New Developments

Washington Court of Appeals on fiduciary duty of LLC member-managers

The Washington State Court of Appeals has held that member-managers of an LLC are analogous to partners and hence owe one another the same fiduciary duties as partners under the UPA. In Bishop of Victoria Corporation Sole v. Corporate Business Park, LLC, Finley owed money to the Bishop of Victoria Corporation Sole (Bishop), which is the Canadian corporation that owns the real property of the Roman Catholic diocese of Victoria, British Columbia. Finley and the Bishop formed an LLC to purchase a specific plot of land that Finley believed was being sold for one-third its value. The parties intended to resell the property quickly and pay off Finley’s debt to the Bishop. The parties were the only manager-members of the LLC.

The LLC obtained a purchase money mortgage in an amount greater than the purchase price and intended to use the excess borrowing to pay the principal and interest on the mortgage until the property could be sold. The property proved difficult to sell, the reserve ran out, and the Bishop began making payments on the mortgage.

A new bishop replaced the retiring bishop as the head of the Bishop and the new bishop’s staff changed their investment intent to one of simply selling the property for enough money to pay off the mortgage without any additional profit. The Bishop missed a payment, which caused the interest rate to rise, and the lender obtained a judgment of about $8.2 million and a decree of foreclosure. The Bishop raised money from parishioners by issuing debentures. The money was put in Fisgard, a trust entity that then purchased the judgment from the lender. The Bishop filed an action seeking appointment of a receiver. The receiver was unable to sell the property and later gave a deed-in-lieu of foreclosure to Fisgard. Finley sued the Bishop for breach of the LLC operating agreement and breach of fiduciary duties. A jury returned a verdict for Finley on both claims for about $12.4 million.

Judge Penoyar first held that the fiduciary duties of member-managed and manager-managed LLCs are identical and that they spring from the relation of trust between the parties. He then held that members in a member-managed LLC are analogous to partners in a general partnership, who owe each other fiduciary duties, which Judge Penoyer describes as “candor and the utmost good faith”. He then ticks off the fiduciary duties of partners under section 404 of the UPA. On these facts, the court held that the Bishop did not breach any fiduciary duties.

This opinion is interesting in several respects. First, the authority Judge Penoyer cites for the proposition that LLC members have fiduciary duties stemming from their trust relationship does not address LLCs in particular. Certainly the Washington LLC statute does not impose fiduciary duties on either members or managers. Second, the authority he cites for the proposition that members of member-managed LLCs are like partners and therefore owe each other partnership duties is simply a suggestion in a law review article. Third, Judge Penoyar’s source for the proposition that those duties are “candor and the utmost good faith” is a case that pre-dates the current UPA, which distinctly constricted the fiduciary duties partners owe. In the end, he finds no breach here, but the bases on which he defines the governing standards are problematic.

Washington State Court of Appeals on duty of good faith

The Washington State Court of Appeals has held that a director who converts corporate property breaches the duty of good faith. In Lang v. Hougan, Lang and Hougan incorporated and equally owned Lang Property Management, Inc (LPM), which was a property management and real estate investment company. Each was an officer and director. About six years later the parties began to have a falling out. They were unable to negotiate a mutually agreeable division of their business and Hougan formed another corporation, Premier. She sent letters to every LPM client telling them that her relationship with LPM was ending and soliciting them to transfer their accounts to Premier, which most of them did. The parties did not have non-competition agreements. Lang brought suit seeking dissolution of LPM and asserting that Hougan breached her fiduciary duties.

Judge Penoyar held, with no discussion, that Hougan’s actions converted LPM’s assets in violation of the duty of good faith in MBCA 8.30 and 8.42. Presumably this case more precisely fits a traditional duty of loyalty analysis. That is, Hougan could not have believed that her actions were in the best interest of LPM. If Washington were to adopt Delaware’s understanding of the duty of loyalty and the obligation to act in good faith, the court would not have conceived of Hougan’s actions as not being in good faith. They were more culpable than that.

