In 2005 John Q. Hammons Hotels, Inc. was sold to a private company. The minority shareholders received $24 per share for their 24% interest and John Q. himself received different consideration for his 76% stake. Hammond's consideration included a small stake in the buyer with a preferential buyout, a line of credit and other consideration. The parties disagreed on whether his consideration was worth more or less than $24 per share.
The plaintiffs brought a class action alleging that Hammons and the board of directors breached their fiduciary duties by negotiating different consideration and allowing the merger to be approved through a deficient process, respectively. In re John Q. Hammons Hotels, Inc. Shareholder Litigation (Del. Ch. October 2, 2009).
The plaintiffs argue that Kahn v. Lynch Communication Systems, Inc. is the controlling case. In Lynch the Delaware court held that when a controlling shareholder makes a cash out merger offer to the minority the standard of review is entire fairness of the transaction and the burden is on the controlling shareholder. The burden shifts to the plaintiff when the approval of the cash-out merger is required of (1) an independent committee of directors or (2) an informed majority of minority shareholders. The defendants countered that the business judgment rule should apply because of the safeguards built into the deal.
The court in Hammons declined to find Lynch controlling because John Q was not the purchaser (i.e. not on both sides of the transaction. But it did find that the business judgment rule could not be invoked because the merger process was deficient.
To make a long story short, in merger transactions involving a controlling shareholder (but not as buyer)the business judgment rule will not be available and instead entire fairness (fair dealing and fair price) will be applied unless (1) an independent committee of disinterested directors approve the deal and (2) a majority of the minority shareholders (not just those voting) approve the merger in a vote that is not waivable by the independent directors. The court made clear that it was not enough that the committee did not waive even though they could have or a majority of all minority shareholders approved the merger even though only those attending the meeting were required to. The form controls the substance in this regard.
-Marc Ward
The Iowa Court of Appeals opinion in Builders Kitchen and Supply Co. v. Moyer, N0. 0-655/09-0194 (September 2, 2009) is a deceptively simple case. On the one hand it represents the folly of not having even run of the mill contracts reviewed by lawyers before they are signed. And on the other hand, it is a warning to lawyers that things aren't as simple as they appear.
Frank Moyer signed a contract with Builders Kitchen for the purchase and installation of some kitchen cabinets and countertops. The contract was just two pages long. On the first page there was a place for the name of the business and a little later a space to indicate the type of entity. Moyer filled in the name of his business, Crystal Creek Development, but neglected to indicate that it was a corporation. He signed the contract as "Frank Moyer, Pres." The second signature line, presumably for the guarantor, was left blank.
Unfortunately for Moyer the contract contained a clause that said "I hereby personally guarantee to pay on demand any and all sums due that my/our company shall fail to pay." Of course, I wouldn't be writing this post if Crystal Creek Development had paid the amount due.
Because it didn't Builders Kitchen sued the company and Moyer personally. The district court found Moyer to be personally liable and the Court of Appeals affirmed finding that Moyer's signature was both in his representative capacity and personally. To find otherwise, both courts said, would negate the language of the contract.
This raises some interesting questions. First, is this also true if a document is signed as ABC, Inc. by John Doe, President and the other signature line for the guarantor is left blank? What if a lower level officer, not the owner of the company, had signed the contract? Would that poor son of a gun be personally liable? Does this mean that signatories to contracts are also parties to the contracts, unless "party" is defined to exclude the signatories? (thus, references to "the parties agree/represent/warrant/ etc." now bind the individuals signing the contract?) And how does this ruling jive with Iowa Code 554.3402(2) which says:
2. If a representative signs the name of the representative to an
instrument and the signature is an authorized signature of the
represented person, the following rules apply:
a. If the form of the signature shows unambiguously that the
signature is made on behalf of the represented person who is
identified in the instrument, the representative is not liable on the
instrument.
Maybe this case is not so simple after all.
-Marc Ward
For me Series LLCs are an enigma. It is not clear to me why one would take on the uncertainty that Series LLCs face when you can accomplish just about the same thing with multiple LLCs owned by a holding LLC.
In this regard the SEC released on September 1, 2009 a staff opinion shooting down the use of a Series LLC with respect to a broker-dealer arrangement in which the Master Series LLC would have no assets but would create two series, one for retail operations and the other for institutional customers.
The Financial Industry Regulatory Authority (FINRA) asked the SEC to bless such an arrangement. Because the structure would run afoul of capital requirements and several financial disclosure regulations, the SEC rejected the idea. Rather than go into the details I'll attach the relatively brief letter here in a little while.
-Marc Ward
I just finished two days of LLC seminars in Des Moines and Cedar Rapids and will be appearing at the ISBA's Travelling Seminar in Sioux City on Tuesday, September 29. Mark your calendars for the Iowa Law School's Corporate Law Seminar on November 6. I'll be discussing the latest LLC developments at that seminar too.
-Marc Ward
The issue addressed by Ethics Opinion 09-03 is whether a law firm can represent a client in litigation arising out of a business transaction in which the firm also represented the client. The Opinion applies two tests for determining whether a lawyer can continue her representation of the client. The first concerns whether the representation will be materially limited by the personal interest of the lawyer to defend her own work product. The second test concerns whether the lawyer will be a necessary witness in the trial. The thrust of the opinion leans towards finding a conflict of interest in such cases.
