, LLC had two members, Michael Weinshel and Joyce Styslinger. In the
course of her divorce, Joyce assigned her membership interest in Brewster Park to her husband
William Styslinger III with the effect that William would receive the distributions from the LLC
while Joyce would remain at member of the company unless and until William was admitted as a
member. While William did ask Michael Weinshel that he be admitted as a member, Weinshel
had not consented to that happening. William brought suit against both the LLC and Weinshel
asserting that Weinshel has breached his fiduciary obligations to the LLC and to William by not
making distributions to William while taking distributions for himself, and for refusing to allow
William to inspect the LLC’s books and records. William’s prayer for relief included dissolution
of the LLC and an appointment of a receiver to wind up its affairs and distribute its assets.
Weinshel and the LLC responded, asking that the complaint be dismissed on the basis that an
assignee does not have the standing to seek the dissolution of an LLC.
The trial court agreed that an assignee does not have standing to seek the dissolution of
an LLC. Then, on appeal, William made an interesting, but ultimately ineffective, twist in his
argument, asserting that, even as he abandoned his efforts to dissolve the LLC, he should be
granted standing to seek the winding up and distribution of the LLC’s assets without the LLC
undergoing a dissolution.
Noting that this is a case of statutory interpretation, the court found that, under the
Connecticut LLC Act, the winding up of an LLC and the distribution of its assets are integral to
dissolution of the entity; there cannot be a winding up absent dissolution. Ultimately it would
find:
In the present case, none of the events of dissolution specified in § 34-206 has
occurred and the plaintiff therefore cannot trigger a winding up of Brewster
Park’s affairs. First, the plaintiff has not alleged that Brewster Park’s articles of
organization have triggered a dissolution and it has no operating agreement.
Second, the plaintiff has not alleged that its members voted to dissolve. Third,
because the plaintiff is not a member of Brewster Park, he cannot pursue a
judicial dissolution under § 34-207. Unless and until the plaintiff is admitted to
membership, Joyce Styslinger continues to hold the sole power to exercise the
rights accompanying her membership interest; see General Statutes §§ 34-
170(a)(4) and 34-172(d); and she has not sought a judicial dissolution of Brewster
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Park in this action. Because no event of dissolution has occurred, and the plaintiff
cannot force a judicial dissolution under § 34-207 as an assignee, we conclude
that the Act does not grant the plaintiff standing to seek a winding up of Brewster
Park’s affairs.
In a footnote, the court dismissed the plaintiff’s efforts to rely on the general
incorporation of “principles of law and equity” into the LLC Act as granting him by the right to
move for dissolution. Rather, the court noted that those principles were incorporated only to the
extent not displaced by the language of the LLC Act. From there the court noted that, even
accepting that equitable principles might otherwise grant an assignee the right to seek a winding
up of an LLC, those principles have been displaced by the express terms of the LLC Act.
The court, in a footnote, distinguished the Delaware opinion in In re Carlisle Etc., LLC,
114 A.3d 592 (Del. Ch. 2015) on the basis of the differing treatments between Connecticut and
Delaware law of the assignor. Under Delaware law, the assignor of all of their limited liability
company interests ceases to be a member in the company. Under Connecticut law, the assignor
(in this case Joyce) remains a member, to the effect that there is not a void in the exercise of
rights with respect to the assigned limited liability company interest.
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Louisiana Court Holds That Assignee Member Is Not a Member With Respect to Assigned
Interests
Every LLC Act, as a default rule, requires some threshold of the members to approve the
admission of an assignee as a member in the company. Often left unaddressed is whether an
assignment among the members results in (a) the assignee being, with respect to the assigned
interest, treated as a member or (b) treats the assignee, with respect to the assigned interest, as an
assignee. In an article recently published in the Journal of Passthrough Entities, I reviewed two
decisions, one from Delaware and one from North Carolina, addressing that question.1 The
Delaware decision, Achaian, Inc. v. Leemon Family LLC,2 is of little assistance in that it is the
interpretation of what can be fairly characterized as curious language in the subject limited
liability company agreement.3 The second decision reviewed in that article is Blythe v. Bell.