New Hampshire Supreme Court on dissolution

The Supreme Court of New Hampshire has held that a court has the equitable power to set aside a shareholder’s election to buy out the shareholder who petitioned for dissolution, even where the electing shareholder does not seek to revoke the election. In Bendetson v. Killarney, Inc. (watch oral argument here and note the wonderful courtroom), Bendetson and Buonato, the two equal shareholders of Killarney, Inc., had a falling out. Killarney served as the sole general partner of a limited partnership that Bendetson and Buonato also owned equally. Bendetson petitioned for dissolution of Killarney on the ground of deadlock and petitioned for dissolution of the limited partnership on the ground that it was not reasonably practical to carry on the limited partnership given Killarney’s deadlock.

Buonato filed an election to purchase Bendetson’s Killarney shares at fair value, pursuant to MBCA § 14.34(a). The trial court stayed dissolution and, when the parties could not agree on value, held a valuation hearing. At the hearing the court noted that the limited partnership dissolution was pending and that, after Buonato purchased Bendetson’s Killarney shares he would also control the limited partnership. The court set aside Buonato’s election and later ordered dissolution of Killarney. Buanato appealed, arguing that the court was without power to set aside his election in the absence of his request to revoke.

Chief Justice Broderick held that the court has the power to set aside a shareholder’s election. The relevant language of § 14.34(a) reads,

An election pursuant to this section shall be irrevocable, unless the court determines that it is equitable to set aside or modify the election.

The Chief Justice acknowledged that the word “irrevocable” ordinarily has reference to a withdrawal only by the original actor (i.e. Buanato) but held that the Official Comments, the statutory scheme, the statute’s purpose and the legislative intent were all consonant with judicial discretion even in the absence of the electing shareholder’s request to revoke.

This result seems correct and the court’s analysis is rather thorough and nuanced.

Delaware Court of Chancery on Caremark duty of loyalty

The Delaware Court of Chancery has held that two directors breached their duty of loyalty by failing to meet their Caremark obligations. In ATR-Kim Eng Financial Corp. v. Araneta, Araneta controlled 90% of a corporation and was one of the three directors. After a falling out with his childhood friend Arnaiz, who’s ATR owned the remaining 10%, Araneta transferred the corporation’s assets to his own children for no consideration.

Vice Chancellor Strine had no difficulty finding Araneta liable. The interesting part of the opinion concerns the other two directors, Berenguer (Araneta’s niece and the CFO) and Bonilla. They were completely overborne by Araneta and readily admitted that they did nothing as directors. It appears that no board meetings were held. Vice Chancellor Strine found that they violated their duty of loyalty by failing to implement a reporting or monitoring system as required by Caremark. It has several characteristically Strinian phrases.

Pedagogically, this case and Stone v. Ritter will probably replace Caremark (casebook pp. 410, 426-27, 443-44). Between them they show that the duty to monitor is a loyalty issue and they also discuss the standard of review. The facts of Araneta are more accessible and interesting than those of Caremark. Since Stone v. Ritter torques Caremark rather considerably, it would be hard to keep Caremark itself as a teaching case. Perhaps it will be less confusing to students if we refer to the duty to monitor as the Loyaltymark duty.

Francis Pileggi (here), Steve Bainbridge (here), and Gordon Smith (here) all have discussions of Araneta.

Delaware Court of Chancery on piercing the corporate veil

The Delaware Court of Chancery has pierced the corporate veil of a corporation after finding that the sole shareholder used the corporation to perpetrate a fraud. In Midland Interiors, Inc. v. Burleigh, Burleigh formed Window Treatment & Carpet, Inc. in 1994 and was the sole shareholder, director, officer, and employee. Burleigh obtained carpet and window treatment installation jobs in Window Treatment’s name and hired subcontractors, including Midland, to perform the work. Apparently Window Treatment owned only a bank account through which the business’s money was run. The business was unsuccessful.

