LLC Law Monitor

Delaware Seminar on Corporate and LLC Law Updates via Blogs

Doug Batey — Thu, 10 May 2012 09:29:44 -0800

I will be speaking at a continuing legal education seminar for the Delaware State Bar Association later this month, on May 22, 2012, in Wilmington, Delaware. The DSBA’s Corporation Law Section will be presenting its annual seminar, Recent Developments in Delaware Corporate and Alternative Entity Law, and I’ll be one of four speakers on a panel discussion about Corporate Law Updates via Blogs.

Francis Pileggi, of the Delaware Corporate & Commercial Litigation Blog, will be our panel moderator. The other panel members are Kevin LaCroix of The D&O Diary; Professor Christine Hurt, The Conglomerate; and Professor Brian Quinn, The M&A Law Prof. For the logistics of the Seminar, see Francis Pileggi’s summary, here.

Francis has given our panel latitude to discuss the process of blogging about corporate law developments, as well as what we have gleaned about corporate and LLC law from our blogging. From my perspective this seminar is a timely opportunity to look back and review the lessons from blogging about LLC law, since this month marks the third anniversary of LLCLawMonitor.com. I’m looking forward to a lively face-to-face discussion with bloggers that I regularly read but have never met in person.

Kansas Authorizes Series LLCs

Doug Batey — Tue, 08 May 2012 15:21:02 -0800

Kansas recently became the latest state to authorize series limited liability companies. Governor Sam Brownback signed Substitute House Bill 2207 on March 29, 2012, amending the Kansas Limited Liability Company Act to authorize series LLCs. Sub. H.R. 2207. The bill will become law on July 1, 2012, and Kansas will then join the eight other states that have authorized series LLCs.

Series LLCs. A series LLC can partition its assets and members into one or more separate series, each of which can have designated members and managers, and can own its own assets separately from the assets of the LLC or any other series. The liabilities of each series will be enforceable only against the assets of that series, and each series can enter into contracts, sue, and be sued in its own name.

Multiple series within one LLC can be used to avoid some of the inefficiencies and costs involved with using multiple LLCs. For example, separate parcels of real estate could each be owned by a separate series, but all within one LLC. Or, the divisions of a business could be held within one LLC, but with each division in a separate series.

Other States. Delaware was the first state to authorize series LLCs, in 1996. Del. Code Ann. tit. 6, § 18-215. Since then Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah have enacted statutes similar to Delaware’s, although there are some differences. I previously wrote about series LLCs when Texas passed its series LLC law in 2009, here, and when the Internal Revenue Service proposed regulations for series LLCs, here.

Kansas Requirements. The Kansas statute is similar in many respects to the Delaware Act. Both authorize an LLC’s operating agreement to establish one or more designated series, and both provide that the liabilities of a series are enforceable only against the assets of the series and not against the LLC generally (and vice versa), if

the records of the series account for its assets separately from the assets of any other series or the LLC generally,
the operating agreement states the liability limitations, and
the certificate of formation, and in the case of a Kansas LLC, the articles of organization, give notice of the limitations on liability.

Series LLCs are relatively new. There are few reported opinions dealing with series LLCs, and the IRS’s proposed regulations have not yet been finalized. There are therefore many unresolved legal questions about series LLC issues such as taxation, bankruptcy, liability limitations, and piercing the veil, particularly when doing business in states outside the state of formation. Caution is advised when implementing a series LLC, given the uncertainty and lack of predictability inherent in their use.

Oregon Workers' Compensation Law Does Not Shield Employer LLC's Managing Member from Negligence Claim by Injured Worker

Doug Batey — Tue, 01 May 2012 19:49:31 -0800

The Oregon Court of Appeals recently held that the exclusive remedy provision of Oregon’s workers’ compensation law does not shield an employer LLC’s managing member from a negligence claim by the LLC’s injured worker. Cortez v. NACCO Materials Handling Grp., Inc., No. A144045; 050302632, 2012 WL 758895 (Or. App. Feb. 29, 2012).

Background. Workers’ compensation insurance provides reasonably quick and sure payments to workers injured on the job, regardless of whether or not the employer is negligent. Payments cover medical expenses and disability, but the tradeoff for not requiring the employee to prove negligence is that the amounts are fixed and limited. Workers’ compensation statutes normally provide that the worker’s claim under the statute is the worker’s exclusive remedy against the employer, other employees, and the officers and directors of the employer.

The Case. In Cortez the plaintiff was injured while employed by Sun Studs, LLC, an Oregon limited liability company. Later he filed for and obtained workers’ compensation benefits from Sun Studs’ insurer. He then sued Sun Studs’ sole member, Swanson Group, Inc., for (a) negligence, (b) violations of Oregon’s Employer Liability Law (ELL), Or. Rev. Stat. § 654.305 to 654.336, and (c) noncompliance with the workers’ compensation statute, Or. Rev. Stat. § 656.017. Sun Studs was member-managed and Swanson Group was therefore its sole managing member.

The plaintiff conceded at trial that he could not prove noncompliance with the workers’ compensation statute, and the trial court dismissed his negligence and ELL claims based on the exclusive remedy provision of Oregon’s workers’ compensation statute.

The question before the Court of Appeals was therefore whether the exclusive remedy language in Oregon’s workers’ compensation statute protected the LLC’s managing member from the plaintiff’s negligence and ELL claims. The statute says:

The exemption from liability given an employer under this section is also extended to the employer’s insurer, the self-insured employer’s claims administrator, the Department of Consumer and Business Services, and the contracted agents, employees, officers and directors of the employer, the employer’s insurer, the self-insured employer’s claims administrator and the department ….

Or. Rev. Stat. § 656.018(3) (emphasis added). The court phrased the issue as “whether the legislature intended to include ‘members’ of limited liability companies among those exempt from liability under the exclusive remedy provisions of ORS 656.018.” Cortez, 2012 WL 758895, at *2.

The Court’s Analysis. The court first noted that an LLC is a legal entity distinct from its members, so that even if the exclusive remedy provision applies to an LLC as an employer, it does not necessarily apply to the LLC’s members. Id. at *3. The court then pointed out that when the legislature enacted Oregon’s LLC Act, it included a provision that extended the coverage of certain other statutes to LLC members and managers: “Whenever a section of Oregon Revised Statutes applies to both ‘partners’ and ‘directors’, the section shall also apply: … [i]n a limited liability company without managers, to the members of the limited liability company.” Id. at *4 (quoting Or. Rev. Stat. § 63.002). The list of entities and persons in the exclusive remedy statute includes directors but not partners, so § 63.002 was nonapplicable. The court saw that omission as further evidence that the legislature had not intended to exempt LLC members from liability under § 656.018(3).

The court also reasoned by analogy to corporate shareholders, citing Fields v. Jantec, Inc., 317 Or. 432, 857 P.2d 95 (1993). “Thus, a shareholder, as an owner of a corporation, does not fall under the protection of the exclusive remedy provision in ORS 656.018(3). By analogy, a member, as an owner of an LLC, also does not fall under the protection of the exclusive remedy provision in ORS 656.018(3).” Cortez, at *4.The court did not discuss the fact that Swanson Group, the LLC’s managing member, was both a member and a manager, much like the sole shareholder in Fields who was also an officer and director.

The defendant also claimed that it was not liable because of § 63.165 of the LLC Act, which states that “[a] member or manager is not personally liable for a debt, obligation or liability of the limited liability company solely by reason of being or acting as a member or manager.” The court pointed out that § 63.165 does not shield an LLC member from its own tortious conduct. Cortez, at *5.

The court’s final conclusion was that neither the exclusive remedy provision of the workers’ compensation statute, § 656.018(3), nor the liability limitation of the LLC Act, § 63.165, shielded Swanson Group from the plaintiff’s negligence claim. The court dismissed the plaintiff’s ELL claim on other grounds, and remanded the case to the trial court to resolve the plaintiff’s negligence claim.

Comment. The court began its analysis by mistakenly framing the issue as “whether the legislature intended to include ‘members’ of limited liability companies among those exempt from liability under the exclusive remedy provisions” of the statute. Cortez, at *2. This characterization oversimplifies by ignoring the distinction between members of a member-managed LLC and members of a manager-managed LLC. The former are both owners and active managers of the LLC. The latter are only owners.

Oregon’s LLC Act defines a manager-managed LLC as an LLC that is designated as a manager-managed LLC in its articles of organization or whose articles of organization otherwise expressly provide that the LLC will be managed by a manager or managers. Or. Rev. Stat. § 63.001.

A member-managed LLC, on the other hand, is defined simply as an LLC other than a manager-managed LLC. Id. Swanson Group was the sole member of a member-managed LLC. Cortez, 2012 WL 758895 at *1.

Members of a member-managed Oregon LLC are “managers” under the LLC Act and have full rights to control the management and conduct of the LLC. Or. Rev. Stat. § 63.130(1)(a), 63.130(7). More significantly, a member of a member-managed LLC is an agent of the LLC and the act of such a member on behalf of the LLC binds the LLC.

Conversely, members of a manager-managed LLC have no right to participate in the management and control of the LLC and are not agents of the LLC. (The rights of members in the two types of LLCs are subject to modification in the articles of organization or operating agreement, but the court in Cortez did not refer to any such provisions of either.)

Thus, members of a member-managed LLC act as agents and representatives of the LLC when they manage it and conduct its business and affairs. And it is representatives of the employer that the key language in the exclusive remedy focuses on: “the contracted agents, employees, officers and directors of the employer.” Or. Rev. Stat. § 656.018(3).

It seems clear that an LLC’s manager is the type of representative that § 656.018(3) is intended to cover. But as the Cortez court pointed out, courts must neither insert in the statute what has been omitted nor omit what has been inserted. Cortez, at *2. The court seems to have ignored, however, the reference in the statute to agents. The LLC Act defines each member of a member-managed LLC as an agent of the LLC, so under a proper understanding of Swanson Group’s status as the sole managing member of the LLC, it should have been shielded from the plaintiff’s negligence claim.

Ohio Tightens Up Its LLC Charging Order Statute

Doug Batey — Thu, 19 Apr 2012 12:54:23 -0800

Ohio has amended the charging order provisions of its Limited Liability Company Act to clarify that a charging order is the exclusive remedy of a judgment creditor against an LLC member. Governor Kasich signed Substitute House Bill 48 on February 2, 2012, and the bill becomes law on May 4, 2012.

The Ohio statute gives a judgment creditor of an LLC member the right to obtain a charging order against the member’s LLC interest. A charging order means that any LLC distributions that would otherwise go to the member must instead be paid to the judgment creditor. The creditor is treated like an assignee until the debt is satisfied, has no management rights, and cannot force the LLC to make any distributions. Most states have a charging order provision in their LLC Acts.

Ohio’s current statute is unclear whether a judgment creditor of an LLC member can also use other creditors’ remedies, such as foreclosing on the member’s interest. This lack of clarity is not uncommon. A number of states use language in their Acts such as “the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment.” E.g., Wash. Rev. Code § 25.15.255; N.Y. Ltd. Liab. Co. Law § 607. This sort of language clearly authorizes the charging-order remedy, but does not address the potential applicability of other remedies.

Ohio’s amendment makes clear that a judgment creditor’s charging order remedy is its exclusive remedy against the member-judgment debtor. The new language is italicized and bolded:

1705.19 [Effective 5/4/2012] Rights of judgment creditor

(A) If any judgment creditor of a member of a limited liability company applies to a court of common pleas to charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interest, the court may so charge the membership interest. To the extent the membership interest is so charged, the judgment creditor has only the rights of an assignee of the membership interest as set forth in section 1705.18 of the Revised Code. Nothing in this chapter deprives a member of the member’s statutory exemption.