4
The one advantage of the Blythe decision is that it interpreted essentially the default rules of the
statute. In this decision, the North Carolina Business Court determined that upon an assignment
of all of the interest from one incumbent member to another: (i) the management rights are fully
conveyed to the assignee; (ii) the assignee may exercise the management rights related to the
assigned interest.
The recent decision from Louisiana, Bourbon Investments, LLC v. New Orleans Equity
LLC,5 came to the opposite conclusion as did the Blythe court. Curiously, the Blythe decision was
not referenced by the Louisiana court.
This dispute arose out of a failed effort to acquire the famous Galatoire’s Restaurant (as
well as a related restaurant in Baton Rouge). One of the issues in contention was whether the suit
filed against the prior owners was legitimate turned on the question whether it had been validly
approved. In support of the notion that there had not been valid approval of the lawsuit, the
defendants pointed to certain interest transfers amongst the members of the plaintiff, claiming
that required majority approval had not been received. In opposition, the plaintiffs “maintain[ed]
that the general rule that requires unanimous consent for the transfer of full membership interest
in an LLC does not apply where such transfer takes place between current member.” The LLC at
issue not having a written operating agreement, the question turned on state law, the court
observing that:
La. R.S. 12:1330 provides that a membership interest in a limited liability
company is assignable, but such assignment entitles the assignee to only “receive
such distribution or distributions, to share in such profits and losses, and to
receive such allocation of income, gain, loss, deduction, credit, or similar item to
1 Rutledge, Interest Assignments Among Members, J. PASSTHROUGH ENTITIES (March/April 2017) 53.
2 25 A.3d 800 (Del. Ch. 2001). This case is also reviewed in J. WILLIAM CALLISON, ACHAIAN AND INTEREST
TRANSFERS AMONG EXISTING PARTNERS AND MEMBERS, RESEARCH HANDBOOK ON PARTNERSHIPS, LLCS AND
ALTERNATIVE FORMS OF BUSINESS ORGANIZATIONS (Edward Elgar Publishing, 2015).
3 In a similar vein, Ault v. Brady, 37 Fed. App. 222 (8
th Cir. 2002), turned on the wording of the particular operating
agreement at issue.
4 2012 NCDC 60, 2012 WL 6163118 (N.C. Super. Dec. 10, 2012).
5 207 So.3d 1088 (La. App. 4 Cir. 2016). Thanks to Bill Callison for the lead on this case.
128
which the assignor was entitled to the extent assigned.” La. R.S. 12:1332 provides
that, except as otherwise provided in the articles of organization or in an operating
agreement, “[a]n assignee of an interest in a limited liability company shall not
become a member or participate in the management of the limited liability
company unless the other members unanimously consent in writing.” The statute
further states that an assignor continues to be a member unless and until the
assignee becomes a member.
Again, the plaintiff would argue “that the transfer restrictions set forth in La. R.S.
12:1332 apply only when the assignment is made to a third party who wishes to become a
member of the LLC.” Rejecting this assertion, the court would find that:
The literal language of the statue does not support Plaintiffs’ interpretation of La.
R.S. 12:1332. The plain language of the statute requires unanimous written
consent of all members for an assignee to become a member of or participate in
the management of the LLC. The statute does not differentiate between a third
party assignee and a current LLC member assignee. The fact that the legislature
did not draft a separate set of rules for membership transfers between current LLC
members further supports the conclusion that the default transfer restrictions
apply regardless of whether the assignee is a third party or a current member.
So there you have it. At least under the North Carolina LLC Act, an interest assignment
among the members is not subject to the requirement of member approval to constitute the
assignee as a member with respect to the assigned interest. In contrast, in Louisiana, the opposite
is true, and the consent of the incumbent members is required to constitute a member with
respect to an additional assigned interest.
Several state statutes, with greater or lesser precision, address this point. Tennessee
exempts the transfer of management rights among members from any requirement of consent
from another member.6 Utilizing a different statutory formula, the same result is dictated by the
North Carolina LLC Act.7 The new Pennsylvania LLC Act, albeit in a rather cryptic formula,
likewise exempts an assignment among members from any requirement of consent.8
6 See TENN. CODE ANN. § 48-249-508(b)(1) (“A member may, without the consent of any other member, transfer
governance rights to another member.”) Thanks to Joan Hemingway for the lead.