In March 1996 Window Treatment was declared inoperative and void for failure to pay franchise taxes. Burleigh became aware of this fact in June but thereafter caused Window Treatment to enter into additional contracts with Midland. Window Treatment defaulted and Midland sued Window Treatment in the Delaware equivalent of small claims court. At the hearing, Burleigh represented Window Treatment, acknowledged that Midland’s claim was valid, asserted that Window Treatment was going to pay the claim, and agreed to a stipulated judgment against Window Treatment of about $7,000. When payment was not made, Midland sued both Window Treatment and Burleigh in the Court of Chancery. After a trial on the merits, Vice Chancellor Parsons entered judgment against Burleigh for the original stipulated judgment.

The result here is surely right but the case is noteworthy on two grounds. First, it is one of the few Delaware piercing cases to go through trial and one of only a handful to allow piercing. Second, although Vice Chancellor Parsons disregards the corporate form, he does so using the traditional Delaware standard, which is more stringent than the standard applied by a few recent Delaware cases. Delaware has historically been reluctant to pierce and the standard requires fraud (see casebook page 282-83). However, a few Delaware federal cases have applied a more general standard of “unfairness” or “equity”, which has been referenced in a couple of Court of Chancery opinion.

Vice Chancellor Parsons quotes both standards (without acknowledging that two approaches exist) and concludes that the piercing decision requires “[C]onsideration of any fraudulent action committed under the guise of the corporate form”. The Vice Chancellor epitomized the standard by framing his inquiry as “Whether Burliegh Used the Corporate Status of Window Treatment to Perpetrate a Fraud”. He found four aspects that constituted “fraud committed by Burleigh in the name of the defunct Window Treatment”. First, Burleigh did not honor any of the corporate formalities. Second, Window Treatment was insolvent. The Vice Chancellor recognized that these, alone or combined, were not sufficient to pierce. Third, Burleigh committed fraud when he negotiated contracts with Midland knowing that Window Treatment had become inoperable and void. Fourth, Burleigh intentionally misled Midland and the small claims judge when he represented that Window Treatment would be able to pay the stipulated judgment. In a nod to the less stringent standard, Vice Chancellor Parsons held that it would be unjust to allow Burleigh to escape personal liability.

Quaere whether piercing was necessary to impose personal liability on Burleigh. When he contracted on behalf of Window Treatment, knowing that Window Treatment had been declared inoperative and void, he presumably rendered himself personally liable on those contracts. Certainly a corporation by estoppel defense would be unavailing.

Francis Pileggi also has a good post on this case (here) and a post on an earlier opinion in the case dealing with discovery problems (here).

Delaware Court of Chancery on waste and fiduciary duties

The Delaware Court of Chancery has held that an alleged misallocation of consideration in a sale of assets may constitute waste. The case is important not only because it is one of the few that suggests the possibility of actually finding waste but because it also tacitly acknowledges the change in Delaware law that Stone v. Ritter brought about.

In Bakerman v. Sidney Frank Importing Co., Inc., Bakerman was the chief counsel for SFIC, which owned half an LLC that owned a French entity, SAS, that made Grey Goose Vodka. The remaining interest in the LLC was owned by SFIC insiders, including Bakerman. Those insiders, but not Bakerman, also owned SFIC stock.

Unbeknownst to Bakerman, other SFIC insiders negotiated the sale of assets of SAS, the LLC, and SFIC to Bacardi. The agreement required the approval of all owners of the LLC. The consideration was cash with an earn-out. The purchase agreement allocated over 99.5% of the consideration to SFIC and less than half of one percent to SAS. Bakerman balked at the allocation and refused to consent to the transaction; he relented under pressure. Three weeks later he was terminated and brought this action for tort, breach of contract, and breach of fiduciary duties. Bakerman did not make prior demand on the LLC’s managers, who moved to dismiss on several grounds.

Chancellor Chandler allowed most of the suit to proceed. Two aspects of his opinion are noteworthy. First, in applying the Aronson test for demand futility, the Chancellor found that the transaction might constitute waste, thus raising a reasonable doubt that the allocation decision was the product of a valid exercise of business judgment.