Here is a link to the opinion: http://tinyurl.com/ksn65l.
-Marc Ward
Joe Kristan writes: "In a rare decision by the full court, the Tax Court yesterday ruled that single-member limited liability companies, which are ignored for income tax purposes under the "check-the-box" rules, are to be respected under the gift tax rules. This opens up the door to using single-member LLCs to obtain estate and gift tax valuation discounts."
Read more about this important case at Joe Kristan's Tax Blog:
http://www.rothcpa.com/taxupdates.php
The Iowa Court of Appeals addressed whether shareholders in a closely-held corporation, in this case a professional corporation of physicians, owed fiduciary duties to one another and whether the claims for breach of those duties could be brought directly rather than derivatively. On both points the Iowa Court of Appeals said no. McGinnis v. Iowa Clinic, P.C., 2009 WL 2424643 (Iowa App., August 6, 2009).
I know it seems early to be concerned with the 2010 Iowa Legislature, but there is a bill carried over from last year that the Bar Association and others have been told will certainly become law if something isn't done about it. And it is a bill that should not become law.
Why am I so concerned with SF 413? Because by creating a new Iowa Code Section 91A.15 it imposes personal liability on officers of corporations, members and managers of LLCs and partners in partnerships "for a judgment obtained against an employer for failure to pay wages dues pursuant to Iowa Code Chapters 91A or 91D (Wage Payment Collection and Minimum Wage, respectively). It is such a poorly written bill that it excludes corporate directors and shareholders, but includes LLC managers and members, the drafter apparently not realizing that they are practically interchangeable concepts. It is also unclear whether it applies to LLPs and LLLPs.
Subsection 2 of this proposed new 91A.15 attempts to soften the liability exposure of subsection 1 by limiting it to persons (a) who control, supervise or have authority over wages and (b) who have a controlling interest or ownership in the entity and knowingly violate 91A or 91D.
This is not as limiting as it might seem because none of the terms are defined. What is "control"? Is being a manager having "authority for"? What does it mean to "knowingly" violate?
If this law is passed you can kiss LLCs in Iowa good-bye. The Legislature will also make it very difficult for out-of-state businesses organized as LLCs to do business in this state. In other words, the preferred business entity, chosen by 77% of all new businesses in the State of Iowa, will be persona non grata. Don't let any legislator who votes for this bill try to tell you they are pro-business or an advocate of business development in Iowa because they are not.
I appreciate what the sponsors of this bill are trying to do, but there is a better way to do it: Codify the elements of piercing the corporate veil. Doing so will give clear guidance to owners and courts alike and see that people are punished for their conduct, not merely their ownership.
-Marc Ward
It is not often you run across a RUPA case and a rare find when it is a duty of loyalty case to boot. What makes In re Brobeck, Phleger & Harrison LLP, 2009 Bankr. LEXIS 2076 (July 2, 2009) particularly interesting is the RUPA provision in the case is nearly identical to the duty of loyalty provision found in the new Iowa LLC Act.
Brobeck, Phleger & Harrison LLP was a prominent law firm with over 900 attorneys. The law firm fell into economic trouble causing the partners to take steps to ensure an orderly dissolution and winding up of its affairs. Just prior to dissolution, the partners agreed upon a Final Partnership Agreement that addressed the "unfinished business rule" and the results of Jewel v. Boxer, 156 Cal. App. 3d 171 (1984).
The unfinished business rule says that unless the partners have agreed otherwise, they have a duty to account to the dissolved partnership and their former partners for the profits they earn on the dissolved firm's "unfinished business." Jewel added emphasis to the UBR by making it clear that the partners can and should agree in advance to waive their rights to unfinished business (a "Jewel Waiver").
This unfinished business agreement/Jewel Waiver waived any claims the firm would have against its partners or that the partners would have against each other to account for the profits from unfinished business at the time of the dissolution of the partnership. In other words, it guided what happens between partners qua partners and between partners and the partnership.
The court did not end its analysis with the UBR and Jewel Waiver, but went on to determine whether the modifications to the partnership agreement (i.e. identifying the activities that did not violate the duty of loyalty) were manifestly unreasonable.
When I first saw the reference to "manifestly unreasonable" I was hoping I had finally come across the definitive definition. No such luck. The judge noted that no cases defined the term and not even a dictionary had one, so he concluded he must rely on his own common sense. Great. The good news is he found the law firm's Jewel Waiver not to be manifestly unreasonable.
You would think the opinion would end at this point, but the UBR and Jewel Waiver only affected the partners and the partnership. There were other actors in this play, the creditors. The bankruptcy trustee, on behalf of these creditors, asserted that the Jewel Waiver was an actual or constructive fraudulent transfer.
As to actual fraud, the court found none in light of the fact that the California courts encouraged partners to enter into Jewel Waivers. Constructive fraud was another matter. The court found that the partnership received nothing of value in exchange for the unfinished business it gave up to the partners. The activities the partners listed as consideration for the unfinished business were either pre-existing duties or ethical obligations under the California Rules of Professional Conduct.
Accordingly, the transfer of the unfinished law firm business was effective among the partners, but because nothing of reasonably equivalent value was given up by the partners in exchange for the partnership giving up its property right in the unfinished business, that exchange was a fraudulent transfer, albeit a constructive one, and the creditors were entitled to judgment against the partners and their new law firms.