(B) An order charging the membership interest of a member of a limited liability company is the sole and exclusive remedy that a judgment creditor may seek to satisfy a judgment against the membership interest of a member or a member’s assignee.

(C) No creditor of a member of a limited liability company or a member’s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.

(D) A limited liability company or one or more members of a limited liability company who are not subject to a charging order entered in favor of a judgment creditor may at any time pay to the judgment creditor the full amount then still due under the judgment and by that payment succeed to the rights of that judgment creditor.

Substitute H. R. 48, 129th Gen. Assemb., Reg. Sess. § 1 (Ohio 2012).

The amendment also clarifies that judgment creditors of an LLC member have no right to reach the assets of the LLC itself, although that should already have been clear from the entity nature of an Ohio LLC. See Ohio Rev. Code § 1705.03.

Presumably the amendment will be interpreted to apply to single-member LLCs, although some state court decisions have reflected a negative view of the asset-protection feature of single-member LLCs. E.g., Meyer v. Christie, No. 07-2230-CM, 2011 WL 4857905 (D. Kan. 2011); Olmstead v. FTC, 44 So. 3d 76 (Fla. 2010). I have discussed those cases, here (Meyer) and here (Olmstead). The amendment’s language appears to be applicable to all Ohio LLCs, however, regardless of the number of members.

Substitute House Bill 48 also makes several other changes to Ohio’s LLC Act. The most significant are that it (a) clarifies which default provisions of the LLC Act may be overridden by the operating agreement, and (b) adds fiduciary duties of loyalty and care for LLC members, apparently even if the LLC is manager-managed.

Federal Court Pierces Veil of Delaware LLC on Alter Ego Theory

Doug Batey — Mon, 16 Apr 2012 13:00:22 -0800

The Federal District Court in New York granted summary judgment to pierce the veil of a Delaware limited liability company in Soroof Trading Development Co. Ltd. v. GE Fuel Cell Systems LLC, No. 10 Civ. 1391(LTS)(JCF), 2012 WL 209110 (S.D.N.Y. Jan. 24, 2012). The court found the LLC to be the alter ego of its members, but did not explain how Delaware’s requirement of unfairness or injustice was met.

Background. This case was a dispute over a distribution agreement made in 2000. The agreement gave Soroof Trading Development Co. Ltd. the exclusive right to distribute fuel cells in Saudi Arabia that were to be manufactured by GE Fuel Cell Systems LLC. Soroof paid the LLC a $1 million, non-refundable distributor fee, and the LLC was obligated to use its reasonable efforts to supply the fuel cells to Soroof. The LLC was unable to complete development of the fuel cells, though, and never delivered any. In 2005 the LLC informed Soroof that it was unable to manufacture the fuel cells, and in 2006 the LLC was dissolved and a certificate of cancellation was filed with the Delaware Secretary of State.

Soroof eventually sued the LLC and its two members for breach of the distribution agreement, misrepresentation, conversion, imposition of a constructive trust, unjust enrichment, and an accounting. The LLC moved for judgment on the pleadings, with the result that the court dismissed all of Soroof’s causes of action but allowed Soroof to replead its claims for breach of contract and misrepresentation.

Soroof desired to pierce the LLC’s veil in order to assert its claims against the LLC’s members, which were not parties to the distribution agreement. (The LLC had been formed as a Delaware LLC with two members, GE Microgen, Inc. and Plug Power, Inc.) Soroof therefore made a two-part motion for partial summary judgment, (a) to nullify the LLC’s certificate of cancellation, and (b) to pierce the LLC’s veil. The defendants made a motion for dismissal of all claims against the LLC.

Dismissal of Claims Against the LLC. When the LLC was dissolved in 2006, a certificate of cancellation was filed, cancelling the LLC’s certificate of formation. See DLLCA § 18-203. Once a certificate of cancellation is filed, a Delaware LLC cannot be sued, unless the certificate is nullified on the ground that the LLC was not properly wound up in compliance with Delaware law. Soroof, 2012 WL 209110, at *13. Soroof alleged that the LLC had not been properly wound up because no provision had been made for Soroof’s claims, but the court pointed out that a dissolved LLC is only required to pay or make provision for claims to the extent of its assets, which in this case were nominal. Id. at *14. Soroof argued that the certificate of cancellation should be nullified because the LLC was the alter ego of the members, but it cited no legal authority to support that argument. The court dismissed all of Soroof’s claims against the LLC.

Piercing the Veil. The court then turned to Soroof’s claim that the LLC’s veil should be pierced, which would enable Soroof to pursue its claims against the LLC’s two members. The court stated the rule as follows:

Delaware law permits a court to pierce the corporate veil where there is fraud or where [the corporation] is in fact a mere instrumentality or alter ego of its owner…. To prevail under the alter-ego theory of piercing the veil, a plaintiff need not prove that there was actual fraud but must show a mingling of the operations of the entity and its owner plus an overall element of injustice or unfairness.

Id. (brackets in original)(quoting NetJets Aviation, Inc. v. LHC Commc’ns LLC, 537 F.3d 168, 177 (2d Cir. 2008)). Interestingly, the court cited no Delaware cases, instead referring only to the NetJets case from the Second Circuit.

The court recited the alter ego factors to be considered (capitalization, solvency, payment of dividends, adequate records, functioning officers and directors, other corporate formalities, siphoning funds off, and the entity functioning as a “façade” for the owner), and pointed out that less emphasis should be placed on LLC formalities than on corporate formalities.

The court then described the undisputed facts relevant to piercing GE Fuel Cell Systems LLC’s veil:

The LLC had no cash assets at the time of dissolution.
The LLC had no employees, and the individuals working at the LLC were actually employees of the members.
The LLC did not lease its office space but used the premises of its members.
There was no sign on the LLC’s premises indicating its presence.

After describing these factors, the court simply stated that “Plaintiff's uncontroverted proffers demonstrate an extensive ‘mingling of the operations’ of [the LLC] and its owners, such that [the LLC] was a mere instrumentality or alter ego of GE Microgen and Plug Power, as well as an overall element of unfairness to Soroof,” and granted Soroof’s motion for summary judgment piercing the LLC’s veil. Id. at *15. The court was silent as to how the facts showed “unfairness to Soroof,” other than implicitly recognizing that without piercing the veil Soroof’s claim would be unsatisfied. Of course, that is usually why plaintiffs seek to pierce a corporate defendant’s veil.

Comment. The court’s refusal to nullify the LLC’s certificate of cancellation seems unexceptional under the circumstances, even though the result is that all of Soroof’s claims against the LLC were dismissed. That dismissal, though, arguably should have led to dismissal of the veil piercing claims against the LLC’s members as well. That is because piercing the veil is not an independent cause of action, but merely a method of imposing liability on an underlying claim. Cambridge Elecs. Corp. v. MGA Elecs., Inc., No. CV02-8636MMM(PJWX), 2005 WL 927179, at *1 (C.D. Cal. 2005). Piercing the veil is an equitable remedy, not a cause of action unto itself. MidAmerican Distribution, Inc. v. Clarification Tech., Inc., 807 F. Supp. 2d 646, 683 (E.D. Ky. 2011).

In short, the claims against the LLC were dismissed, and therefore there was no underlying LLC liability for which the members should be made liable by piercing the LLC’s veil.

Even ignoring that issue, it appears unlikely that a Delaware court would have pierced the veil of the LLC on the facts recited by the Soroof court. The threshold in Delaware to pierce the veil of a corporation or LLC is high. Generally fraud, illegality, or other egregious facts must be present, and the Delaware courts “have only been persuaded to ‘pierce the corporate veil’ after substantial consideration of the shareholder-owner’s disregard of the separate corporate fiction and the degree of injustice impressed on the litigants by recognition of the corporate entity.” Midland Interiors, Inc. v. Burleigh, No. CIV.A. 18544, 2006 WL 3783476, at *3 (Del. Ch. 2006). See Francis Pileggi’s discussion of Midland Interiors, here.

The Soroof opinion is not an isolated instance of a court straining to pierce the veil of an LLC. Last month I posted here about Colorado’s Martin v. Freeman case, where the veil of a single member LLC was pierced without any showing of wrongdoing. Both cases support Professor Stephen Bainbridge’s thesis that “veil piercing achieves neither fairness nor efficiency, but rather only uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 78.

Colorado Court of Appeals Pierces the Veil of Single-Member LLC with No Showing of Wrongdoing

Doug Batey — Fri, 30 Mar 2012 13:50:56 -0800

The Colorado Court of Appeals last month liberalized the standard for piercing an LLC’s veil by holding that neither fraud, wrongful intent, nor bad faith need be shown by an LLC’s creditor to reach the assets of the LLC’s single member. Martin v. Freeman, No. 11CA0145, 2012 WL 311660 (Colo. App. Feb. 2, 2012).

Background. Dean Freeman was the single member of Tradewinds Group, LLC, a Delaware limited liability company. Tradewinds contracted to have Robert Martin construct an airplane hangar, but in 2006 Tradewinds sued Martin for breach of the construction agreement. While the litigation was pending, Tradewinds sold its only meaningful asset (other than its claim in the litigation) for $300,000 in 2007. Tradewinds distributed the proceeds to Freeman, and Freeman continued to pay the litigation expenses.

The trial court found for Tradewinds on its breach of contract claim and entered judgment in its favor, and Martin appealed. The Court of Appeals reversed the trial court and remanded with directions to enter judgment in Martin’s favor. On remand, the trial court in 2009 awarded Martin costs of $36,600. Tradewinds was unable to pay, and Martin sued Freeman to pierce the LLC veil and recover the $36,600 from Freeman. The trial court pierced the LLC’s veil and found Freeman personally liable for the cost award. Id. at *1.

The Court of Appeals began by reciting the Colorado requirements to pierce the LLC veil: “the court must conclude (1) the corporate entity is an alter ego or mere instrumentality; (2) the corporate form was used to perpetrate a fraud or defeat a rightful claim; and (3) an equitable result would be achieved by disregarding the corporate form.” Id.

Alter Ego. The court described several factors to be considered in determining alter ego status, including commingling of funds and assets, inadequacy of corporate records, thin capitalization, disregard of legal formalities, and using entity funds for non-entity purposes. The court then listed the trial court’s findings in support of the conclusion that Tradewinds was Freeman’s alter ego:

• Tradewinds’ assets were commingled with Freeman’s personal assets and the assets of one of his other entities, Aircraft Storage LLC;
• Tradewinds maintained negligible corporate records;
• the records concerning Tradewinds’ substantive transactions were inadequate;
• the fact that a single individual served as the entity’s sole member and manager facilitated misuse;
• the entity was thinly capitalized;
• undocumented infusions of cash were required to pay all of Tradewinds’ operating expenses, including its litigation expenses;
• Tradewinds was never operated as an active business;
• Legal formalities were disregarded;
• Freeman paid Tradds’ debts without characterizing the transactions;
• Tradewinds’ assets, including the airplane, were used for nonentity purposes in that the plane was used by Aircraft Storage LLC, without agreement or compensation;
• Tradewinds was operated as a mere assetless shell, and the proceeds of the sale of its only significant asset, the airplane, were diverted from the entity to Freeman’s personal account.

Id. at *2. The list is long, but many of the items amount to disregard of various formalities.

The court quoted part of the section of the relevant Colorado LLC statute that addresses LLC veil piercing, Colo. Rev. Stat. § 7-80-107(2), but did not discuss it. The court also referred to other secondary authorities such as 1 Fletcher’s Cyclopedia of the Law of Corporations § 41.35 (“a sole shareholder will not likely be suspect merely because he or she conducts business in an informal manner”) and 2 Ribstein and Keatinge on Limited Liability Companies § 12.3 (“veil piercing on the ground of inadequate capitalization is even less likely for LLCs than corporations”). The Court of Appeals nonetheless concluded, with no further analysis, that the trial court’s findings supported the conclusion that Tradewinds was Freeman’s alter ego. Martin, 2012 WS 311660 at *2.