This strikes me as an unusual willingness to look at the substance of a transaction and suggests that the facts might sustain a claim of waste. On the one hand, this case is at the 12(b)(6) stage so there is no definitive finding of waste. However, the Chancellor found that Bakerman met both aspects of Aronson’s first prong, meaning the LLC managers were arguably interested and not independent. The facts upon which that finding were made are relatively clear. Having found the first Aronson prong met, there would seem to be no reason to reach out to make a statement about the possibility of waste unless the Chancellor wanted to highlight the possibility of the Delaware courts’ becoming more active in this area. This seems particularly noteworthy in light of the Disney finding of no waste.

The second noteworthy finding is a silent acknowledgment of Stone v. Ritter. In articulating the second Aronson prong, Chancellor Chandler wrote,

[T]he managers of an LLC are presumed to have acted on an informed basis and in the honest belief that the decisions were in furtherance of the best interests of the LLC and its members.

Note the absence of “good faith” in this incantation. Traditionally, directors’ fiduciary duties are described as the obligation to act “on an informed basis, in good faith, and in the honest belief. . .”. After Stone, we know good faith is a subset of the duty of loyalty so Chancellor Chandler’s formulation is apparently the new statement of fiduciary duties.

There may be a sly back story to this. As academics and the Delaware courts were trying to figure out whether good faith was a separate duty, some judges were engaging in subtle disobedience. In 1996, three years after the Supreme Court emphasized that there is a triad of fiduciary duties, Vice Chancellor Steele quoted Aronson but left out “, in good faith,” without indicating the omission. A few years later Vice Chancellor Noble followed suit. Those cases were, of course, pre-Stone. Bakerman is the first post-Stone case that describes a dyad of duties. It will be interesting to see whether this becomes the standard description and whether any opinion will acknowledge the change.

Francis Pileggi (link) has a more detailed description of Backerman.

Massachusetts court on buyout remedy and shareholder fiduciary duty

The Massachusetts Supreme Judicial Court has held that buyout is not within a court’s equitable power to impose as a remedy for violation of a shareholder’s fiduciary duty. In Brodie v. Jordan, (watch the oral argument here) the plaintiff inherited from her husband one-third of the shares of a closely held corporation. The two defendants owned the remaining shares. Plaintiff’s husband and the other shareholders had a falling out in the early 1990s. Plaintiff’s husband died in 1997. The corporation has paid no money to plaintiff or her husband since 1995. The defendants have not provided financial or operational information to plaintiff, they have not performed a valuation of the company, nor has the corporation held an annual meeting for five years. The Superior Court found that the defendants violated their fiduciary duty of utmost good faith and loyalty, required under Donahue and Wilkes, “by excluding her from corporate decision-making, denying her access to company information, and hindering her ability to sell her shares in the open market.” The Appeals Court affirmed and defendants did not seek further review of the liability issue. The Superior Court judge ordered the defendants to buy out the plaintiff at a price to be determined by a court-appointed expert. No corporate document requires a shareholder to sell or buy shares.

Justice Cowin, speaking for the court, made a subtle but potentially far reaching assertion. After quoting various examples of freeze-outs from Donahue, she concludes, “What these examples have in common is that, in each, the majority frustrates the minority’s reasonable expectations of benefit from their ownership of shares. We have previously analyzed freeze-outs in terms of shareholders’ ‘reasonable expectations’ both explicitly and implicitly.” She cites two Massachusetts cases (including Wilkes) then cites the standard New Jersey, New York, and North Carolina cases that use the reasonable expectations test to determine oppression.

As near as I can tell, Justice Cowin’s description of Massachusetts law is incorrect. I’ve found no appellate case that analyzes the Donahue/Wilkes fiduciary duty in terms of the minority’s reasonable expectations. In a footnote Justice Cowin notes that Massachusetts is different from those other states in that no Massachusetts statute permits a claim for relief for oppression. However, says she, the standards for determining a breach of fiduciary duty and finding oppression are often the same. That’s probably an accurate description of the law in other states, but not (until now) in Massachusetts.