-Marc Ward
Two cases decided three weeks apart have made it very clear that LLC membership interests are not limited partnership interests under the passive activity loss rules of IRC Section 469. This determination is important because if an LLC interest is treated as a limited partnership interest the member would be limited in his or her ability to claim material participation in the business operations. Material participation is critical to ordinary loss treatment for tax purposes. Ordinary loss treatment is better than passive activity loss treatment because the latter can only offset passive activity income.
In Garnett v Commissioner, 2009 U.S. Tax Court LEXIS 18, 132 T.C. 19 (June 30, 2009) the Tax Court ruled that the LLP and LLC interests of the petitioners (it just so happens they entities in question were Iowa LLPs and LLCs) were entitled to be treated as general partnership interests and not subject to the special rule of IRC Section 469(h)(2). Instead, the seven factor test of Temp. Reg. Sec. 1.469-5T(a) would be used to determine whether the taxpayer materially participated in the business operations.
The Federal Court of Claims went further in Thompson v. US, No: 06-211 T (July 20, 2009). Garnett was unwilling to simply conclude that LLCs are not partnerships therefore LLC interests are not limited partnership interests. Instead, the opinion relies on the general partnership exception found in the regulations to hold an LLC interest to be a general partnership interest. Thompson shared no such reluctance. The IRS regulations say that "a partnership interest shall be treated as a limited partnership interest if...[t]he liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized." Treas. Reg. Sec. 1.469-5T(e)(3)(i)(B) (emphasis added by the court). The court was compelled to enforce the "plain meaning" of the regulation. An LLC is not a limited partnership. Therefore an LLC interest could not be a limited partnership interest. QED.
The Thompson opinion goes on for six more pages with a rather anticlimactic discussion about whether limited liability or participation in management was more important to the determination of limited partnership status. Didn't the court just conclude that it didn't matter?
-Marc Ward
Last Friday Steve Roy, Frank Carroll and I spoke to the Solo and Small Firm Seminar about the new LLC law. It is always good to hear from others in the profession about a subject that has a lot of open questions. Here are some pearls of wisdom from the panel:
1. Read the operating agreement. This gem is from Frank Carroll. He noted that he has run across a lot of lawyers including in-house counsel that will read a particular section of the act, such as the provision that calls for unanimous votes to amend the operating agreement, and assume that it is the new law in the Tall Corn State. Of course readers of this blog should know otherwise. The operating agreement will still control if it speaks to the issue. The statute is the default rule in the absence of words to the contrary in the operating agreement. Which leads me to the second pearl.
2. The default rules stink. Steve Roy delivered this line. And it is so true. Imagine an LLC that shares distributions on a per member basis regardless of the investment by the members, that requires the members to manage the company with each member having one vote on all matters that come before them, and requires unanimous consent to change the "operating agreement" that can be oral, written or implied. I am afraid there might be quite a few out there already and they don't even know it.
3. Read Section 110, read it and understand it. This section explains how the operating agreement interacts with the Act. Understanding section 110 is critical to drafting an operating agreement.
4. Try to get your clients to focus on their fiduciary duties. Because the duties of care and loyalty can be altered and in some cases eliminated, bringing this issue up early with your clients is of critical importance. It is also difficult in practice if you are dealing with neophytes. I've run into cases where the clients' eyes glaze over as you talk about their fiduciary duties and how they should consider addressing them up front. They just want to sign the papers and start making money (hopefully).
5. Clients need to deal with single member LLCs carefully. The casebooks, at least figuratively in this digital world, are full of cases of the veil being pierced when the LLC or corporation is owned by only one person. Dot the i's and cross the t's when organizing them and for God sake keep the money separated between the company and the owner.
-Marc Ward
It's just a hunch, but I am willing to bet the bank's lawyer in this case forgot to read the Illinois LLC Act, hence this opinion, In re Michael E. Lahood, 2009 Bankr. LEXIS 1832 (Bkrptcy. Ill. C.D. July 16, 2009).
Heartland Bank and Trust obtained a general lien on the personal property of the debtor. It didn't, however, obtain a charging order with respect to the debtor's distributional interest in an LLC. When it realized its mistake the bank tried a number of arguments to get its hands on the only asset with value in the debtor's estate.
First, it argued that the distributional interest in the LLC was subsumed in the general lien it had on the assets. That is, its broader more general lien included the LLC interest. The court said no, the legislature was very specific that the charging order was the exclusive remedy for an LLC distributional interest, the LLC interest was not a subpart of a general lien.
Then the bank argued that "exclusive" didn't really mean exclusive, but just one way to have a lien on an LLC distributional interest; its general lien was another (which sounds a lot like its first argument). Nope, said the court, if the bank didn't obtain a charging order it had nothing but air in terms of the LLC interest.
-Marc Ward
IRS Private Letter Ruling 200927014 (March 20,2009), presents an interesting fact pattern. The two individuals who own all of the shares of X, an S corporation, will each transfer their shares to two LLCs. They will manage their LLCs and retain all rights to profits, losses and distributions. But each of them will also transfer certain management rights to Y. It is not clear whether Y is an individual or an entity. These rights include the right to participate in management of the LLCs, the right to vote on their business activities, merger or sale of substantially all of their assets, borrow money, make distributions, liquidate the LLCs, amend their operating agreements, and transfer their interests to others. Y would also appoint new managers if the shareholders die while acting as managers. All of these actions would indirectly affect the S corporation. Y is not a member of either LLC.