7 See NC LLC ACT § 57D-5-04(b) (“[A] transferee of an ownership interest [(a term of art defined to mean all of the
rights and obligations (economic, management, and others) of an interest owner in a LLC] or portion thereof who is
or becomes a member has to the extent transferred to the transferee (i) the rights and powers and is subject to the
restrictions and liabilities of a member under the operating agreement and this Chapter with respect to the
transferred ownership interest….” (emphasis added). Thanks to Warren Kean for the lead.
8 See 15 PA. C.S. § 8851(b) (“Only right that may be transferred. – A person may not transfer to a person not a
member any rights in a limited liability company other than a transferable interest.”) See also Pa. Drafting
Committee Comment:
This section is patterned after UNIFORM LIMITED LIABILITY COMPANY ACT (2006) (Last Amended 2013) §
501. Absent a contrary provision in the operating agreement or the consent of the members, a “transferable
interest” is the only interest in a limited liability company that can be transferred to a non-member. See 15
Pa.C.S. § 8852. As to whether a member may transfer governance rights to a fellow member, the question
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Operating agreements should address the question and provide a clear answer.
is moot absent a provision in the operating agreement changing the default rule, see 5 Pa..S. § 8847(b)(2),
allocating governance rights per capita. In the default mode, a member’s transfer of governance rights to
another member: (i) does not increase the transferee’s governance rights; (ii) eliminates the transferor’s
governance rights; and (iii) thereby changes the denominator but not the numerator in calculating
governance rights.
Thanks to Lisa Jacobs for the lead.
130
Employment Law
131
Your Rights As An Employee Are Not Violated If You Are Not An Employee
In a recent decision, the federal district court was able to easily dismiss a case alleging
that the rights afforded employees were violated. In this instance, the plaintiff was not an
employee, but rather an independent contractor. Brown v. Outback Steakhouse, Civ. Case No.
5:14-CV-372-JMH, 2015 WL 5304617 (E.D. Ky. Sept. 9, 2015).
Brown ran a company, Alfred Cleaning Services, that provided, as it were, cleaning
services to Outback Steakhouse restaurants in Fayette and Madison County. Brown complained
about the manner in which certain Outback officers referred to him and his employees. When the
cleaning services contract was terminated, Brown brought suit alleging violation of the Kentucky
Civil Rights Act which, at KRS § 344.040, declares it unlawful to discharge or discriminate
against employees who fall within certain protected categories. In this instance, however, Brown
alleged that his company was an independent contractor of Outback. In that the Kentucky Civil
Rights Act protects employees, not independent contractors, there was no viable claim. Further,
Brown’s efforts to rely upon KRS § 344.280, which makes it unlawful to conspire to retaliate or
discriminate against a person who has opposed a practice declared unlawful by the Kentucky
Civil Rights Act, failed in that Brown had not identified a primary violation for which a
conspiracy could attach. Rather:
He has alleged only conduct affecting an independent contractor
and, as discussed, this is not proscribed by the KCRA.
On that basis, summary judgment was granted to Outback.
132
Kentucky Supreme Court Affirms Finding of No “Up The Ladder” Liability for
Workes’ Comp Coverage
In a decision rendered last Thursday, the Kentucky Supreme Court affirmed the
determination that there would not be “up the ladder” liability with respect to Workers’
Compensation liability. At the same time, they affirm the determination that it was the
corporation, rather than its shareholders that was the employer. Nonetheless, closer attention to
the corporate structure could have avoided many of the items here in dispute. Uninsured
Employers’ Fund v. Crowder, 2015-SC-000362-WC, 2016 WL 2605624 (Ky. May 5, 2016).
In 2009, Eugene Davis and James Dick purchased a Quizno’s franchise. They did this in
their individual names. Only later did they organize a corporation, Pulaski Franchises, Inc. While
neither the franchise agreement nor the assets of the restaurant were ever transferred to the name
of Pulaski, the company’s receipts were deposited into its accounts, and disbursements for
wages, taxes and royalty payments due to Quizno’s were paid therefrom.