No matter. Justice Cowin then holds that the goal in a freeze-out case is to restore the minority to the position it would have been in had there been no freeze-out. Here, because no corporate document permits or requires a buyout and no market for the corporation’s shares exists, ordering a buyout provides a different and more favorable remedy than plaintiff would have had if defendants had not violated their fiduciary duties. Justice Cowin then makes a slippery slope argument that buyout would be appropriate in every freeze-out case. Finally, she drops a footnote that distinguishes cases from other states that permit forced buyouts. She correctly notes that those states have statutes that permit involuntary dissolution and, by inference, the courts in those states have arrogated the power to order a buyout. In Massachusetts, by contrast, dissolution is only permitted for deadlock.

So it seems that Massachusetts is now using one of the standards for oppression as its test for determining whether the Donahue/Wilkes fiduciary duty has been violated. Where this leaves the rather elaborate weighing process in Wilkes is unclear. Could it be that Massachusetts is finally ready to abandon the notion that close corporation shareholders owe one another the same duties partners owe one another?

Further, of course, this raises one of the more problematic issues of the reasonable expectations test. That is, when the complaining shareholder did not purchase shares from the corporation, to what extent should the corporation and other shareholders be required to honor that shareholder’s reasonable expectations? A stark example is a shareholder who obtains shares from a parent. The parent and child may have very different, and reasonable, expectations about the optimal investment horizon. Whose expectations should be other shareholders respect?

Washington State Supreme Court on partner liability

The Supreme Court of Washington has held that a tort plaintiff may recover against the partner of a general partnership without suing the partnership or exhausting partnership assets where the general partner is independently liable for the tort. In Gildon v. Simon Property Group, Inc., plaintiff was employed by a mall tenant as a cleaning service worker. She fell while performing her cleaning services and sued Simon Property, which she believed to be the mall owner, on a theory of premises liability. She later moved to amend her complaint to name the title owner of the mall, a general partnership. The trail court denied the motion on the ground that the amendment would not relate back and also dismissed the action on the ground that the partnership was an indispensable party and that the statute of limitations had run so that plaintiff could not file a separate action against the partnership. Simon Property was one of the partnership’s two general partners.

Justice Madsen held that that the partnership was not an indispensable party because Gildon could recover directly against Simon Property as a “possessor” of the mall. She also rejected Simon Property’s argument that the action should be dismissed because Gildon could not recover from Simon Properties without exhausting the partnership assets, which was not possible because the statute of limitations against the partnership had run. Justice Madsen held that the partnership need not be sued because UPA § 307(a) is permissive (citing my friend and colleague Kelly Kunsch). She then held that § 307(d)(5) permits Gildon to execute against Simon Properties. That section reads,

(d) A judgment creditor of a partner may not levy execution against the assets of the partner to satisfy a judgment based on a claim against the partnership unless the partner is personally liable for the claim under Section 306 [imposing joint and several liability on partners] and:

(5) liability is imposed on the partner by law … independent of the existence of the partnership.

Here, Simon Property is liable as a partner for the partnership’s debt (UPA § 306) and is independently liable for premises liability as a possessor.

This strikes me as clearly correct, though somewhat convoluted. The UPA’s liability scheme is generally intuitive: partners are jointly and severally liable for partnership debts (§ 306). However, a judgment against the partnership is not a judgment against the partner and a partnership judgment creditor may not execute against a partner’s property without a judgment against the partner (§ 307(c)).

Section 307(d) is not intuitive, however. It deals with the situation in which a claim against a partnership is asserted against one or more partners rather than against the partnership, which is permitted under § 307(a). In that setting, a judgment creditor typically cannot execute against the partner’s assets (even though the judgment is against the partner!) until the partnership’s assets are exhausted (§ 307(d)(1)). This seems to run counter to the point of permitting a plaintiff to sue the partnership or one or more partners, or both. However that rule is subject to four exceptions applies (§ 307(d)(2-5)), one of which applied in this case.