The IRS held that the transfer of the S corporation's shares to the LLCs and the role of Y in the management of the LLCs would not cause the corporation to lose its S corporation status. For tax purposes Y is not considered a member of either LLC and each LLC will be treated as owned, respectively, by the two former shareholders of X. The shares of X are treated as owned directly by the two individuals. The LLCs will be disregarded entities for tax purposes.
It appears from the ruling that Y will participate in management but not have sole responsibility for management. It is not clear if Y has control, but the tenor of the ruling suggests that the outcome was not be dependent on control, but on the determination that for tax purposes membership status is based solely on the right to the economic interest in the LLC.
-Marc Ward
Our sagging economy is resulting in a lot of business foreclosures. This will mean a lot of litigation and quite a bit of new law. Tredit Tire & Wheel Co. Inc. v. Regency Conversions, LLC et al, 2009 US Dist. LEXIS 50323 (E. D. Mich, June 12, 2009) is one example.
Tredit Tire supplied specially designed and manufactured tires to Regency for the conversion vans it created. Regency was owned by TAG, its sole member. TAG defaulted on its loan from WB Automotive Holdings, Inc. ("WBAH"). WBAH foreclosed and became the owner of all of TAG's assets including its membership in Regency.
WBAH loaned Regency $1 million and replaced its president with its own employee. Its efforts to save Regency failed, however, and Regency ceased making payments to its vendors.
One of those vendors was Tredit Tire. It sued Regency and WBAH for breach of contract alleging that it was holding $350,000 of inventory made specifically for Regency and was owed $195,000 for tires already delivered to Regency. It sued WBAH on several theories including piercing the corporate veil.
The piercing claim was based on the fact that WBAH exercised control over Regency (replacing the president with its own employee) and made all of the tactical and strategic decisions for the company, including the decision to liquidate Regency and which vendors to pay and which to stiff.
WBAH contended that the Tredit Tire allegations were defeated by the successor liability doctrine which holds that a successor to another company's assets does not assume responsibility for its liabilities unless done so expressly or implicitly.
The court applied Michigan law which will pierce the corporate veil if (1) the subsidiary is a mere instrumentality of its parent, (2) the parent committed fraud or wrong, and (3) the plaintiff suffers an unjust loss.
The court concluded that the allegations, if proven, could show that Regency was a mere instrumentality of WBAH due to the control the parent asserted over its new subsidiary. It also held that breach of contract was a sufficient "wrong" to meet the second test. Finally, the third prong, an unjust loss, could be proven if the facts bear out plaintiff's contention that it was led to believe that its debts would be repaid by Regency once WBAH took over.
The defendant's contention that the successor liability doctrine should apply was turned aside by the court. It found that the allegations, if proven, would mean that the piercing the corporate veil doctrine tests were met and liability could be imposed on WBAH. In effect, the court said that the piercing doctrine trumps the successor liability doctrine.
This is dangerous ground for creditors. If a creditor takes over 100% ownership of a debtor's subsidiary, who else is to make the tactical and strategic decisions for the subsidiary but its only owner? A lot of the focus of this case suggests that installing its own employee as president of Regency was a mistake. An outsider might have been a better choice. But what if the outsider doesn't do what the sole owner expects? Will replacing him or her also result in liability? Scary stuff.
-Marc Ward
Forgive me for being cynical, but in the case that follows it seems to me that price was the issue, not timely performance.
In High Development Corp. v. Star of the West Company, 2009 Iowa App. LEXIS 561 (June 17, 2009) the Iowa Court of Appeals held that "time is of the essence" provisions in real estate contracts must be read literally and restrictively. High Development agreed to buy from Star of the West property located at 1101 Old Marion Road in Cedar Rapids. The closing was scheduled for August 30. High Development was not able to close on the 30th, but did tender payment the following day. Star of the West refused to close on the 31st and kept the $5,000 down payment. Within two weeks it had entered into another contract to sell the property to someone else.
High Development sued for specific performance and attorney fees. The real estate contract provided that if the buyer failed to perform the seller may forfeit the contract under Iowa Code Chapter 656 or proceed by an action at law or equity. Star of the West did neither.
The trial court concluded that the forfeiture clause in the contract was controlling and the sole remedy of the seller. Because the buyer tendered the consideration the next day the ability of the seller to forfeit the contract was cut off. The lower court granted the request for specific performance and awarded attorney fees to the buyer. The court of appeals reversed.
The appellate court first concluded that Iowa Code Section 656.1 does not mean what it says when it states that the buyer's rights under a real estate contract if it fails to perform shall "not be forfeited or canceled except as provided in this chapter." Statutory forfeiture is not the only remedy available to the seller. The court interpreted Chapter 656 to apply to real estate installment contracts where the buyer has an equitable interest in the property as a result of having made several installment payments. In the case of a "one-time closing," according to the court of appeals, Chapter 656 is just one of several remedies available to a seller notwithstanding the language of 656.1. The court fails to explain the difference between several installment payments and one down payment.
In support of this conclusion the appellate court cites just one Iowa Supreme Court case. However, in Passehl Estate v. Passehl, 712 NW 2d 408, 414 (Iowa 2006) the supreme court referred to Chapter 656 as "irrelevant" to the case and in the related footnote said the forfeiture provision "is inapplicable because the arguments in this case do not center on this provision and do not call for a forfeiture of the subject property." To cite this case as authority for the proposition that statutory real estate foreclosure is just one of several remedies available to a seller in the event the buyer fails to perform is just simply wrong.