The court’s perfunctory treatment of Colorado’s LLC Act is puzzling. The Act provides:

7-80-107. Application of corporation case law to set aside limited liability.

1) In any case in which a party seeks to hold the members of a limited liability company personally responsible for the alleged improper actions of the limited liability company, the court shall apply the case law which interprets the conditions and circumstances under which the corporate veil of a corporation may be pierced under Colorado law.

(2) For purposes of this section, the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself a ground for imposing personal liability on the members for liabilities of the limited liability company.

The statute appears to require that most of the Martin court’s alter ego factors be disregarded, which probably would have resulted in failure of the veil-piercing claim.

The court also did not consider what law should apply. Tradewinds was a Delaware corporation, but the court did not discuss whether Delaware law should apply. Although the authorities are split, many jurisdictions apply the law of the state of incorporation to resolve veil piercing questions. 1 Fletcher’s Cyclopedia of the Law of Corporations § 43.72. Application of Delaware law on piercing the veil almost certainly would have resulted in dismissal of Martin’s claim. See Francis Pileggi’s discussion at Delaware Corporate & Commercial Litigation Blog, here.

Perpetrate a Fraud or Defeat a Rightful Claim. The second factor necessary to pierce the veil is that the LLC form was used to perpetrate a fraud or defeat a rightful claim. Martin, 2012 WL 311660 at *3. The trial court’s findings of fact were clear that there was no fraud, wrongful intent or bad faith in Freeman’s actions, so for the Court of Appeals the question came down to whether the LLC form was used to “defeat a rightful claim.” Bearing in mind that the LLC’s sale of the airplane and the distribution of the sale proceeds to Freeman took place in 2007, while the award of costs against the LLC did not occur until two years later in 2009, the Court of Appeals concluded that “defeating a potential creditor’s claim is sufficient to support the second prong…. Any party engaged in litigation is exposed to potential liability.” Id.

The trial court had found as a factual matter, however, that Freeman had fully provided for all known or reasonably possible debts of the LLC at the time of the distribution of the airplane sale proceeds. Id. The Court of Appeals dismissed that finding as irrelevant because it was made in analyzing whether Freeman violated the LLC Act’s restrictions on distributions by insolvent LLCs. One would have thought that facts are facts, though, especially when the Court of Appeals had said at the beginning of its opinion: “We therefore accept the [trial] court’s factual findings and review de novo its application of the law to those facts.” Id. at *1.

As part of its analysis of whether Freeman used the LLC to defeat a rightful claim, the court said it was not aware of any Colorado case establishing that a party must show wrongful intent to pierce the corporate veil. The dissent by Judge Jones, however, cited and quoted numerous prior Colorado cases that appear to require fraud, crime, an illegal act, or conduct that was at the least intended to defeat the creditor’s claim. Id. at *6-7. In any event, the court concluded, “as a matter of first impression, that wrongful intent or bad faith need not be shown to pierce the LLC veil.” Id at *3.

Equitable Result. Having navigated between the Scylla and Charybdis of “alter ego” and “perpetuate a fraud or defeat a rightful claim,” the court sailed to its conclusion that Tradewinds’ veil should be pierced and Martin’s claim against Freeman sustained. Id. at *4. The court never discussed the third prong (that an equitable result would be achieved), because the defendants only challenged the trial court’s conclusions on the first and second prongs.

Comment. Piercing the veil is a “seriously flawed doctrine,” “one of the most befuddled [areas of the law],” and is beset by “uncertainty and lack of predictability.” Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 77 (2005); Franklin A. Gevurtz, Piercing Piercing: An Attempt to Lift the Veil of Confusion Surrounding the Doctrine of Piercing the Corporate Veil, 76 Or. L. Rev. 853, 853 (1997).

The Martin case illustrates some of the problems that appear in many veil-piercing cases. For example, the court lists 11 alter ego factors but discusses only one, the commingling (which consisted mainly of Freeman using personal assets to satisfy the LLC’s obligations, and receiving a distribution of the airplane sale proceeds after he had provided for all known or reasonably foreseeable debts). Then, after summarizing the defendants’ arguments, the opinion simply cuts to the conclusion that “the court considered the appropriate factors and its findings support a conclusion that Tradewinds was Freeman’s alter ego.” It would be useful to know the extent to which the LLC Act’s maxim, that non-observance of formalities is not grounds for imposing personal liability, applies in a veil-piercing case.

It also would have been helpful if the court had provided guidance on the extent to which the single-member nature of the LLC was considered in the alter ego determination. Because the court found that an LLC’s veil could be pierced even without any wrongful intent or bad faith, it’s hard to escape the conclusion that the court was heavily influenced by the single-member character of the LLC.

The Martin case can be viewed as an example of the uphill battle that single-member LLCs must wage in having their existence and separate nature respected. But the court’s holding that no wrongdoing, wrongful intent, or bad faith of any kind need be shown to pierce the LLC veil and impose personal liability is a hollowing out of the liability protection for LLC members and corporate shareholders, and goes far beyond existing law.

Texas Court Follows Form Over Substance In Sorting Out Different Fiduciary Duties in Multi-Level LLC and Partnership

Doug Batey — Fri, 23 Mar 2012 16:04:45 -0800

The Texas Court of Appeals struggled to reconcile conflicting fiduciary duty rules between two related entities, an LLC and a limited partnership, in Strebel v. Wimberly, No. 01-10-00227-CV, 2012 WL 112253 (Tex. App. Jan. 12, 2012).

Douglas Strebel and John Wimberly started a tax advisory business and formed Black River Capital, LLC, a Delaware limited liability company, in 2003. The business prospered, and on December 8, 2005 they restructured the business and amended and restated the LLC agreement. Strebel and Wimberly were the LLC members, with profit sharing ratios of 60% and 40% respectively. They and their wives were the managers, and Strebel was the Managing Manager and CEO with broad decision-making and management powers. Strebel was required to consult with the other managers before making certain major decisions, and to obtain Wimberly’s consent before taking certain other specific actions, including changes to Wimberly’s profit sharing ratio.

At the same time, they formed a new Texas limited partnership, Black River Capital Partners, LP, and transferred all of the LLC’s business assets to the limited partnership (LP). The LLC was the LP’s general partner, with broad power and authority to control the LP, and had a 1% profit share. The limited partners were Strebel, Wimberly, Strebel’s wife, and Eric Manley. Later Steve Houle also became a limited partner.

The LLC and the LP had completely different fiduciary duty rules. The LLC’s operating agreement stated that “the Managers shall have fiduciary duties to the Company and the Members equivalent to the fiduciary duties of directors of Delaware corporations.” Id. at *3 (emphasis added) . In stark contrast, the LP’s partnership agreement stated that “the General Partner shall have no duties (including fiduciary duties) except as set forth in th[e] Agreement,” and there were no other relevant provisions. Id. (emphasis added).

Problems between Strebel and Wimberly began to develop later. Strebel was in the driver’s seat as Managing Manager of the LLC, which in turn was the general partner of the LP. He also held a majority of the limited partners’ voting rights in the LP. Using his authority, Strebel retroactively reduced Wimberly’s profit share in the LP, and caused the LP in 2007 to award a $3 million bonus to himself and another $1 million in bonuses to limited partners Houle and Manley. Wimberly received no bonus. Id. at *5. Unhappy with these developments, Wimberly sued Strebel in 2007, alleging breach of fiduciary duty, unjust enrichment, oppression of a minority member, defamation, and breach of contract.

A jury trial returned a verdict in Wimberly’s favor. The jury found that Strebel had breached his fiduciary duties and awarded Wimberly damages of $2.9 million. Id. at *6. The trial court had instructed the jury that Strebel owed Wimberly fiduciary duties in his management of the business of the “Black River Entities,” because of their relationship at the LLC level (Strebel as Managing Manager and Wimberly as member) and at the LP level (both were limited partners). Id.

The Court of Appeals analyzed the fiduciary duties separately at the LLC level and at the LP level. Id. at *8. The court began with the LLC. Strebel had contended that the words in the LLC agreement “the Managers shall have fiduciary duties to the Company and the Members” meant that fiduciary duties were owed to the Members collectively, and that therefore no fiduciary duties were owed to any Member individually. Id. After a surprisingly lengthy discussion, the court disposed of that argument and pointed out that such an interpretation would in effect delete the words “and the Members” from the LLC agreement. The court agreed with the trial court that the LLC agreement imposed on Strebel, as the Managing Manager, fiduciary duties of due care, good faith, and loyalty to Wimberly as an individual member of the LLC. Id. at *9.

The limited partnership agreement, on the other hand, was clear that the LP’s general partner (the LLC) owed no fiduciary duties to the LP or its limited partners. The trial court had found, however, that Strebel owed Wimberly a fiduciary duty because they were both limited partners. The LP agreement was silent on whether there were any fiduciary duties between the limited partners. After a lengthy discussion of prior cases and a Baylor Law Review article, the court concluded: “We reconcile these cases by holding that status as a limited partner alone does not give rise to a fiduciary duty to other limited partners.” Id. at *13.

The court’s determination that there were no fiduciary duties owed by the LP’s general partner or any limited partner effectively destroyed Wimberly’s cause of action, because the court focused only on the harm to Wimberly directly resulting from the actions of the LLC as it controlled the LP, and ignored the obligations of the LLC’s manager to its members as he directed the LP’s activities:

[W]e conclude Wimberly’s claims relate to actions taken by Strebel as the controlling manager of the general partner (i.e., Black River, LLC) against Wimberly as a limited partner in Black River LP while operating under the LP agreement. The contractual disclaimer of fiduciary duties in the Black River LP Agreement thus forecloses Wimberly’s recovery on his breach of fiduciary duty claim.

Id. at *15. The court reversed the trial court’s finding on the breach of fiduciary duty claim, and remanded for further proceedings on Wimberly’s oppression of a minority member claim. Id. at *18.

Unfortunately, the court’s analysis exalted form over substance. The LLC’s only business was to control the LP – all of the LLC’s assets had been assigned to the LP. The LLC’s Managing Manager Strebel owed the LLC’s members the duties of good faith and loyalty. How could the LLC’s manager satisfy the duty of loyalty he owed to the members other than ensuring, as the LLC directed the LP, that the LP’s limited partners who were also LLC members were treated fairly and in good faith?

The court in its analysis relied on the chestnut that applying the LLC’s fiduciary duties to the actions taken by its manager in directing the LP “would render meaningless the express disclaimer of fiduciary duties in the limited partnership agreement under which that the parties were operating.” Id. at *17. But that’s not correct, because three of the limited partners (Manley, Houle, and Strebel’s wife) were not members of the LLC, and for them the disclaimer was highly meaningful.

This case shows the analytical difficulties that can arise in sorting out the obligations of managers in multi-entity, multi-level structures. It’s also a lesson for the lawyer advising clients about such structures to be wary of inconsistent standards and obligations.

Disobedience of Ohio Court Order Lands LLC's Controller and Single Member in Jail

Doug Batey — Thu, 15 Mar 2012 12:39:36 -0800

Sometimes pushing the envelope is not a good strategy, and that’s clearly the case when your litigation strategy ends you up in jail. In an Ohio case the judge found an after-the-fact excuse for disobedience of the court’s order to be insufficient, held the LLC’s owner and its controller in contempt of court, and sentenced them to seven days in the county jail. Spero v. Project Lighting, LLC, No. 2011-P-0002, 2011 WL 6371881 (Ohio Ct. App. Dec. 19, 2011).

