New Developments

Minnesota Court of Appeals on de facto LLC and LLC-by-estoppel

The Minnesota Court of Appeals has held that the de facto LLC doctrine does not exist in Minnesota and that the LLC-by-estoppel doctrine is inapplicable where a party’s intention to deal solely with an LLC is induced by fraud.

In Stone v. Jetmar Properties, LLC, Ortega gave Hammond an unsecured $200,000 loan to develop property that Ortega had planned to sell to Jetmar, Hammond’s LLC. The sale was not completed because Hammond could not obtain sufficient funds. Although the loan was to be repaid in three days, Hammond never repaid it. A few months later, Hammond met Stone and convinced him to invest more than $50,000 in Jetmar projects. Hammond convinced Stone to quitclaim a rented duplex to Jetmar so that Jetmar’s balance sheet would show sufficient assets to obtain further financing. Hammond promised to reconvey the property in sixty days and told Stone he could continue to keep the rent from the tenants.

Hammond recorded the deed the next day and mortgaged the duplex to Ortega the day after that in exchange for Ortega’s agreement to extend the $200,000 loan. Ortega recorded the mortgage a few days later after confirming that Jetmar had title. Ortega foreclosed on the duplex about seven months later, sending notice to the tenants who forwarded it to Stone. Relying on Hammond’s assurances that all would be well, Stone did not contact Ortega to assert his interest in the duplex. A couple of months later Ortega conducted a foreclosure sale at which he purchased the duplex in return for his $200,000 loan to Jetmar. About a week later, Hammond filed Jetmar’s articles of organization. Apparently neither Ortega nor Stone knew that Jetmar had not been formed. Stone filed suit against Jetmar, Hammond, and Ortega seeking damages and a declaratory judgment that he owned the duplex. Jetmar and Hammond defaulted.

Judge Lansing held that Stone’s quitclaim dean to Jetmar was void because Jetmar did not exist at the time. Neither the de facto entity doctrine nor the entity-by-estoppel doctrine prevented Stone from reclaiming title to the duplex. Judge Lansing held that an element of the de facto doctrine was not met because Hammond made no colorable attempt to form the LLC at the time Stone conveyed the duplex. She further held that the de facto entity doctrine cannot apply to LLCs. Minnesota’s corporations act, which is based, in pertinent part, on the MBCA of 1950, abolished the de facto corporation doctrine. The reporter’s notes to the Minnesota LLC statute state that corporate law should apply to analogous portions of the LLC statute. Because the LLC statute’s section stating that an LLC’s existence begins at filing is based on a similar corporations act section, the de facto entity doctrine cannot apply to LLCs.

The entity-by-estoppel doctrine was not abolished by statute but does not allow Ortega to retain the duplex. Although Stone intended to deal only with Jetmar, not Hammond, that intention was induced by fraud, which allows the court to decline to apply the entity-by-estoppel doctrine. Thus Stone cannot be estopped from seeking to recover the duplex.

As a policy matter, it makes sense to be consistent in applying the defective formation doctrines of de facto entity and entity-by-estoppel. The drafters of the current MBCA concluded that the 1950 MBCA’s attempt to end the de facto corporation doctrine was misguided; courts continued to provide equitable relief despite the statute. Whether the drafters were right in that conclusion is less than obvious and the survival of the 1950 MBCA provisions in a few states, such as Minnesota, suggests that the appropriate policy choice is not obvious. The entity-by-estoppel doctrine is so amorphous that perhaps the best one can say is that, if their courts are consistent, then they’ve made an appropriate choice in terms of defining the doctrine.

This case could be taught in Chapter 19 either right before or just after P.D. 2000, L.L.C. v. First Financial Planners, Inc., on casebook page 745. It would make a good contrast with P.D. 2000, L.L.C. on the entity-by-estoppel question.

One other aspect of this case caught my eye. Jetmar’s counsel was Alex W. Russell, Esq. Mr. Russell practices with, and, in fact, seems to be the only lawyer at, the firm called, “Evening & Weekend Law Offices”. This is an interesting marketing technique and I wonder whether Mr. Russell’s practice is helped or hurt on the whole by his choice of firm name.

Delaware Court of Chancery on stock options, Stone v. Ritter, and Caremark

In Desimone v. Barrows, Sycamore Networks, Inc., issued stock options to certain non-executive employees, certain officers, and the four outside directors. Desimone, a shareholder, brought a derivative suit to recover from the recipients and the two inside directors on the ground that the board breached its fiduciary duties. Vice Chancellor Strine dismissed the complaint on the grounds that plaintiff lacked standing to challenge some of the options because he was not a stockholder when some of the option grants were made, had not shown demand futility as to some claims, and did not state a claim upon which relief can be granted as to the remaining claims.

The pedagogical value of this opinion lies in Strine, VC’s discussion of the current options litigation and his discussion of the effect of Stone v. Ritter on Caremark claims. He quite lucidly describes backdating and distinguishes it from spring loading and bullet-dodging practices. But more importantly, he gives his view of Stone. I don’t read the Vice Chancellor as differing from my own interpretation of Stone (here) though he claims that my reading is not “entirely consistent” with Stone:

In this same vein, the importance and utility of the Delaware Supreme Court’s recent decision in Stone v. Ritter, reinforcing the vitality of this court’s decision in In re Caremark Int'l Inc. Deriv. Litig. should not be ignored. Some respected scholars seem to fear that Stone opens directors to new kinds of claims foreclosed by Caremark, while others read it as taking away a non-scienter based claim Caremark supposedly seemed to suggest. Neither position seems entirely consistent with the decision itself. Stone clarified one of the most difficult questions in corporate law — when directors with no motivation to injure the firm can be held responsible if the corporation incurs serious harm as a result of its failure to obey the law. What Stone makes clear is that Caremark and its progeny, such as Guttman v. Huang, are still good law. For reasons Caremark well-explained, to hold directors liable for a failure in monitoring, the directors have to have acted with a state of mind consistent with a conscious decision to breach their duty of care. Caremark itself encouraged directors to act with reasonable diligence, but plainly held that director liability for failure to monitor required a finding that the directors acted with the state of mind traditionally used to define the mindset of a disloyal director — bad faith — because their indolence was so persistent that it could not be ascribed to anything other than a knowing decision not to even try to make sure the corporation’s officers had developed and were implementing a prudent approach to ensuring law compliance. By reinforcing that a scienter-based standard applies to claims in the delicate monitoring context, Stone ensured that the protections that exculpatory charter provisions afford to independent directors against damage claims would not be eroded. Stone has obvious implications for cases like this, when a plaintiff seeks to hold directors accountable for failing to prevent backdating by corporate officers.

Professors teaching Desimone could do so at page 400 of the casebook at the end of section 4. Alternatively, one could summarize this case in the Notes and Questions following Stone, which is inserted at page 394. Both Stone and Desimone are included in the casebook Supplement.

Francis Pileggi has a characteristically good discussion of Desimone (here). Larry Ribstein also has a very good post on this case (here).