After interpreting one provision of the contract and the related Iowa Code provision loosely, the court of appeals shifts gears and interprets "time is of the essence" strictly and narrowly. The closing date was August 30. Period. If buyer missed the date by even a day, which it did, the contract was breached because time was of the essence. Recall that payment was tendered the very next day. Seller refused and a couple of weeks later sold to someone else. If time really was "of the essence" wouldn't seller have taken the money the very next day? Or did it get wind of a better offer and was happy to "forfeit" the contract on a technical breach? "Essence" according to my well-worn American Heritage dictionary means "the intrinsic or indispensable properties that identify something." Subsequent events seem to prove that time was neither intrinsic nor indispensable to this deal.
The trial court should have been affirmed.
-Marc Ward
In a case more interesting for its facts than the law, the US District Court for the Middle District of Alabama recently considered whether the attorney-client privilege extended to an independent contractor of the client. Hope for Families v. Warren, 2009 US Dist. LEXIS 46009 (April 21, 2009). It's a good refresher and relies particularly on an Eight Circuit case for its ruling. In re Bieter Co., 16 F.3d 929 (8th Cir. 1994). The general answer is yes it can.
Now for the facts. The independent contractor was a former state senator and lieutenant governor hired by a bingo parlor to (1) secure a document signed by the county sheriff authorizing Lukcy Palace to operate a bingo parlor (2) find an opponent to run against the sheriff and (3) run the campaign. Apparently the lawsuit involved claims that the sheriff was conspiring with others to create a bingo monopoly in the county. Think big Macon. Sheriff Warren was re-elected.
-Marc Ward
... and so is a deal. That old saw was taught to me by a client years ago. I haven't forgotten it, but sometimes businesspersons do. If you ever have a client that feels he or she has been slighted by another party when the apparent "gentlemen's agreement" turns to nothing does your client have legal recourse? In Iowa, maybe not. But in Maryland, yes.
Take the case of Giant Food, Inc. v. Ice King,Inc., 536 A. 2d 1182 (Md. App. 1988). The court held that despite the lack of a contract between the parties Ice King could recover damages for negligent misrepresentation by Giant Food. For several months Ice King and Giant Food discussed the possibility of Ice King supplying ice to Giant Food. All along, unbeknownst to Ice King, Giant Food was planning to build its own ice plant. Ice Food believed it had a commitment to supply ice based on 30 or 40 communications between the parties, including authorization by Giant for Ice King to inform its bank of their "deal."
The court concluded that in light of the more than casual response of Giant Food "a businessman in [the Ice King representative's] shoes might have reasonably relied on the informal 'deal or gentlemen's agreement.'" In fact, Ice King had "the right to rely upon Giant, and Giant owed a duty to give the correct information." When Ice King learned about the possibility of a new Giant ice plant and attempted to learn the truth the court held that it was incumbent on Giant to provide the "true facts." When instead the Giant representative said "everything was all right" the assurance "was, at the very minimum, negligent."
So the next time a client believes he had a deal and was double-crossed, remember this case and supporting cases from New York and Prosser and Keeton on the Law of Torts, Section 107 (1984) and the Restatement (Second) of Torts, Section 552 (1977).*
-Marc Ward
*The research of Allison Miller, a second year law student at the University of Iowa and Dickinson summer associate, is the source of this case and analysis.
In Bushi v. Sage Healthcare PLLC, 203 P. 3rd 694 (Idaho 2009), the Idaho Supreme Court held that members of Idaho LLCs owe one another fiduciary duties. The court reached this conclusion even though the applicable Idaho LLC Act was silent on the issue (like Iowa, Idaho is transitioning from an original LLC statute to a new one, the latter providing that members do owe each other the fiduciary duties of care and loyalty).
These fiduciary duties can be breached even if the members act within the letter of the operating agreement. In Bushi, the majority of the members, all save Bushi himself, amended the operating agreement to allow a member to be dissociated by majority vote and then promptly removed Bushi by a similar vote. They contended that they had good reason to dissociate him because he was dating an employee and had used a company line of credit to pay personal expenses. Bushi argued that he was dissociated in order to advance their personal financial interests. Because taking an action that improperly advances their financial interests can be a breach of a fiduciary duty even if technically allowed by the operating agreement, the court concluded that a material factual issue remained that negated the entry of summary judgment.
The case also mentions a provision in the operating agreement that lawyers should consider inserting into their forms. The operating agreement stated that "no Member shall have any vested rights in the [operating agreement] which may be modified through an amendment to the [operating agreement]." This provision negated Bushi's assertion that he was denied the benefits of the original operating agreement. In its original form the operating agreement did not permit the members to essentially expel another member.
-Marc Ward
In a relatively novel approach, defendants in a bankruptcy proceeding asserted reverse piercing as a defense to a claim of fraudulent conveyance brought by the bankruptcy trustee. The trustee was attempting to cause a third-party to pay $450,000 to the estate. In re Freelander Capital Management Corp., 2009 Bankr. LEXIS 1195 (US Bkrptcy. Ct., SD Fla, April 29, 2009).