Tyler Hibbard was hired to manage the restaurant, and he in turn hired Darlene Crowder
to serve as an assistant manager. She began work on April 3, 2010. Just 12 days later, she was
severely injured on the job. Unfortunately, the Workers’ Compensation policy, which had been
issued in the name of Pulaski, and as of the date of injury lapsed.
As to efforts to impose up the ladder liability on the franchisor of the Quizno’s
restaurants, that being QFA Royalties, LLC (“QFA”), there was testimony that QFA was
exclusively devoted to licensing of Quizno’s Restaurants, making all of its profits from franchise
fee and monthly royalties. Ultimately, QFA is not in the business of making sandwiches or
operating any restaurants. Notwithstanding the detailed requirements set forth in the franchise
operating manual, the Supreme Court affirmed the determination below that QFA was not in the
business of “making and selling sandwiches to customers.”. Further, it found that the role of
QFA vis-a-vie an individual Quizno’s restaurants is indistinguishable from the situation
reviewed by the Kentucky Supreme Court in Doctors’ Associates, Inc. v. Uninsured Employers’
Fund, 364 S.W.3d 88 (Ky. 2011). In furtherance thereof, the Supreme Court wrote:
In this matter, the ALJ’s determination that QFA does not have up-the-ladder
liability is supported by substantial evidence. The ALJ found that QFA is in the
business of granting and overseeing franchisee agreements and that, unlike the
Quiznos in Somerset, making and selling sandwiches to customers is not a regular
and recurrent part of its business. This finding is supported by the fact that QFA
did not actually operate any Quiznos restaurant. While the franchise agreement
and operating manual do provide detailed instructions on how to manage the
restaurants on a day-to-day basis, these guidelines were instituted to protect the
brand which QFA sold. Keeping the brand strong is a critical part of QFA’s
purpose because it derives its revenue from franchise fees and royalties.
Additionally, while the success of individual franchises does benefit QFA, its
primary focus is making Quiznos franchises attractive to investors. Thus, since
QFA is not in the business of making and selling sandwiches to customers and the
Quiznos in Somerset was engaged in that work, QFA cannot be considered the
contractor, and does not have up-the-ladder liability in this matter.
133
From there, the Uninsured Employers’ Fund had argued that, in addition to treating
Pulaski as Crowder’s employer, Davis and Dick should likewise be treated as the employers
through means of a joint venture. Applying the factors of Huff v. Rosenberg, 496 S.W.2d 352
(Ky. 1973), the administrative law judge had found that no such joint venture existed. This
determination was affirmed by the Kentucky Supreme Court. Although the language employed
by the court could have been more express, it found that Davis and Dick were as to each other
involved in a joint venture, but that Pulaski had been created in order to effect that objective even
as it shielded Davis and Dick from personal liabilities arising out of the business.
The court went on to note that the real question is whether Pulaski was Crowder’s
employer notwithstanding that the assets of the restaurant in the franchise agreement had never
been transferred to Pulaski. “If Pulaski is Crowder’s employer, then Davis and Dick are shielded
from being jointly and severally liable for the Workers’ Compensation benefits.”
Based upon facts including that neither Davis nor Dick had any involvement in
Crowder’s hiring, that Pulaski was incorporated to operate the Quizno’s, that Crowder was paid
from Pulaski’s bank account and, had the policy been in place, would’ve received no Workers’
Compensation benefits from an insurance policy held in Pulaski’s name, the record that Crowder
was Pulaski’s employer was found to be sufficient and affirmed.
134
Kentucky Court of Appeals Addresses the Distinction between
an Independent Contractor and an Employee
In a December, 2016 decision, the Kentucky Court of Appeals again waded into the
question of whether a particular person, based upon the manner in which they perform services,
is properly characterized as an independent contractor or as an employee. On the facts here
presented, the court found that an individual engaged in the delivery of newspapers was, as a
matter of law, an independent contractor and not an employee. Armstrong v Martin Cadillac,
Inc., No. 2015-CA-001892-MR (Ky. App. December 22, 2016).
This dispute arose out of an automobile accident and related claims by the estate of
Jonathan Elmore, one of the deceased in the accident, who was at the time of the accident was
delivering the Daily News paper. One question was whether Elmore, delivering the papers, was
an employee of the publisher, News Publishing, LLC, in which case liability under respondeat
superior could attach, or rather was he an independent contractor?