Indiana Court of Appeals on disregarding an LLC

The Court of Appeals of Indiana, in a case of first impression, has held that the criteria for piercing the corporate veil apply to whether an LLC should be disregarded and its managers held personally liable. In Troutwine Estates Development Co., LLC. V. ComSub Design and Engineering, Inc., ComSub provided engineering services to Troutwine, which owned raw land it intended to develop. Troutwine did not pay for all the services rendered and ComSub sued for breach of contract. ComSub also sued two individuals, the Jordans, and an entity they owned, Master Mark, the developer that purchased the land from Troutwine.

Judge Robb affirmed the trial court’s holding that no enforceable contract existed between Troutwine and ComSub but that ComSub was entitled to damages from Troutwine on a quantum meruit theory. The court reversed the imposition of individual liability on the Jordans and Master Mark on the ground that the trial court did not enter findings of fact and conclusions of law on this issue.

The court quoted the Indiana statute granting limited liability to LLC members, managers, agents, and employees. Judge Robb then reasoned that, “Because the Indiana Business Flexibility Act [the LLC statute] provides protections to limited liability companies like those of corporations, to circumvent those protections we apply an analysis similar to that for determining the personal liability of a corporation’s officers.” The court cites as authority a case, Brant v. Krilich, that is completely inapposite. Brant dealt with so-called reverse piercing of a corporation. Judge Robb goes on, though, to cite cases from California, New York, Georgia, and Connecticut for the proposition that corporate piercing principles are applicable to LLCs. In reversing personal liability the court also observed that personal liability might well be imposed on the Jordans or Master Mark under quantum meruit principles. That is, they might be directly rather than indirectly liable.

Once again a court has the opportunity to be thoughtful about the principles by which an LLC may be disregarded and its owners held personally liable. Once again the court declined to be thoughtful. The Indiana LLC statute language is comparable, but not identical, to the Indiana corporation statute language, which is the MBCA language from § 6.22. As a final note, the Jordans were described as Troutwine’s managers, rather than members. I suspect they were also the members. To the extent the court means what it says and is willing to hold LLC managers liable on corporate piercing theories, there is even less rationality to the result.

Washington State Supreme Court on dissolution

The Washington State Supreme Court has held that an action on a post-dissolution claim must be filed within two years after dissolution. In Ballard Square Condominium Owners Association v. Dynasty Construction Co., Dynasty developed and built Ballard Square Condominiums. Dynasty was administratively dissolved and almost six years later Ballard Square’s COA sued Dynasty for breach of contract alleging that shoddy construction resulted in extensive water damage.

Justice Madsen held that a statutory amendment adopted after oral argument barred the action. The amendment created a two year statute of repose for suits against dissolved corporations and Justice Madsen held that the statute was intended to apply retroactively.

At the time the lawsuit was filed, Washington had a survival statute, based on the pre-1984 MBCA, that did not cover post-dissolution liabilities. The Washington Court of Appeals applied the common law rule that dissolution ends the corporate existence and thus bars post-dissolution suits. Justice Madsen, however, held that the legislative intent in adopting the current MBCA was to preempt the common law rule, thus the six year statute of limitations for contract actions would apply. Arguably plaintiff’s claims were timely.

However, the Washington legislature amended the survival statute in response to the Court of Appeals decision in this case. The amendment added post-dissolution lawsuits to those that must be brought within two years of dissolution. Plaintiff almost won.

MBCA §  14.07 would impose the result Justice Madsen reached before considering the legislative amendment. That is, post-dissolution claims are governed by the underlying claim’s statute of limitation. Section 14.07 also permits a corporation to limit the filing of post-dissolution claims to three years if it publishes a particular notice. The DGCL has a comparable, though more prolix, system. See DGCL §§ 278, 280, and 281.

Pedagogically, this case might be interesting to teach if you wanted to cover the question of pre- and post-dissolution litigation. See casebook page 305-306.