The relevant facts are these. On March 14, 2001 the debtor corporation loaned Designs, Inc. $500,000. The debtor corporation was wholly-owned by Burton Freelander. The sole shareholder of Designs was the debtor's second ex-wife. On April 11, 2001 the ex-wife withdrew $500,000 from a Designs account and deposited the money in a joint account owned by Burton and this ex-wife. A short time later Burton transferred $50,000 to the debtor's account. In a nice twist, Burton used $375,000 of the money to pay off a judgment involving his first ex-wife. All parties agreed that the second ex-wife thought the loan was from Burton and repaid to Burton.
The debtor filed Chapter 7 bankruptcy in 2003. All involved agree that the second ex-wife never withdrew funds from the joint account, never deposited any more funds into the account, and believed the payment of the $500,000 was a repayment of the loan. Nevertheless, the trustee asserted that the payment was a fraudulent conveyance and the second ex owed $450,000 to the debtor corporation.
The defendants, the second ex-wife and her corporation, Designs, Inc., asserted the doctrine of reverse veil piercing as their defense, claiming that the payment to the individual joint account was payment to the debtor corporation. The bankruptcy court agreed.
Applying Connecticut law because the debtor was a Connecticut corporation, the court found that there was such a unity of interest between Burton and the debtor and dominance by Burton over the corporation that the independence of the corporation had ceased to exist. The court further found that applying the doctrine of reverse piercing would achieve an equitable result and avoid unfair prejudice to the second ex-wife. The point being that she had already made the payment, she would not be retaining anything of value, and the loss to the creditors (who had already received restitution or had weak claims) was outweighed by the hardship to her if she had to make a second payment of $450,000.
Key to the court's decision, it appears, is the fact that the trustee had little use for the money given the status of the creditors' claims. Had there been substantial creditors with strong claims for the funds, the equities of the case might have caused a different result.
This as another example of the willingness of the courts to ignore the corporate form when it suits the equities of the situation. Is that what the law is supposed to be about?
- Marc Ward
As you all know, loan agreements include financial and non-financial covenants imposed on the borrower. Failure to maintain a covenant leads to an event of default. A financial covenant might be maintaining a certain debt-to-equity ratio. A non-financial covenant might be preventing a change in control of the board of directors. Changing the make-up of a board of directors, is of course, the right of the shareholders. When a board of directors agrees that such a change could trigger a default under a loan it may be impermissibly intruding on the shareholders' franchise.
Here is what Vice Chancellor Lamb had to say on the subject in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., 2009 WL 1337150 (May 12, 2009):
“This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. In the context of the negotiations of a debt instrument, this is particularly troubling, for two reasons. First, as a matter of course, there are few events which have the potential to be more catastrophic for a corporation than the triggering of an event of default under one of its debt agreements. Second, the board, when negotiating with rights that belong first and foremost to stockholders (i.e., the stockholder franchise), must be especially solicitous to its duties both to the corporation and to its stockholders. This is never more true than when negotiating with debtholders, whose interests at times may be directly adverse to those of the stockholders. Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.”
The case is on appeal.
-Marc Ward
An opinion last week issued by the US District Court for the Northern District of Illinois provides a nice primer on claims that can be brought against directors, in this case directors of a wholly-owned subsidiary. Seidel v. Byron, et al, 2009 US Dist LEXIS 40712 (May 12, 2009).
Seidel, the bankruptcy trustee for Mosaic Data Solutions brought an action against the former directors and officers of the debtor for breach of fiduciary duty and similar claims. The trustee alleged that improper management of the company by the directors and officers led to its insolvency. Specifically, he claimed that pledging the assets of Mosaic Data for no consideration so that its parent corporation could obtain financing in its bankruptcy was a breach of their fiduciary duty.
This is what you will glean from the case:
1. Wholly-owned subsidiaries under Delaware law are expected to operate for the benefit of their parent corporations unless the subsidiary is insolvent.
2. Under the trust fund doctrine directors of insolvent corporations are liable for the debts of the corporation when they breach their fiduciary duties by improperly distributing the corporate assets.
3. Corporate creditors cannot file direct actions against directors for breach of fiduciary duties but may bring derivative actions against the directors of insolvent corporations for the breach of such duties (the beneficiary of a derivative action is the corporation).
4. A motion to dismiss pursuant to the business judgment rule can be overcome if the pleading establishes a "reasonable doubt" about whether the actions of the directors are protected by the BJR. As you may recall, the business judgment rule protects the actions of a board unless it is proven that the board breached its duty of loyalty, the duty of good faith or the duty of care. That is, "if directors act loyally and carefully, they are not liable even if the transaction goes awry." (quoting Alliant Energy Corp. v. Bie, 277 F. 3d 916, 918 (7th Cir. 2002))
-Marc Ward
The Missouri courts have developed a nice formulation for applying the piercing the veil to corporations and LLCs. It's a three-part test: (1) A showing of control, complete domination of not only finances, policy and business practices (the alter ego test); (2) a breach of the duty of the controlling party not to use such control to perpetrate a statute or commit a dishonest and unjust act; and (3) the breach was the proximate cause of the plaintiff's injury or unjust loss. See Carpenters' District Council of Greater St. Louis v. J&J Contractors, LLC, 2009 US Dist LEXIS 36607 (April 29, 2009) quoting Mobius Management Systems, Inc. v. West Physician Search, LLC 175 SW 3d 186, 188-89 (Mo. Ct. App. 2005).