Background. Spero involved a dispute over a joint venture made up of several limited liability companies. Two were owned 50-50 by defendant Sam Avny and plaintiff Mitchell Spero. One of the LLCs was owned by Avny and ownership of the fourth was disputed. Id. at *1.

In the course of the litigation a receiver was appointed to take possession of all the assets of the three LLCs other than the one owned by Avny, Project Light, LLC. Two months later the trial judge entered a detailed order calling for the funds in all bank accounts controlled by the three LLCs “to be transferred immediately to the exclusive control of the Receiver,” and directing that “[a]ll funds derived from the sale of any Prospetto inventory will be deposited with the Receiver and remain under his control pending further order of the Court.” Id. (Prospetto was one of the three LLCs.)

When the plaintiffs learned that the court’s order had not been complied with, they filed a motion requesting that the defendants be held in contempt of court. After an adversarial hearing, the trial court found beyond a reasonable doubt that Sam Avny and Anthony DeAngelis, the controller of the three LLCs, had disobeyed the court’s order by causing at least $89,000 of proceeds from the sale of Prospetto’s inventory to be deposited in Project Light’s bank account. Id. at *2.

The court found DeAngelis, Avny, and Project Light to be in contempt of court. They were each fined $250, and DeAngelis and Avny were sentenced to serve seven days in the county jail.

Analysis. DeAngelis and Avny argued unsuccessfully on appeal that the trial court lacked jurisdiction because (1) a notice of appeal was filed before the contempt hearing, and (2) a subsequent settlement agreement disposed of the contempt issue.

The Court of Appeals held that when a case goes up on appeal, the trial court retains jurisdiction over collateral matters such as contempt of court. In considering the effect of the settlement, the court distinguished civil contempt, which is remedial in nature, from criminal contempt, which is intended to punish the offender for acts in disregard of the court’s authority. The sanctions in Spero were for criminal contempt and could therefore be pursued even after the underlying action was no longer pending. Id. at *3.

DeAngelis and Avny’s central argument was that there was not a clear violation of the trial court’s order because of the way the funds were handled. DeAngelis testified that although the money in question was deposited into Project Light’s bank account, “it was clearly earmarked on the books as payable to Prospetto Light so that all of that money could be segregated and any time that it was called for, it could be turned over.” Id. at *5.

The court didn’t buy it. First, the trial court’s order was clear: “all funds derived from the sale of any Prospetto inventory will be deposited with the Receiver and remain under his control pending further order of the Court.” Id. at *6. Second, the earmarking procedure was inadequate and plainly contravened the court’s order. And third, DeAngelis testified that he believed Project Light had paid for the inventory sold by Prospetto and therefore was entitled to be paid for it, although he never informed the receiver of his belief and the receiver was not aware until later that the funds had been diverted. Without saying so, the court implied that DeAngelis’s motivation was for Project Light to retain the funds notwithstanding the court’s order.

DeAngelis and Avny also argued that the seven-day jail term was unreasonable and disproportionate to their acts. The Court of Appeals pointed out, however, that under the Ohio statute that authorizes criminal contempt sanctions, a first offense may be punished by a fine of up to $250, and up to 30 days in jail. Ohio Rev. Code § 2705.05(A)(1). In light of the statutory potential for a 30-day sentence and the discretion accorded the trial court, the Court of Appeals found seven days not to be disproportionate to the conduct. Spero, 2011 WL 6371881, at *6. The trial court’s ruling was affirmed. Id. at *7.

Comment. Although this case involved LLCs, the issues were not LLC-specific. But LLC dissolutions and court-ordered receivers are not uncommon, and the lessons of the case are worth considering.

The result here underscores the importance of paying attention to the wording of a court order. Unilaterally implementing a non-compliant procedure (here, depositing the funds to the wrong company’s account but earmarking the source of the funds), which might have been allowed by the court if properly requested, is simply asking for trouble. Failing to disclose the process to the court-appointed receiver compounded the difficulty. Placing the funds in the wrong account and not disclosing the situation to the receiver could have led to the receiver’s filing of inaccurate reports to the court, and conceivably could have led to the receiver’s having inadequate funds to carry on the operations of the three jointly owned LLCs.

The maxim “It’s easier to ask forgiveness than it is to get permission” (generally attributed to U.S. Navy Rear Admiral Grace Hopper) is bad advice when it comes to a court order.

No Diversity in LLC Derivative Suit; Federal District Court Remands to Wisconsin State Court

Doug Batey — Fri, 09 Mar 2012 15:10:39 -0800

A recent U.S. District Court ruling shows why LLC derivative suits by LLC members against other members cannot normally be successfully removed from state court to federal court on diversity grounds. Price v. Smith, No. 11-C-0763, 2012 WL 336169 (E.D. Wis. Feb. 2, 2012).

Background. Sarah Price and Chris Smith were members of Bluemark Productions, LLC, a Wisconsin limited liability company. Bluemark is noteworthy for producing the film American Movie, which won the 1999 Grand Jury Prize for the best documentary at the Sundance Film Festival in Park City, Utah. Price was a co-director of American Movie, but Smith refused to acknowledge her and the director credit went solely to Smith. Price, 2012 WL 336169 at *1.

As part of his work for Bluemark, Smith then began directing commercial advertisements. Bluemark was paid for this work, and Price alleged that Smith wrongfully caused Bluemark to distribute the income from Smith’s work solely to himself, even though Price was also a Bluemark member and entitled to at least 10% of Bluemark’s profits. Price claimed that Smith had also hidden and withheld significant amounts of Bluemark’s revenue from her. Id.

In 2011 Price and Bluemark filed suit in Wisconsin state court against Smith, raising individual claims on Price’s behalf and derivative claims on behalf of Bluemark. The claims included breach of contract, fraud, and breach of fiduciary duty.

Shortly thereafter Smith removed the case to the U.S. District Court on the grounds of diversity, contending that the action is between citizens of different states and that the amount in controversy exceeds $75,000. See 28 U.S.C. § 1332; 28 U.S.C. § 1441(a).

Court’s Analysis. Smith and Bluemark then moved to remand the case back to state court, contending that the federal court lacked jurisdiction because there was not complete diversity between the parties. The court found Price to be a citizen of California and Smith to be a citizen of Wisconsin. But the court found Bluemark’s citizenship for diversity purposes to be that of its members, citing Cosgrove v. Bartolotta, F.3d 729, 731 (7th Cir. 1998). And if so, there would not be diversity of citizenship between the plaintiffs and the defendant, and the case would have to go back to the state court.

Price and Smith disputed whether Price was a member of Bluemark, but it was agreed that Smith was a member. The court therefore found Bluemark to be a Wisconsin citizen, and because Smith was also a Wisconsin citizen, diversity was lacking.

Smith contended, however, that Bluemark’s joinder as a plaintiff was unnecessary because Price’s derivative claims were really direct, individual claims on behalf of Smith, and that Bluemark’s presence in the case as a plaintiff was therefore superfluous and intended only to prevent removal of the case to federal court. Price, 2012 WL 336169 at *2, *3.

The court found that Smith’s argument ignored Wisconsin’s LLC Act, which states that a member who assents to a distribution in violation of the LLC’s operating agreement “is personally liable to the limited liability company for the amount of the distribution that exceeds what could have been distributed without violating … the operating agreement.” Id. at *3 (emphasis added by the court) (quoting Wis. Stat. § 183.0608(1)). The court also referred to a member’s statutory duty to account to theLLC and hold as a trustee for it any improper personal profit derived by that member from transactions connected with the conduct of the LLC or from use of the LLC’s property. Id. at *3; see Wis. Stat. § 183.0402(2). The court therefore found that the claims raised by Smith belong to Bluemark, Bluemark was a proper party to the suit, and Bluemark’s presence therefore defeated complete diversity.

Smith also argued as an alternative theory that Bluemark had been fraudulently joined to the suit. The court pointed out that the cases cited by Smith to support dismissal of Bluemark all involved fraudulent joinder of an in-state defendant in order to defeat removal to federal court. Smith’s claim, in contrast, was that Bluemark was fraudulently joined as a plaintiff. Price, 2012 WL 336169 at *2. Smith provided no authority indicating that the doctrine of fraudulent joinder applies to plaintiffs, and the court concluded that “[f]raudulent joinder does not provide a basis for dismissal of Bluemark.” Id.

The court concluded by granting Price and Bluemark’s motion to remand the case to the Wisconsin state court. Id. at *4.

Comment. The court’s analysis and ruling demonstrate the unavailability of the federal courts as a forum to resolve disputes between LLC members when the complaint is based on a member’s breach of the operating agreement, breach of fiduciary duty, or other wrong against the LLC. In a derivative suit the LLC is a necessary party as a plaintiff and is considered a citizen of the states where its members are citizens, including the defendant member. The defendant and the plaintiff LLC will therefore inevitably be citizens of the same state, resulting in a failure of diversity.

Even if the parties all desire the case to be in federal court, the court on its own initiative may remand the case back to state court. “A district court may raise the issue of subject matter jurisdiction sua sponte, and due to the constitutionally limited jurisdiction of the Federal Courts, is obligated so to do if it lacks jurisdiction.” Bartfield v. Murphy, 578 F. Supp. 2d 638, 644 (S.D.N.Y. 2008).

It’s also worth noting that the rule is decidedly different for corporations. “In the case of a regular corporation, the owners’ state of citizenship is irrelevant to whether there is the required complete diversity . . . .” Cosgrove v. Bartolotta, F.3d 729, 731 (7th Cir. 1998). For partnerships, whether general or limited, the rule is the same as for LLCs. Id.

Colorado Court Divides Contingent Fee Between Attorney Members of Dissolved LLC Law Firm

Doug Batey — Thu, 01 Mar 2012 09:43:25 -0800

Law firm breakups sometimes result in disputes between the lawyers over continuing legal work. Some of the most difficult disputes are those over contingent-fee cases that were started before the firm broke up and will be concluded after the breakup. A contingent-fee case may require thousands of hours of lawyer time and, regardless of the amount of time spent on the case, may result in a fee anywhere from zero to millions of dollars.

A Colorado court recently had to decide such a case involving the distribution of a contingent fee to two lawyers who had dissolved their two-member LLC law firm in the middle of a contingent-fee case. LaFond v. Sweeney, No. 10CA2005, 2012 WL 503655 (Colo. App. Feb. 16, 2012).

Background. Richard LaFond and Charlotte Sweeney formed a law firm as a Colorado LLC in 1999 and orally agreed to share equally in all the firm’s profits, without regard to who brought cases in or who did work on them. In 2008 their law firm dissolved. Id. at *1.

At the time of dissolution the law firm represented Bobby Maxwell in a qui tam whistle-blower action brought under the False Claims Act. LaFond continued to represent Maxwell in the qui tam suit after the LLC’s dissolution. LaFond and Sweeney could not agree on how to divide the fees that might ultimately be earned on the Maxwell case, and LaFond filed a suit for declaratory relief against Sweeney to determine how the contingent fee should be distributed.

Trial Court. The trial court ruled that the Maxwell case was an asset of the LLC and that its value was to be determined at the time of the dissolution. Because LaFond and Sweeney had agreed that any profit from the case would be divided equally, the court held that Sweeney would be entitled to one-half of any contingent fee recovered by LaFond, up to a ceiling based on the number of hours worked on the case before the LLC’s dissolution. Sweeney appealed, contending that the law firm was entitled to all of any contingent fee received and that she was therefore entitled to one-half of the total fee.

The Court of Appeals first noted that the Maxwell lawsuit had settled after the trial court’s decision. The settlement amount was not clear to the court from the pleadings, but the fact of settlement meant that the Court of Appeals only had to deal with a completed contingent-fee case and a determinable fee.