After reviewing the manner in which particular individuals are contracted with to deliver
papers, including the fact that the carriers purchase the paper at a bulk rate and in effect resell to
generate a profit, the court applied the then factor test set forth in the Restatement (Second) of
Agency § 220. The Court of Appeals affirmed the lower court’s determination that the
relationship between News Publishing and Elmore was that of an independent contractor. On that
basis, the newspaper publisher was not responsible for the consequences of the accident.
135
Bankruptcy Remote
136
Pigs Get Fat and Hogs Get Slaughtered: Bankruptcy Remote Structure Declared
Invalid For Elimination of Fiduciary Duties
In a recent decision from Illinois, a bankruptcy remote structure was declared void on the
basis that the fiduciary duties of the person inserted by the creditor were eliminated. In re: Lake
Michigan Beach Pottawattamie Resort LLC, Case No. 15bk42427, 2016 WL 1359697 (N.D. Ill.
April 5, 2016).
Lake Michigan Beach Pottawattamie Resort LLC (“LMBPR”) was a debtor to BCL-
Bridge Funding, LLC (“BCL”). In the course of entering into certain forbearance and related
agreements, LMBPR amended its operating agreement to provide for a “Special Member” to be
appointed by BCL. The amended operating agreement would go on to provide that (i) the
Special Member would owe no fiduciary duties to LMBPR or its constituents and (ii) the no
bankruptcy or similar filing could take place without the consent of the Special Member.
LMBPR was unable to perform on its various financing commitments. BCL filed a
complaint against LMBPR, and published a notice of a non-judicial foreclosure sale. On the eve
of that sale LMBPR filed a voluntary Chapter 11 bankruptcy, it having been approved by all
members save and except the Special Member appointed by BCL. BCL challenged the filing on
the basis that (1) it was done for an improper purpose and (2) was in violation of the blocking
rights of the Special Member.
The court assessed the purpose of the Chapter 11 petition under the test set forth in In re
Tekena USA, LLC, 419 B.R. 341, 346 (Bankr. N.D. Ill. 2009) and determined that BCL had not
met its burden of showing it to have been in bad faith.
As for the lack of authority to make the bankruptcy filing, LMBPR (here described as the
“Debtor”) asserted:
The Debtor argues, in response, that the provision in the Third Amendment
requiring BCL’s consent for the filing of a bankruptcy petition by the Debtor, is
void as against public policy because it amounts to a prohibition of the Debtor’s
right to exercise its right to bankruptcy relief and, alternatively, is not valid under
Michigan law. 2016 WL 1359697, *7.
The court then provided a review of the bankruptcy remote structure and the role of the
independent director, noting that the format is permissible because the independent director has a
fiduciary obligation to, on appropriate facts, vote in favor of the bankruptcy that would be
against the interests of the creditor appointing that director. Specifically:
Even though the blocking director structure described above impairs or in
operation denies a bankruptcy right, it adheres to that wisdom. It has built into it a
saving grace: the blocking director must always adhere to his or her general
fiduciary duties to the debtor in fulfilling the role. That means that, at least
theoretically, there will be situations where the blocking director will vote in
137
favor of a bankruptcy filing, even if in so doing he or she acts contrary to purpose
of the secured creditor for whom he or she serves. 2016 WL 1359697, *10.
In contrast, the court here focused upon the fact that the operating agreement amendment that
added the Special Member as well eliminated any fiduciary obligations of that member.
The Third Amendment limits BCL duties as the Special Member to those “rights
and duties expressly set forth in this Agreement.” Third Amendment, Article
12.2(viii), p. 2. Those rights and duties are then limited by Article 12.4(iv):
Notwithstanding anything provided in the Agreement (or other provision
of law or equity) to the contrary, in exercising its rights under this
Section, the Special Member shall be entitled to consider only such
interests and factors as it desires, including its own interests, and shall to
the fullest extent permitted by applicable law, have no duty or obligation
to give any consideration to any interests of or factors affecting the
Company or the Members.