Unfortunately, there is a reference in the Mobius quote to undercapitalization that suggests undercapitalization at the time of the wrong doing may be a breach of this duty. Such a holding would upset the concept of limited liability.
Although the court doesn't identify it as such, a good example of the application of this formulation to the parent-subsidiary relationship from another jurisdiction can be found in Transition Healthcare Associates, LLC v. Tri-State Health Investors, LLC, 2009 US App. LEXIS 636 (6th Cir. January 9, 2009).
-Marc Ward
In Terminal Properties, Inc. v. Hampton Propane Terminal, L.C., 2009 Iowa App. LEXIS 231 (March 26, 2009) the Court of Appeals applied the Business Judgment Rule to LLCs formed under Iowa Code Chapter 490A. The BJR protects corporate boards of directors from liability for their actions if they are disinterested, informed and there is a rationale basis for the actions. It is not applicable to partnerships. There probably wasn't much doubt that the rule applied to LLCs in light of the many similarities between the entities (limited liability, often centralized management, perpetual existence) but this case removes all doubt.
This is not important news to 489 LLCs because the BJR was codified in Iowa Code Chapter 489.409(7).
By the way, the trial court used a delightful phrase one will only find in Iowa when he likened the plaintiff's claims of conflict of interest to a "frog calling a garter snake green." I believe that is the English translation of pari delicto.
-Marc Ward
Why do so many people including the IRS and now the U S Supreme Court continually refer to unincorporated LLCs as "limited liability corporations"? To wit:
" As a part of the scheme, respondents invested in various stock warrants through newly created limited liability corporations (LLCs), which are also respondents in this case."
-Justice Scalia, Arthur Anderson LLP v. Carlisle, 2009 US LEXIS 3463 (May 4, 2009)
There is clearly a flaw in the Harvard Law School curriculum.
As you may know, Iowa Code 489.409(2) identifies three duties that constitute the duty of loyalty. It is not an exhaustive list so there may be more, but for now let's leave it at three. Section 489.110(4) says that so long as it is not "manifestly unreasonable" the duty of loyalty can be eliminated in an operating agreement. I discussed somewhat tongue in cheek what that means a few months ago.
In a seeming contradiction, Section 489.110(7) prohibits an operating agreement from eliminating a manager's liability for monetary damages for the breach of the duty of loyalty. But it is no contradiction at all because 110(4) deals with what constitutes a breach of the duty of loyalty and 110(7) concerns the consequences for breaching that which has been defined as a breach of the duty.
When is it "reasonable" to eliminate the duty of loyalty? Although it is a Delaware corporate law case and not directly on point for LLCs, Sutherland v. Sutherland, 2009 Del. Chancery 46 (March 23, 2009) is instructive. Sutherland involved a family corporation, a sister sued her two brothers and a cousin who were directors of the family corporation for using corporate funds for personal benefit. ( I once represented two brothers in defense of breach of duty claims brought by their mother and sister, a very awkward role to play, but I digress).
The directors sought dismissal of the claims because the certificate of incorporation contained a clause they claimed eliminated the duty of loyalty in toto for the directors. The court rejected that argument because it would "effectively eviscerate the duty of loyalty for corporate directors as it is generally understood under Delaware law." The court then cited a Delaware corporate law provision very similar to 489.110(7). But as I said, this type of provision is concerned with the consequences of a breach, not what constitutes a breach.
But the broader point is this, a blanket elimination of the duty of loyalty didn't work in the context of a Delaware corporation and probably won't work with an Iowa LLC even when that possibility hangs tantalizingly within the framework of 489.110(4). So don't use a meat cleaver when a scalpel is more effective. Precise exclusions from the duty of loyalty are more likely to be upheld.
-Marc Ward
If you read the transition provisions of Iowa Code 489.1304 regarding the move from 490A (it still applies to LLCs formed before January 1, 2009 until January 1, 2011) to 489 you will not see the word "foreign."
So let's say you have a client that is a foreign LLC. It was formed in its home state several years ago and wants to come into the state for the first time. It asks if it is required to register to do business in this state.
Do you consult 490A or 489? It matters because the rules for registering foreign LLCs are different under the two statutes. For example, owning real property "without more" does not require registration under 490A but owning "income-producing" real property does under 489.
Iowa Code 489.1304 is of no help on its face, but I think it is reasonable to conclude that foreign LLCs coming into this state for the first time in 2009 and 2010 should be treated like newly formed domestic LLCs and 489 should apply. Foreign LLCs that were in the state before 2009 should be able to continue to rely on 490A until January 1, 2011.
Of course on January 1, 2011, 490A disappears and a lot of foreign LLCs will be required to register with the state. An obligation that will probably be honored in the breach.
-Marc Ward
In Mickman v. Am. Int'l Processing, LLC, 2009 Del. LEXIS 43 (April 1, 2009) the Delaware Chancery Court drew this conclusion in a comparison to corporations: "Based on the flexible and less formal nature of LLCs, it is reasonable to consider evidence beyond the four corners of the operating agreement, where, as here, the plaintiff has presented admissible evidence that, notwithstanding the language of the operating agreement, suggests the parties to that agreement intended to make, and believed they had made, the plaintiff a member of the LLC."
At first blush I thought an integration/merger clause in the operating agreement would solve this or a provision requiring all amendments to be in writing. The opinion is silent as to whether the operating agreement in this case contained such provisions. But I am not so sure. Then I remembered something from law school called the parol evidence rule and thought that should clear things up. Nope.