Contingent Fee. The court then discussed at length the law of contingent-fee cases and the attorney-client relationship, and derived three principles. First, said the court, “the case belongs to the client,” meaning that when an attorney with the primary responsibility for a case leaves a law firm, the client can choose to be represented by the law firm, to be represented by the departing attorney, or to hire new counsel. Id. at *3.

Second, a contingent-fee agreement provides the attorney with certain rights. Id. at *4. An agreement between attorney and client that calls for a fee contingent on the outcome of a case is generally enforceable, assuming the lawyer satisfies his or her professional ethics obligations.

The court’s third principle required a review of the Colorado LLC Act’s dissolution rules. After its dissolution, an LLC continues in existence for the purpose of winding up and liquidating its business and affairs. Colo. Rev. Stat. § 7-80-803(1). As part of the winding up process, the LLC completes its executory contracts, including pending contingent-fee cases. LaFond, 2012 WL 503655 at *7. Therefore, said the court, “[a]n attorney who carries on the representation of a client on an existing case after a law firm dissolves does so on the firm’s behalf.” Id. The court pointed out that under the LLC Act, a member must “[a]ccount to the [LLC] and hold as trustee for it any property, profit, or benefit derived by the member or manager in the conduct or winding up of the [LLC’s] business.” Id. (quoting Colo. Rev. Stat. § 7-80-404(1)(a)).

The court’s analysis – a pending contingent-fee case constitutes unfinished business of the law firm, and a former LLC member who completes the case does so on behalf of the LLC – led it to its third principle, that the fee ultimately earned in such a contingent-fee case belongs to the LLC.

The court next examined LaFond’s and Sweeney’s relative rights in the fee. The court looked to other jurisdictions and applied the majority partnership rule: “The great majority of states have concluded that contingent fees ultimately generated from cases that were pending at the time of dissolution of a law firm must be divided among the former law partners according to the fee-sharing arrangement that was in place when the firm dissolved.” Id. at *10.

Compensation for Post-Dissolution Work. The court then had to determine whether LaFond should be compensated for his work on the Maxwell case after the LLC’s dissolution, or whether the fee should be split equally without regard for his post-dissolution time spent on the case.

The court first compared the winding-up provisions of Colorado’s LLC Act with its Partnership Act. The Partnership Act states that “[a] partner is not entitled to remuneration for services performed for the partnership except for reasonable compensation for services rendered in winding up the business of the partnership.” Id. at *13 (quoting Colo. Rev. Stat. § 7-64-401(8)) (emphasis added by the court). In contrast, the winding-up section of the LLC Act does not authorize or even refer to compensation for services rendered in winding up the LLC. Colo. Rev. Stat. § 7-80-803.3.

Because Colorado’s LLC Act was modeled in part on its Partnership Act, the court viewed the exclusion of compensation language from the LLC Act as an intentional legislative choice, and read the LLC Act to mean that an LLC member is not entitled to compensation for services rendered in winding up the business of the LLC. LaFond, 2012 WL 503655 at *13.

The court also relied on the reasoning of Jewel v. Boxer, 203 Cal. Rptr. 13 (Ct. App. 1984), quoting from its opinion:

At first glance, strict application of the rule against extra compensation might appear to have unjust results (e.g., where a former partner obtains a highly remunerative case just before dissolution, and nearly all work is performed after dissolution). But undue hardship should be prevented by two basic fiduciary duties owed between the former partners. First, each former partner has a duty to wind up and complete the unfinished business of the dissolved partnership…. Second, no former partner may take any action with respect to unfinished business which leads to purely personal gain. … If there is any disproportionate burden of completing unfinished business here, it results from the parties' failure to have entered into a partnership agreement which could have assured such a result would not occur. The former partners must bear the consequences of their failure to provide for dissolution in a partnership agreement.

Id. at 18-19.

Consistent with the Jewel approach, the court held that LaFond and Sweeney were each entitled to one-half of the contingent fee obtained by LaFond in the Maxwell case, without any reduction for compensation to LaFond for his post-dissolution work.

Comment. On the facts of the case this is not a terrible result, since LaFond’s hours spent on the Maxwell case after dissolution only amounted to about 4% of the total. But the court did not rely on that, and by extrapolation its holding would have yielded the same result, i.e., a 50-50 split of the fee, even if most of the work on the case had been performed after dissolution. That clearly would have been an inequitable result.

The court relied in part on a perceived duty for LaFond to wind up and complete the unfinished business of the dissolved LLC, including working on the Maxwell case: “We conclude that LaFond had a duty to wind up unfinished business of the dissolved law firm, including continuing to represent Maxwell.” LaFond, 2012 WL 503655 at *14. The source of this duty is not made clear in the opinion, but presumably it lies in either (i) the contingent-fee agreement with Maxwell, (ii) the LLC Act, or (iii) the fiduciary duty of a member.

The Contract. Maxwell’s contingent-fee agreement was with the LLC, not with LaFond. As the court said, “[a] contingent fee case that is pending at the time a law firm dissolves is a form of executory contract between the law firm and the client.” Id. at *7. The LLC, not LaFond, was obligated to represent Maxwell in his suit.

LLC Act. The LLC Act limits the activities of an LLC after dissolution to those appropriate to wind up and liquidate its business and affairs, but it imposes no duty on members to wind up the LLC after its dissolution. “After dissolution, the manager or, if there is no manager, any member may wind up the limited liability company’s business.” Colo. Rev. Stat. § 7-80-803.3(1) (emphasis added). The statute empowers the members to conduct the winding up, but does not obligate any member to do so.

Fiduciary Obligations. As an LLC member, LaFond had fiduciary obligations to the LLC’s other member, Sweeney, just as Sweeney had fiduciary obligations to LaFond. LaFond, 2012 WL 503655 at *6. Mutual fiduciary obligations would not obligate LaFond to handle the case after dissolution without compensation any more than they would obligate Sweeney. LaFond’s failure to insist on an Alphonse-and-Gaston routine with Sweeney should not doom him to non-recognition of his successful efforts to complete the contingent-fee case.

The LaFond case was easy in one respect – by the time the case went up on appeal it involved a dispute over a fully earned contingent fee, because by that time the Maxwell case was over. The fairest approach in such a case probably would be to divide the contingent fee into two portions pro rata, based on the hours spent on the case pre-dissolution and the hours spent post-dissolution. The pre-dissolution portion of the fee would be distributed to the members (50-50 in LaFond), and the post-dissolution portion would go to the member who worked on the case.

ABA Publishes Revised Prototype LLC Act

Doug Batey — Thu, 23 Feb 2012 15:25:56 -0800

The ABA’s Revised Prototype Limited Liability Company Act has been published in the November 2011 Business Lawyer, copies of which were received at my firm last week. The Revised Prototype incorporates a number of welcome changes, and will likely become an even more widely used resource by states considering amendments to their LLC Acts.

Many state LLC Acts were first adopted in the early 1990s. In adopting and amending their LLC Acts, state legislatures have been able to look for guidance to several sources:

The Uniform Limited Liability Company Act (“ULLCA”) promulgated by the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) in 1994;

The Prototype Limited Liability Company Act (the “Prototype”) published in 1992 by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities; and

NCCUSL’s Uniform Partnership Act and Uniform Limited Partnership Act.

Both the ULLCA and the Prototype were influential as the states drafted their LLC Acts, but neither fully occupied the field. As a result there is a lot of variation in LLC laws from state to state. According to NCCUSL, the revised ULLCA has been adopted by only the District of Columbia, Idaho, Iowa, Nebraska, Utah, and Wyoming. The Prototype also was used as the basis for several states’ LLC Acts, and has been used as a reference by other states in amending their Acts.

The Revised Prototype is a major revision and modernization of the Prototype. Changes include terminology, organization, and major points of law. The following is a partial list of the major changes.

Terminology. The name of the formation document has been changed from “articles of organization” to “certificate of formation,” and the principal contract that defines an LLC’s structure and the members’ rights has been renamed from “operating agreement” to “limited liability company agreement.” The latter change reflects the more common terminology, although it is cumbersome. E.g., Washington (RCW § 25.15.005), Delaware (DLLCA § 18-101).

Nonwaivable Provisions. Most state LLC statutes provide numerous default provisions that may be modified by an LLC agreement. Often each default rule will be preceded by language such as “except as otherwise provided in a limited liability company agreement.” Usually, however, some provisions of the statute will be nonmodifiable or nonwaivable by an LLC agreement, in which case the “except as otherwise provided …” language is not used to limit the statutory rule. This was the approach used in the 1992 Prototype.

The Revised Prototype instead simply states that the LLC agreement governs the LLC and its members, and that when the LLC agreement is silent the Act will govern, except that certain statutory provisions listed in Section 110 may not be modified by the LLC agreement. This approach eliminates the need to repeat variants of “except as otherwise provided [in an LLC agreement]” throughout the statute, as all of the default rules in the statute are subject to modification in an LLC agreement unless modification is barred by Section 110.

Manager-Managed vs. Member-Managed; Authority. Many state LLC Acts assume that management of the LLC will be vested either in the members or in one or more managers. Typically the statute will also describe the actual and apparent authority of the members or managers. Oregon and Washington both follow this approach, as did the Prototype.

The Revised Prototype instead takes a more flexible approach by eliminating the need to pigeon-hole the LLC as member-managed or manager-managed. The default rule is that the activities of the LLC are under the direction and oversight of its members. Revised Prototype, § 406. That can be changed by the LLC agreement, which may establish managers, officers, or other decision-makers and define their authority.

The Revised Prototype does not define any actual or apparent authority for members or managers. Instead, the actual and apparent authority of the members or of any officers, managers, or other agents, will be established by the LLC agreement, the decisions of the members, any filed statement of authority, or the common law of agency. Revised Prototype, Article 3.

Power. Most if not all state LLC Acts explicitly state that an LLC formed under the Act has adequate power. The statutes typically refer to LLCs having the powers that are “necessary or convenient” for their activities, or to comparable language. E.g. Delaware (DLLCA § 18-106(b), Washington (RCW § 25.15.030(2)), Oregon (ORS 63.077). Entity power is a fundamental attribute. For example, if an entity lacks power to form a contract and purports to do so, the contract will not be enforceable.

The importance of this issue is shown by legal opinion-letter practice. Lawyers for parties in major transactions are often required as a condition of the transaction to provide a legal opinion to the other party covering, among other things, the power of the lawyer’s client to enter into and carry out the transaction. The TriBar Opinion Committee’s 2006 Report on LLC closing opinions states that a lawyer’s opinion that an LLC has the power to enter into and perform its obligations under an agreement means that the LLC “has that power under … the statute under which it was formed.” TriBar Opinion Committee, Third-Party Closing Opinions: Limited Liability Companies, 61 Bus. Law. 679, 687 (2006) (emphasis added).

The Prototype intentionally did not include any language dealing with the LLC’s power to carry out its activities, apparently relying on the contractual aspect of LLCs. See Prototype, § 106, Commentary. The Revised Prototype, however, has included a statement that an LLC will have the powers “necessary or convenient to the conduct, promotion, or attainment of the business, purposes, or activities” of the LLC. Revised Prototype, § 105(b).

The Revised Prototype explicitly recognizes the entity nature of LLCs, defining an LLC as “an entity formed or existing under this Act.” Revised Prototype, § 102(13) (emphasis added). The Prototype, in contrast, defines an LLC as “an organization formed under this Act.” Prototype, § 102(F) (emphasis added).

It seems odd that the summary of major changes in the introduction to the Revised Prototype makes no mention of the addition of a powers clause, which I think most practicing lawyers would consider major, and the comment to Section 105 of the Revised Prototype makes no mention of the change.