Id. at Article 12.4(iv), p. 2–3 (emphasis added). This language results in BCL as
the Special Member having no duties to the Debtor, despite otherwise being a
member of the Debtor. 2016 WL 1359697, *11 (footnote omitted).
From there the court was able to determine that the provision requiring the consent of the
Special member appointed by BCL before LMBPR may seek bankruptcy protection is
unenforceable. Hence the case may proceed.
138
Another Hog Get Slaughtered: Delaware Bankruptcy Court Invalidates Lender’s
Efforts to Preclude Debtor’s Bankruptcy.
In a decision rendered on June 3, 2016, the United States Bankruptcy Court for Delaware
invalidated certain requirements requested by a lender that had the effect of rendering its debtor
incapable of filing bankruptcy. In re: Intervention Energy Holdings, LLC, Case No. 16-11247
(KJC) (Bankr. De. June 3, 2016).
Intervention Energy Holdings, LLC and its wholly-owned subsidiary, Intervention
Energy, LLC were jointly indebted to EIG Energy Fund X V-A, L.P. EIG had purchased senior
secured notes issued by Intervention; those notes were secured by various liens. Over time,
various amendments have been made to the relevant note purchase agreements, including with
respect to certain coverage covenants. Certain of those coverage covenants were ultimately
violated. Those violations led to Intervention and EIG entering into a Forbearance Agreement
and Contingent Waiver (the “Forbearance Agreement”) pursuant to which, assuming EIG would
raise $30 million of equity capital to pay down the secured notes, the coverage violations would
be waived. However, as a condition to the effectiveness of that Forbearance Agreement, EIG
required Intervention to amend its operating agreements to provide:
that a single unit would be issued to EIG, making it a member in
Intervention; and
requiring the unanimous approval of the members before any filing for
bankruptcy could take place.
Ultimately Intervention would file for bankruptcy protection notwithstanding that it did
not have the consent of EIG to it doing so. That led to a motion to dismiss, brought by a EIG
against Intervention, on the basis that Intervention lacked the authority to file for bankruptcy
protection. In its decision, the Bankruptcy Court would reject that motion to dismiss. As such,
the bankruptcy will proceed.
EIG, in support of its motion to dismiss, argued that, under the LLC Act, there is
essentially full freedom of contract, including to set the requisite threshold for filing a petition in
bankruptcy. intervention relied upon the fact that a waiver of the capacity to file for bankruptcy
is invalid and as well the recent decision rendered in In re Lake Michigan Beach Pottawatamie
Resorts LLC in which a bankruptcy remote structure relying upon a “independent director” who
lacked fiduciary duties was held to be unenforceable.
Obviously the arguments of Intervention would prevail. After string citing numerous
decisions rejecting the notion that the right to file bankruptcy can be waived by contract,
including a decision from the United States Supreme Court, it was observed:
A provision in a limited liability company governance documents obtained by
contract, the sole purpose and effect of which is to place into the hands of a
single, minority equity holder the ultimate authority to eviscerate the right of that
entity to seek federal bankruptcy relief, and the nature and substance of whose
primary relationship with the debtor is that of creditor - not equity holder – and
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which owes no duty to anyone but itself in connection with an LLC’s decision to
seek federal bankruptcy relief, is tantamount to an absolute waiver of that right,
and, even if arguably permitted by state law, is void as contrary to federal public
policy. Slip op. at 9 (citations omitted).
From there, in light of the factual background of the mechanism by which EIG acquired its
single interest in Intervention and the amendment of the LLC agreement requiring unanimity in
order to file bankruptcy, it found those to be “the unequivocal intention of EIG to reserve for
itself the decision of whether the LLC should seek federal bankruptcy relief.” Following the
other federal bankruptcy courts, it was the determination of the Intervention court that it would
not enforce a waiver of the right to seek bankruptcy protection and, from there, it concluded that
Intervention had the necessary authority to commence its Chapter 11 proceeding.
Decisions such as this as well as the In re Lake Michigan Resort decision identify outlier
structures that will not be enforced with respect to bankruptcy remoteness. They do not stand for
the proposition that bankruptcy remoteness is itself either improper or unattainable. The proper
structuring of these relationships can be achieved, but that structuring should begin at the
beginning of the debtor/creditor relationship.