In Iowa the parol evidence rule "forbids the use of extrinsic evidence to vary, add to, or subtract from a written agreement." Montgomery Props. Corp. v. Econ. Forms Corp, 305 NW 2d 470, 476 (Iowa 1981). But this is limited to negotiations or agreements that are prior to or contemporaneous with the written instrument. Garland v. Brandstad, 648 NW 2d 65, 69 (Iowa 2002).
In this case you have an operating agreement that presumably identified two persons as the members of an LLC and extrinsic evidence after the fact (i.e. a tax return) showing three.
I take exception with the Chancery Court that LLCs are less formal than corporations, less rigid, yes, and certainly more flexible, but in any case no less entitled to application of the same contract rules as apply to corporations.
The reason the Iowa LLC Committee adopted 489.111(4) (there is no comparable provision in the Uniform Act) was to avoid this situation. Section 111(4) says "An operating agreement in a signed record that excludes modification or rescission except by a signed record cannot be otherwise modified or rescinded."
Is this court saying that such a limitation can be ignored because LLCs are informal organizations and members don't mean what they say in a contract? I hope not. It does reinforce in my mind the absolute necessity of restricting amendments to those that are in writing and agreed to by (usually) all of the members.
-Marc Ward
In Lyondell Chemical Company v. Ryan, 2009 Del. LEXIS 152 (March 25, 2009) the Delaware Supreme Court clarified what it means for directors to breach their duty of loyalty by failing to act in good faith. Recent decisions on this issue include In re Walt Disney Co. Deriv. Litig., 906 A.2d 27 (Del. 2006) and Stone v. Ritter, 911 A2d 362 (Del. 2006).
Lyondell concerns the sale of the company, at the time the third largest independent publicly traded chemical company in North America, to Basell AF, a private Luxembourg company. Basell first made an overture to the Lyondell in April 2006; an overture that was rebuffed by the Lyondell CEO out of hand. About a year later, in May 2007, Basell made a 13D filing with the SEC indicating its interest in acquiring Lyondell.
The Lyondell board immediately held a meeting to discuss the 13D filing and decided that although the company appeared to be "in play" to adopt a "wait and see" approach. Two months went by with the Lyondell board doing nothing further regarding the company's potential sale.
On July 9, 2007 discussions between the two CEOs heated up resulting in an offer of $48 per share, no financing contingency, a $400 million break up fee and a requirement to sign a merger agreement by July 16.
On July 10 and 11 the Lyondell board met twice for no more than an hour each time to review the proposal, the possibility that others might be interested in buying the company, and to retain a financial advisor.
On July 12 the board met again to instruct the CEO to seek a higher price, a go-shop clause, and a reduction in the break-up fee. These negotiations resulted in only the break-up fee being reduced to $385 million.
On July 16 the board met again, this time to review the financial advisor's opinion that the $48 per share offer was fair as well as its belief that no other entities would top this offer. The board approved the merger and recommended it to the shareholders.
Because Lyondell's charter contained a section 102(b)(7) exculpatory provision protecting the directors from personal liability for breaches of the duty of care, the plaintiff alleged a breach of the duty of loyalty. Since the board was found to be independent and not motivated by self-interest or ill will, the breach of the duty of loyalty claim was further narrowed to whether the directors failed to act in good faith. The Chancery Court concluded they had. The Supreme Court reversed.
Applying Walt Disney and Stone, the question, according to the Supreme Court, was whether the board's actions were an "intentional dereliction of duty, a conscious disregard for one's responsibilities" (quoting Walt Disney). Under this standard the court could only impose liability if there is "a showing that the directors knew that they were not discharging their fiduciary obligations" (quoting Stone).
The Delaware Supreme Court also noted that the Chancery Court misapplied Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A2d 173 (Del. 1986). It did this by applying the Revlon duties (maximize shareholder value) before the board had decided to sell the company or the sale had become inevitable. Further, the Chancery Court wrongly concluded that Revlon imposed a set of requirements on a board that must be met during the sale process. And third, the court had wrongly concluded that failure to meet the Revlon standard was the equivalent of "a knowing disregard of one's duties that constitutes bad faith." (It is a breach of the duty of care.)
The Chancery Court had determinedthat the inaction of the Lyondell board between May and July was the key to the finding of a breach of the duty of loyalty. The Supreme Court disagreed. The Revlon duties to find the best price do not kick in when a company is "in play" but when a sale becomes inevitable. In this case, the Revlon duties did not begin until July 10. The Supreme Court noted that it was possible that the Revlon duties might not have been met since the board did not conduct an auction or a market check to get the best price, but these were due care considerations when the only legal issue was whether the board failed to act in good faith.
The Supreme Court found a "vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties." It takes "an extreme set of facts" to make a claim of disloyalty stick. In this case the failure of the directors to do all they should have done might be a breach of the duty of care, but they would have had to "knowingly and completely failed to undertake their responsibilities" in order to have breached their duty of loyalty.
This case is a very important explanation of Walt Disney and Stone (as well as In re Lear Corp Shareholder Litig., 2008 LEXIS 121). It seems the Court realized it had not been clear enough or had left the impression in those earlier cases that the standard for finding a breach of the duty of loyalty for failure to act in good faith was not as high as it clearly is in Lyondell.
-Marc Ward