Fiduciary Duties. The Revised Prototype does not provide for fiduciary duties and allows broad latitude to the LLC agreement to expand, restrict, or eliminate fiduciary duties. The implied contractual covenant of good faith and fair dealing may not be eliminated. Revised Prototype, § 110. Note that the absence of a default specification of fiduciary duties does not mean that the applicable state’s common law would necessarily hold that managers of LLCs have no fiduciary obligations. See Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012), which I wrote about, here.

Charging Orders. The Prototype provided that a court may issue a charging order, which gives an LLC member’s judgment creditor the right to receive any distributions the member would otherwise receive. The Prototype left unclear whether a charging order was a judgment creditor’s exclusive remedy. I wrote about the exclusivity of charging orders last year, here.

The Revised Prototype makes clear that a judgment creditor’s charging order is its exclusive remedy against an LLC member’s interest in the LLC. This change brings desirable clarity, but many would argue that there is a policy issue left unaddressed by the Revised Prototype, i.e. whether the charging order should be exclusive even in the case of a single-member LLC.

The new provision provides additional detail about the exercise of the charging order, and also makes clear that a charging order may be obtained against an assignee’s LLC interest.

Derivative Suits. The Prototype did not provide a default rule for derivative suits, although nothing in the Prototype prevented an LLC agreement from authorizing derivative suits. The Revised Prototype authorizes derivative suits for members as a default rule, although not for assignees (unlike Delaware, which allows members and assignees to bring a derivative suit, DLLCA § 18-1001).

Series LLCs. Series LLC provisions were added to the Revised Prototype. A series LLC is an LLC that is split into separate series, each having its own members and managers, owning its own assets separate from the assets of the LLC or any other series, and incurring obligations enforceable only against its own assets. At least eight states have authorized series LLCs (see my blog post, here).

Evergreen. The Revised Prototype has been published by the ABA’s Committee on LLCs, Partnerships and Unincorporated Entities. The Committee deserves praise for this comprehensive revision and the thoughtful comments.

The Committee stated in the overview to the Revised Prototype that it will be revised on an ongoing basis, to anticipate and respond to legal and business changes affecting LLCs. This will be especially useful if the Committee can make such revisions publicly available on the Internet (once released), with clear delineation of the changes from one version to another and with adequate comments explaining the changes.

Comments. The Committee has encouraged interested parties to submit suggestions and comments on the Revised Prototype. The Committee can be reached through the ABA’s website, here.

Delaware Kerfuffle Over Exclusive Forum For Corporate Derivative Suits - Applicable To LLCs?

Doug Batey — Thu, 16 Feb 2012 09:41:19 -0800

To prevent forum-shopping by plaintiffs in shareholder derivative suits, some Delaware corporations in the last couple of years have amended their bylaws to lock in the Delaware Court of Chancery as the exclusive forum for derivative suits. One study showed that as of the end of 2011, 195 Delaware corporations have adopted or proposed exclusive forum provisions in their bylaws or articles.

At least nine lawsuits have been filed this month by shareholders challenging the new bylaw provisions. The lawsuits seek to have the bylaw provisions declared invalid on grounds that (a) the forum of a derivative suit is an external matter and not a matter of internal corporate governance, (b) there was no mutual shareholder consent to the new forum rule, and (c) the new bylaws are overly broad and violate due process. The corporations have apparently threatened to sue any shareholders daring to bring a derivative suit outside of Delaware in violation of the new bylaw provisions.

Francis Pileggi and Professor Stephen Bainbridge have commented on these lawsuits, and I refer you to their reports for more details and commentary. Alison Frankel has also written about the lawsuits and includes links to some of the complaints, here.

What about limited liability companies? LLC managers observing the forum restrictions that many corporations have adopted might well consider implementing similar restrictions.

The concern would not be unfounded – derivative suits are available to members of LLCs. Delaware allows a member or an assignee of an LLC interest to bring a derivative action in the right of an LLC. DLLCA, § 18-1001. Washington has a similar provision in its statute, except that Washington only allows members, and not assignees, to bring the action. RCW 25.15.370.

Forum restrictions are contemplated by the Delaware LLC Act. A written LLC agreement can provide that its members consent to the exclusive jurisdiction of the Delaware courts. DLLCA § 18-109(d). (This is one of the few sections in the Delaware LLC Act where a provision of an LLC agreement must be in writing to be enforceable.)

Changing the rules for an existing LLC is not as easy as a corporate board’s amendment of the corporation’s bylaws. An LLC agreement is a contract between the members and can only be changed with their consent, so member consents would be required for an LLC to add a forum-limiting provision to its LLC agreement.

Whether or not the consent of all the members would be required depends on the terms of the LLC agreement, which may or may not allow amendments on the approval of less than all members. The Delaware LLC Act authorizes an LLC agreement to limit the voting or approval rights of any member or group of members. DLLCA, § 18-302(a). For example, an LLC could have two classes of members, voting and non-voting. The non-voting members would be presumed to have known their rights when they became parties to the LLC agreement, and under the policy in the Delaware statute of giving maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements, a forum-limiting amendment to the LLC agreement, approved by only the voting members, should be enforceable. DLLCA, § 18-1101(b).

If the LLC agreement is silent on the subject of its amendment, unanimous approval of the members will be required for any change to the agreement, as with any other multi-party contract.

Delaware Court of Chancery Pores Over Fiduciary Duty Claims Against LLC Manager

Doug Batey — Wed, 08 Feb 2012 10:27:01 -0800

The Delaware Court of Chancery last month issued a lengthy and thorough analysis in a dispute over an LLC manager’s claimed breaches of fiduciary duties. Auriga Capital Corp. v. Gatz Props., LLC, No. C.A. 4390-CS, 2012 WL 294892 (Del. Ch. Jan. 27, 2012).

The dispute arose because the LLC’s manager and majority owner (along with his family) took steps to squeeze out the minority investors in order to obtain ownership of the LLC’s valuable golf course. The court’s lengthy catalog of the manager’s activities shows a manager bent on ridding the LLC of the disfavored minority. Professor Ann Conaway in her blog described the manager as “a devilish manager of an LLC who acted every bit the part of Lord Voldemort determined to ‘do in’ his members,” here. The court’s unremarkable holding, given the facts, was that the manager breached his fiduciary duties of loyalty and care. Auriga, 2012 WL 294892 at *25.

The court’s discussion and analysis, on the other hand, were remarkable. Not for the court’s legal conclusion, but for its comprehensive and detailed review of the Delaware LLC Act and the Delaware case law on LLC fiduciary duties. The court’s conclusion was consistent with prior Delaware case law: “[O]ur Supreme Court, and this court, have consistently held that default fiduciary duties apply to those managers of alternative entities who would qualify as fiduciaries under traditional equitable principles, including managers of LLCs,” unless those duties are clearly waived or modified in the LLC’s operating agreement. Id. at *2.

In explaining its decision, the court reviewed (i) the Delaware LLC Act; (ii) the lack of any language in the Act establishing fiduciary duties for LLC managers; (iii) the Act’s authorization in Section 18-1101 that, to the extent a member or manager has duties including fiduciary duties, those duties may be expanded, restricted, or eliminated by the LLC agreement; and (iv) the history of revisions to Section 18-1101. The court analogized the LLC Act to Delaware’s General Corporation Law and noted the Delaware Supreme Court’s application of fiduciary duties to Delaware corporations notwithstanding the absence of any definition or creation of fiduciary duties in the DGCL.

The court also examined Section 1104 of the LLC Act, which provides that “[i]n any case not provided for in this chapter, the rules of law and equity … shall govern.” Del. Code Ann. tit. 6, § 18-1104 (emphasis added). The court found fiduciary duties to be grounded in equity and therefore to be mandated by Section 1104. Auriga, 2012 WL 294892 at *8.

The facts are complex, and the court’s lengthy analysis is multi-part, thorough, and detailed. The brief description above is only a high-level overview. For a more detailed review of the Auriga opinion, I recommend Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here, and Peter Mahler’s post on his New York Business Divorce blog, here.

A part of the opinion that I found particularly interesting is the court’s discussion of the difference between the implied covenant of good faith and fair dealing, and the fiduciary duties of loyalty and care. Both are equitable gap-fillers, but they operate in different ways. The implied covenant of good faith and fair dealing applies only “when the express terms of the contract indicate that the parties would have agreed to the obligation had they negotiated the issue.” Auriga, 2012 WL 294892 at *10. In other words, the implied covenant operates only in cases where the language of the contract as a whole suggests an obligation and points to a result, but does not provide an explicit answer. Id. at *10 n.57. Fiduciary duties, in contrast, provide a framework to govern the discretionary actions of business managers acting under the enabling framework of the LLC agreement. Id. *10.

One part of the opinion will likely be of more interest to litigators than to business lawyers – the court’s award of attorneys’ fees to the plaintiffs. In civil litigation such as the Auriga case, each party normally bears its own legal fees. (This is sometimes referred to as the American Rule, and is in contrast to the English Rule, under which the loser pays the winner’s attorneys’ fees.)

Delaware recognizes an exception to the American Rule when a litigant has acted in bad faith. Id. at *29. The Auriga court awarded the plaintiffs one half of their reasonable attorneys’ fees and costs – the award because of the defendants’ bad faith, and the one-half limit because the plaintiffs’ efforts in the litigation were “less than ideal in terms of timeliness or prudent focus.” Id.

The court said the bad-faith exception should not be lightly invoked and requires clear evidence of the wrongdoer’s subjective bad faith. The court found plenty of evidence, though: “The record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue. Rather than focus on only bona fide arguments, Gatz and his counsel simply splattered the record with a series of legally and factually implausible assertions.” Id. The court also considered the defendants’ pre-litigation conduct, as well as violations of the discovery rules.

The procedure mandated by the court for determining the attorneys’ fees appears designed to streamline the process. The plaintiffs must simply submit an affidavit with the amount of their “reasonable attorneys’ fees and costs.” Id. The court will then consider that amount to be reasonable unless the defendants’ legal counsel produces their own billing records in support of an argument that the plaintiffs’ attorneys’ fees are too high. And in case there was any doubt about the court’s attitude, the court remarked that “[i]n objecting to the amount of the fee, Gatz and his counsel should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it.” Id. at *29 n.184.

The Auriga case is fascinating for a host of reasons: (a) the court’s detailed and lengthy review of Delaware’s LLC fiduciary duty law, (b) the emphasis on the origins of fiduciary duty principles in equity (the Delaware Court of Chancery, like the original English version, is a court of equity), (c) the discussion of the implied covenant of good faith and fair dealing, (d) invocation of the principle that uncertainties in damages are resolved against the breaching fiduciary, (e) the award of attorneys’ fees, and (f) the court’s colorful language. The opinion has already generated significant commentary in the blogosphere, and in the future it will undoubtedly be the subject of law review articles and continuing legal education seminars.

New York Court Orders Dissolution of LLC - Recharacterizes Capital Contributions as Loans to Reach Equitable Result

Doug Batey — Fri, 27 Jan 2012 14:35:46 -0800

An involuntary dissolution case was decided by the New York Supreme Court (the trial court) two weeks ago, on a petition for dissolution by one of the two members of a limited liability company. Mizrahi v. Cohen, No. 3865/10, 2012 WL 104775 (N.Y. Sup. Ct. Jan. 12, 2012).