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Good Faith & Fair Dealing
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Delaware Supreme Court Emphasizes the Gap-Filling Role of the Implied Covenant of Good
Faith and Fair Dealing.
In this decision, the Delaware Supreme Court reviewed the gap-filling role of the implied
covenant of good faith and fair dealing, emphasizing that it addresses lacuna between negotiated
terms in order to give full effect to the agreement. In this instance, notwithstanding asserted
compliance with the express terms of the agreement, the plaintiff’s case could go forward
because the defendant’s actions, even if the in strict compliance with the agreement’s express
terms, did not satisfy the obligation of good faith and fair dealing. Dieckman v. Regency GP LP,
No. 208, 2016, 2017 WL 243361 (Del. Jan. 20, 2017).
The underlying transaction involved a merger between two limited partnerships, both
within the same family of a master limited partnership. In that transactions of this nature are
anticipated, the partnership agreement contained a pair of mechanisms for addressing the
conflict. First, the proposed transaction could be negotiated and approved by an independent
committee. In the alternative, the transaction could proceed if it received the approval of a
majority of the unaffiliated limited partners. In this instance, a belt and suspenders approach was
(purportedly) employed. First, a two-person independent conflicts committee was charged to
oversee the transaction. Thereafter, a comprehensive proxy statement (not required by the
partnership agreement) was distributed to the limited partners soliciting their consent to the
transaction based, in part, upon the independent review of the conflicts committee.
When a limited partner challenged the transaction, it was defended on the basis that it had
received the approval of both the independent conflicts committee and a majority of the
unaffiliated limited partners, and on that basis the transaction was not subject to further scrutiny.
While the Chancery Court accepted that argument, it was rejected by the Delaware Supreme
Court. With respect to the independent conflicts committee, the Supreme Court found that it was
not, at least for the standards employed in connection with a motion to dismiss, independent.
Rather, of the two members, one of them had begun review of the transaction while still
affiliated with the general partner. In fact, the persons comprising the committee had to effect
certain resignations in order that they could become “independent,” and immediately after
approving the transaction they were rehired to positions that would have created a conflict. Also,
the standard for independence included that for members of an audit committee of a company
listed on the New York Stock Exchange, but those standards were never satisfied.
As with the contract language regarding Unaffiliated Unit Holder Approval, this
language is reasonably read by Unit Holders to imply a condition that a
Committee has been established whose members genuinely qualified as
unaffiliated with the General Partner and independent at all relevant times.
Implicit in the express terms is that the Special Committee membership be
genuinely comprised of qualified members and that deceptive conduct not be used
to create the false appearance of an unaffiliated, independent Special Committee.
The plaintiff has agreed that the LP Agreement’s safe harbor provisions, if
satisfied, would preclude judicial review of the transaction. But we find that the
plaintiff has pled sufficient facts to support his claims that those safe harbors were
unavailable to the General Partner. Instead of staffing the Conflicts Committee
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with independent members, the plaintiff alleges that the chair of the two-person
Committee started reviewing the transaction while still a member of an Affiliate
board. Just a few days before the General Partner created the Conflicts
Committee, the same director resigned from the Affiliate board and became a
member of the General Partner’s board, and then a Conflicts Committee member.
Further, after conducting the negotiations with ETE over the merger terms and
recommending the merger transaction to the General Partner, the two members of
the Conflicts Committee joined an Affiliate’s board the day the transaction closed.
The plaintiff also alleges that the Conflicts Committee members failed to satisfy
the audit committee independence rules of the New Your Stock Exchange, as
required by the LP Agreement. In the proxy statement used to solicit Unaffiliated
Unit Holder Approval of the merger transaction, the plaintiff alleges that the
General Partner materially misled Unit Holders about the independence of the
Conflicts Committee members. In deciding to approve the merger, reasonable unit
holder would have assumed based on the disclosures that the transaction was
negotiated and approved by a Conflicts Committee composed of persons who
were not “affiliates” of the general partner and who had the independent status
dictated by the LP Agreement. This assurance was one a reasonable investor may
have considered a material fact weighing in favor of the transaction’s fairness.