Background. Mizrahi and Cohen’s LLC owned a four-story commercial office building, with the ground floor rented by Cohen’s optometry business and the second floor rented by Mizrahi’s dental practice. The LLC consistently operated at a loss from 2006, the first year the building was occupied. The losses were covered by the members’ periodic capital contributions, although the LLC’s operating agreement didn’t require any additional capital contributions after the initial contributions. The two members each had a 50% ownership interest in the LLC, and initially they contributed additional capital in equal amounts. After a few years, however, Cohen’s capital contributions became sporadic and Mizrahi contributed most of the capital necessary to keep the LLC from defaulting on its mortgage. Over a span of several years Mizrahi contributed approximately $900,000 more than Cohen.

Mizrahi sued for dissolution of the LLC and an accounting of the proceeds of the company. The New York LLC Act uses the familiar standard for judicial dissolution: “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” N.Y. Ltd. Liab. Co. Law § 702. (Washington and Delaware, for example, have similar provisions in their LLC statutes. RCW 25.15.275; Del. Code Ann. tit. 6, § 18-802.)

The Appellate Division held in 2010 that Section 702 requires that for dissolution to be ordered, the petitioner must show, “in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.” In re 1545 Ocean Ave., LLC, 72 A.D.3d 121, 131, 893 N.Y.S.2d 590 (N.Y. 2010).

Dissolution. The gist of the court’s analysis was that continuing the LLC was financially unfeasible because of (a) the significant losses incurred over the years, (b) Cohen’s failure to contribute equally in meeting the losses and his undermining the financial integrity of the LLC by unilaterally withdrawing $230,000 of his capital, and (c) the likelihood that it was only a matter of time, should Mizrahi exercise his right to refrain from making further capital contributions, until the LLC would default on its mortgage and the mortgage be foreclosed upon. Mizrahi, 2012 WL 104775, at *8.

The facts of the case and the court’s analysis are ably described in more detail by Peter Mahler in his New York Business Divorce law blog, here.

Accounting and Winding Up. Having determined that the LLC would be dissolved, the court discussed the accounting procedures to be followed and the winding up and distribution requirements of the LLC’s operating agreement. The operating agreement required that after payment to the LLC’s creditors and satisfaction of its liabilities, any remaining assets would be distributed to the members “according to their ownership interests,” i.e., 50% to each. There was no provision for returning a member’s capital, apparently on the assumption that the members would contribute capital in equal amounts, thus maintaining the 50/50 ratio for contributions as well as for their ownership interests.

But as it turned out, Mizrahi had contributed $900,000 more than Cohen. Ignoring that fact in the final 50/50 distribution would be consistent with the operating agreement but manifestly unfair. “[C]rediting the sums advanced by plaintiff to his capital account would work an inequitable result in that the Operating Agreement prevents the return of a Capital Contribution.” Id. at *11.

The court therefore ordered that Mizrahi’s capital contributions in excess of the amount of Cohen’s capital contributions would be treated as a loan to the LLC, to be repaid to Mizrahi as a debt of the LLC prior to the distributions to the members based on their 50/50 percentage of ownership. Id.

The court also ordered that Cohen’s $230,000 withdrawal from the LLC, whether treated as a loan or a capital withdrawal, would be applied to reduce the amount of any distribution to Cohen. Id. at *9.

The court’s resolutions of these two issues are clearly equitable and fair, but it is striking that the court gives no explanation or authority for either, other than its passing reference to avoiding an “inequitable” result. Trial courts have broad equitable powers, but one would have expected at least some citations to authority for the court’s application of those powers.

Colorado Court Reviews Classical and Modern Approaches to Anti-Assignment Clauses, and Holds That Assignment of Member's LLC Interest in Violation of Operating Agreement Is Void

Doug Batey — Wed, 18 Jan 2012 16:39:25 -0800

Many LLC operating agreements prohibit or limit transfers of member interests. What’s the result if a member transfers its interest notwithstanding the operating agreement’s prohibition on transfers? Is the transfer void, in which case the transferee receives nothing? Or is the transfer effective, even though the transferor is in breach of the agreement and may be subject to a breach of contract claim by the LLC or other members? That was the question before the Colorado Supreme Court last month in Condo v. Conners, No. 10SC703, 2011 WL 6318980 (Colo. Dec. 19, 2011).

Thomas Banner was one of three members of Hut at Avon, LLC, a Colorado limited liability company. As part of a divorce settlement, Banner agreed to assign to Elizabeth Condo, his ex-wife, the right to receive monetary distributions on his LLC interest, and to vote against all issues that under the LLC agreement required unanimous consent unless his ex-wife directed otherwise. The LLC’s operating agreement limited the assignability of member interests, stating that “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest in” the LLC “without the prior written approval of all of the Members.” Id. at *5.

Banner contacted the two other members and requested approval of the proposed assignment. The two others objected, but Banner later went ahead without their consent, assigned his rights to his ex-wife, and promised to vote as required in the divorce settlement. When the two other members learned of the assignment they complained and offered to buy Banner’s interest in the LLC. Ultimately Banner sold his entire interest in the LLC to the two other members.

Condo then sued the two LLC members and their attorney for tortious interference with contract and civil conspiracy. She claimed that they conspired with Banner in bad faith to buy his interest at a “fire-sale” price, destroying the value of her right to receive Banner’s distributions and interfering with Banner’s assignment to her.

The trial court reasoned that Condo’s claims were dependent on the validity of the assignment, and found the assignment to be invalid because it was made without the consent of the two other members. The assignment was void as against public policy because the lack of consent from the other members constituted bad faith by Banner. The trial court therefore dismissed Condo’s tort claims. Condo appealed, and the Court of Appeals affirmed on other grounds. Id. at *4.

Colorado’s Supreme Court began by noting that the appeal turned on the validity of the Banner assignment, because Condo’s tort claims of interference and civil conspiracy with contract required the existence of a valid contract. The court then addressed the defendants’ argument that the LLC’s operating agreement should not be interpreted in accordance with prevailing contract law, but instead should be viewed as a constitution or a charter rather than a contract. As such, the operating agreement was claimed to restrict the power of a member to assign his interest, without regard to any potential exception found within contract law. The court disagreed, finding that the Colorado LLC Act and the language in the operating agreement established the operating agreement as a conventional, multilateral contract that should be interpreted in light of prevailing contract law principles. Id. at *5.

Condo did not dispute the restrictive language in the operating agreement or that the two other members never consented to Banner’s assignment. The gist of her argument was instead that (a) the restrictive clause limited only the assignment of duties, not the assignment of contractual rights, and (b) even if the assignment did violate the LLC agreement, it was still effective to convey the member interest to her, notwithstanding Banner’s breach of the restriction and his resulting exposure to a breach of contract claim by the LLC. Id.

The court briskly disposed of the contention that the restrictive clause applied only to duties and not to an assignment of rights to receive distributions. The court referred to the anti-assignment language in the operating agreement – “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest” (emphasis added) – and pointed out that the LLC Act’s definition of “membership interests” includes a member’s right to receive distributions. See Colo. Rev. Stat. § 7-80-102(10). The court found that the right to receive distributions was included within the broad prohibition on transfers of any portion of a membership interest. Condo, 2011 WL 6318980, at *6.

The court then examined whether the nonconforming assignment was void or whether it was legally effective despite its noncompliance with the anti-assignment clause. If Banner had no power to make the assignment, it was void and Condo’s interference claim failed. “If, in contrast, Banner had the power but not the right to make the assignment, the assignment can be said to have occurred – albeit wrongfully – and Condo’s present claims against the defendants may survive summary judgment.” Id. at *7.

The court reviewed what it termed the classical approach and the modern approach to anti-assignment clauses. In the classical approach, an assignment that violates an anti-assignment clause is void from the beginning because the assignor has no power to make the assignment. In the modern approach, by contrast, an anti-assignment clause is seen as creating a duty to refrain from making a nonconforming transfer, but not as limiting the transferor’s power to make the transfer. In the modern approach the unlawful transfer is not void but is a breach of the obligation not to transfer, which the LLC can then enforce with a suit for breach of contract.

Under the modern approach the unlawful transfer is void only if the anti-assignment clause specifically states that a nonconforming assignment is “void” or “invalid” (sometimes called the “magic words” approach). Id.

The court ultimately held that the LLC agreement’s anti-assignment clause rendered Banner powerless to assign any portion of his membership interest, and that Banner’s assignment was therefore void and could not support Condo’s claims of tortious interference with contract and civil conspiracy. Id. at *10. In reaching its conclusion the court relied on two principles to reach its conclusion: maximizing freedom of contract, and the “pick your partner” policy.

The court recognized the strong public policy of the LLC Act in favor of freedom of contract: “It is the intent of this article to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” Colo. Rev. Stat. § 7-80-108(4). The court saw this policy as favoring the ability of a party to contractually restrict the ability of other parties to assign their rights. Condo, 2011 WL 6318980, at *8. The court also saw “a clear public policy in favor of allowing the members to tightly control who may receive either rights or duties under the operating agreement,” at least in the context of a closely held LLC. Id. at *9. The court was reluctant to force LLC members to deal with strangers with whom they had not contracted.

Although the court’s result appeared to reject the modern in favor of the classical approach, the court characterized its determination as a “facts and circumstances” analysis:

[W]e narrowly hold that the strict “magic words” approach is inapplicable to the present case. “Whether an attempted assignment … must fail because the rights or duties are of too personal a character is a question which turns upon the express or presumed intention of the parties, which must be ascertained from the entire contract, giving due consideration to the nature of the contract and the surrounding circumstances.”

Id. (ellipsis in original) (quoting 6 Am. Jur. 2d. Assignments § 27 (2011)).

The rule of the case is fairly clear for closely held LLCs, such as Hut at Avon (three members). Unfortunately it is not clear how to apply the court’s holding to other fact patterns. What facts and circumstances will be deemed relevant, when the court relied only on the pick-your-partner principle and freedom of contract in reaching its conclusions? As Justice Eid said in her concurring opinion, “The majority thus leaves open the possibility that, under different circumstances, the ‘modern approach’ might apply to an operating agreement with anti-assignment language similar to this one. This approach renders virtually every such anti-assignment provision open to challenge.” Id. at *12 (Eid, J., concurring) (citation omitted).

District Court Finds Common Law Fiduciary Duties Applicable to Wisconsin LLCs

Doug Batey — Wed, 11 Jan 2012 13:49:43 -0800

LLCs are sufficiently new that issues of first impression continue to come up in various states. One of those issues is whether common law fiduciary duties apply to LLCs, when the state statute is silent or unclear. That was the situation in Wisconsin, when the defendants in a case before the U.S. District Court for the Eastern District of Wisconsin contended that common law fiduciary duties do not apply to Wisconsin LLCs and that they therefore owed no fiduciary duties to the plaintiff. Executive Ctr. III, LLC v. Meieran, No. 10-CV-263-JPS, 2011 WL 4704274 (E.D. Wis. Oct. 4, 2011).

The dispute arose out of the plaintiff’s $1.2 million purchase of an office building from BRIC Executive, LLC. In connection with the sale, BRIC agreed to lease office space back from the plaintiff (Executive Center). But BRIC defaulted on its lease obligations almost immediately and made no rent payments. Executive Center sued BRIC on the lease and obtained a judgment for $152,000, but BRIC was insolvent and never paid on the judgment.

Executive Center then investigated and learned that the defendants, part owners of BRIC, had been paid $400,000 by BRIC immediately after the closing of the real estate sale. BRIC paid the $400,000 to the defendants in order to redeem their part ownership in BRIC, under an agreement made by BRIC and the defendants 11 months before Executive Center’s real estate purchase.

Executive Center next sued the defendants in federal court, challenging the $400,000 transfer from BRIC to the defendants and seeking an award of damages. (The case was filed in federal court on the basis of diversity jurisdiction; no federal law issues were involved.) Executive Center claimed that by accepting the $400,000, the defendants (1) violated portions of Wisconsin’s Uniform Fraudulent Transfer Act; (2) breached a fiduciary duty they owed to the plaintiff; and (3) benefited from an inequitable preference. Id. at *2.

After pretrial discovery the defendants moved for summary judgment on all of Executive Center’s claims. The court granted summary judgment to the defendants on the fraudulent transfer claim and on the inequitable preference claim, but denied summary judgment on the fiduciary duty claim.

The gist of Executive Center’s fiduciary duty claim was that the defendants breached fiduciary duties they owed to Executive Center, a BRIC creditor, when they accepted BRIC’s payment of $400,000 at a time when BRIC was insolvent. The defendants argued that “common law fiduciary duties do not apply to Wisconsin LLCs because LLCs are purely statutory creatures that have their duties defined entirely by statute.” Id. at *7 (citing Gottsacker v. Monnier, 697 N.W.2d 436, 447 (Wis. 2005)). The defendants also pointed out that Wisconsin’s LLC Act does not expressly state that common law fiduciary duties apply to LLCs, other than referring to the Act’s incorporation of veil-piercing principles. Id.

The District Court distinguished Gottsacker, however, pointing out that its only discussion of the applicability of common law fiduciary duties to LLCs was in one Justice’s concurring opinion. The court then examined precedent from other jurisdictions, finding it persuasive: “In fact, there is growing consensus that common law fiduciary duties should apply to the operations of LLCs.” Id. at *8 (citing seven cases from Indiana, Kentucky, California, Connecticut, and Idaho). The court also looked to the policy supported by fiduciary duty rules. “Fiduciary duties exist to protect people who are affected by the actions of those who control businesses. Therefore, it would not make any sense if the expectation for a business to act fairly were to be different simply due to the business owners’ choice of form – an LLC, in this case.” Id. at *9 (citation omitted). The court concluded that common law fiduciary duties apply to Wisconsin LLCs. Id.

The court next considered whether any duties were owed to Executive Center in particular. (Executive Center was a creditor of BRIC, not a member.) Under Wisconsin case law, the defendants would owe a fiduciary duty to Executive Center if (a) BRIC was insolvent at the time of the $400,000 transfer, and (b) BRIC had ceased to act as a going concern. The court had already found that BRIC was insolvent at the time of the transfer, and defendants had conceded that there was an issue of fact regarding whether BRIC was no longer a going concern at the time of the transfer. The court therefore found that genuine issues of material fact remained, and denied defendants’ summary judgment motion on the fiduciary duty claim, which meant that the issue could go to trial.

This case is a nice example of a court resolving a question left unanswered by the state’s LLC Act. (I have written about this issue before, in connection with the Idaho case cited by the Executive Center opinion, here.) It’s also not a surprising result – it’s difficult to imagine a court finding that fiduciary duties do not in general apply to LLCs.

New York High Court Punts on Fiduciary Duties of LLC Promoters

Doug Batey — Fri, 06 Jan 2012 09:28:48 -0800

Last month New York’s highest court, the Court of Appeals, affirmed a 2010 ruling by the Appellate Division that LLC promoters were fiduciaries of the investors they solicited, prior to the LLC’s formation, to become members. Roni LLC v. Arfa, 2011 WL 6338906 (N.Y. Dec. 20, 2011). The top court’s ruling was a surprisingly short memorandum opinion, given the significance of the issue presented.

The Appellate Division had applied the corporate rule on pre-formation activities to LLCs. “It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders…. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members.” Roni LLC v. Arfa, 74 A.D.3d 442, 444 (N.Y. App. Div. 2010). I wrote about the Appellate Division’s ruling here, and about last month’s oral argument before the Court of Appeals, here.

The Appellate Division’s ruling had also garnered attention from New York lawyer Peter Mahler, here and here, and from the late Professor Larry Ribstein, who passed away recently, here. Professor Ribstein also filed an amicus brief on the case with the Court of Appeals. The major criticisms of the 2010 ruling have been that the rule of the old corporate cases is no longer necessary because of the disclosure requirements of the federal and state securities laws, and that the corporate rule should not be applied to LLCs because their contractual nature distinguishes them from corporations.

The Court of Appeals put off the question, however, whether mere status as a pre-formation LLC promoter is adequate to create a fiduciary relationship. “Based on the foregoing analysis, we need not decide the question of whether the promoter defendants’ status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship.” Roni LLC v. Arfa, 2011 WL 6338906, at *4 n.2.

The court instead began by citing prior case law to the effect that a fiduciary relationship exists “when confidence is reposed on one side and there is resulting superiority and influence on the other,” id. at *2. The court then reviewed the complaint’s allegations that (1) the promoters planned the business venture, organized the LLC, and controlled the invested funds; (2) the promoters were in the best position to disclose material facts to the investors; (3) the promoters represented to the foreign investors that they had particular experience and expertise in the New York real estate market; and (4) the promoters played upon the cultural identities and friendship of the investors. The court found that the complaint’s allegations showed confidence by the investors and resulting superiority and influence by the promoters, and therefore adequately pled a fiduciary relationship. Id. at *3.

The Court of Appeals ignored the Appellate Division’s holding that the complaint’s allegations are inadequate to establish a fiduciary relationship, which suggests that the Court of Appeals went out of its way to affirm without ruling on the “LLC-promoter-status-equals-a-fiduciary” issue. But if so, it’s slightly puzzling that the court also saw no distinction between LLCs and corporations for the issues in this case:

Certainly there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case: a potential exists regardless of corporate form for “conscienceless promoters [to] accumulate property at a low price under a well-devised scheme to unload it upon others at a high price.

Id. at *4 n.1.

Although the court’s opinion leaves open the “LLC-promoter-status-equals-fiduciary” issue, I suspect that most plaintiff’s attorneys will conclude that the court left them with enough to work with when pleading pre-formation fiduciary duty claims against LLC promoters. For one thing, the first three of the four factual points in Roni referred to by the court and summarized above are likely to apply to most promoter situations.

Ohio LLC's Incentive Compensation Creates Partnership With Former Employee

Doug Batey — Fri, 16 Dec 2011 14:47:31 -0800

Business acquirors sometimes give the acquired company’s management financial incentives to enhance the acquired company’s value. These are often structured as bonus compensation for achieving defined milestones, and sometimes include equity in the acquired company or in the buyer.

In a recent Ohio case the buyer of a company’s assets provided incentive compensation to the company’s management, based on the profits of a division of the company. The employee was later terminated, and claimed the company had entered into a partnership with him and then breached its fiduciary obligations.

Although the contract never referred to a “partnership,” the court held that the incentive compensation provisions created a partnership between the buyer and its employee. Rhodes v. Paragon Molding, Ltd., No. 24491, 2011 Ohio App. LEXIS 3553 (Ohio Ct. App. Aug. 26, 2011). And once the court determined that a partnership existed, the door was opened to the former employee’s claims of breach of fiduciary duty.

Huntin’ Buddy Industries was a seller of turkey and duck calls designed by Roy Rhodes, one of its owners. In 2004 Huntin’ Buddy sold its assets to Paragon Molding, Ltd., an Ohio LLC. As part of the acquisition, Rhodes entered into a five-year employment agreement with Paragon. In the asset sale agreement Rhodes was given profit-sharing rights based on the “Roy Rhodes Championship Call division” (Division).

Fifteen months after the acquisition, Paragon terminated Rhodes’ employment and contended that his profit-sharing rights in the Division were also terminated. Rhodes sued, claiming that the profit-sharing provisions in the asset purchase agreement had created a partnership between Rhodes and either Paragon or its executive officers, and that Paragon and its principal officers had breached their fiduciary obligations to him. The trial court ruled on summary judgment that no such partnership or fiduciary duty existed.

The Court of Appeals first stated the Ohio partnership rule:

A partnership exists when there is (1) an express or implied contract between the parties; (2) the sharing of profits and losses; (3) mutuality of agency; (4) mutuality of control; (5) co‑ownership of the business and of the property used for partnership purposes or acquired with partnership funds.

Id.at **7 (quoting Grendell v. Ohio EPA, 146 Ohio App.3d 1, 764 N.E.2d 1067 (2001)).

The court pointed out that the parties had no express partnership agreement, and then examined the relevant provisions of the Huntin’ Buddy asset purchase agreement. The salient terms were:

1. “Rhodes will maintain 35% of the value of the [Division].”

2. “Should [the Division] be sold, Roy Rhodes will be entitled to 35% of the net purchase price related to the [Division].”

3. “Should [Paragon] be sold as an entirety including [the Division], Roy Rhodes will be entitled to 35% of the net value of the [Division] only.”

4. “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.”

Id.at **10.

The court’s analysis focused on the co-ownership requirement. The agreement did not say that Rhodes “owns” 35% of the Division. But, said the court, the language “Rhodes will maintain 35% of the value” of the Division meant that the parties intended for Rhodes to retain ownership of 35% of the Division. That interpretation was also supported by the clause that Rhodes is entitled to 35% of distributions of Division profits.

There was also a deposition in the case that may have been the final nail in the coffin of Paragon’s argument. One of Paragon’s owners agreed in his testimony that Rhodes “owned thirty-five percent” of the Division. The Court of Appeals noted that “even the owner of Paragon intended for Rhodes to retain a thirty-five percent ownership interest” in the Division. Id. at **12.

So the court found that an implied partnership had been created. “Accordingly, this evidence supports a conclusion that an implied partnership existed between Rhodes and Paragon such that Rhodes was entitled to ownership of thirty-five percent of the company itself, thirty-five percent of any profit distribution instituted by the company, and thirty-five percent of the net profits generated during the sale of the company.” Id. at **12-13.

Partners in a partnership owe each other fiduciary duties, id. at **7-8, and the court found ample evidence in the record to create a genuine issue regarding whether Paragon had breached its fiduciary duties. For example, Paragon purported to strip Rhodes of his 35% interest when it terminated his employment, and Rhodes was excluded from any involvement in or information about the Division. Result: The Court of Appeals reversed the trial court’s summary judgment dismissing Rhodes’ fiduciary duty claims, and sent the case back for a trial on Rhodes’ fiduciary duty claims.

The court didn’t discuss what type of entity Paragon was, so the result presumably would have been the same if Paragon had been a corporation instead of an LLC. But Paragon’s LLC status may have affected the phraseology used by the drafter of the incentive compensation language. The clause on distributions of profits in particular sounded like it could have come from a partnership or LLC operating agreement: “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.” Although this clause does not directly refer to ownership of the Division, it satisfies part of the definition of a partnership and provides additional support for the court’s conclusion.

Kansas Court Broadens Charging Order Against Single-Member LLC

Doug Batey — Fri, 02 Dec 2011 13:19:32 -0800

Judgment creditors of LLC members usually have the right under state law to obtain a charging order against a member’s LLC interest. A charging order mandates that any distributions by the LLC that would otherwise be made to the member be paid instead to the creditor. The charging order provides no benefit, though, if no distributions are made to the LLC’s members. And if the judgment debtor is the only member of the LLC, it’s unlikely that he or she will cause the LLC to make distributions, since those would have to go to the creditor.

The U.S. District Court in Kansas recently had to determine the scope of a charging order against a single-member LLC in Meyer v. Christie, No. 07-2230-CM, 2011 U.S. Dist. LEXIS 118590 (D. Kan. Oct. 13, 2011). Although the Kansas LLC Act says a charging order against an LLC member’s interest is the creditor’s exclusive remedy, the court surprisingly found that, in the case of a single-member LLC, the creditor could assert management rights and take control of the LLC.

The relevant facts are straightforward. The plaintiffs obtained a final judgment of about $7 million against the defendants, who had interests in several Kansas LLCs. The plaintiffs asked the judge to issue a charging order against the defendants’ interests in the LLCs, under the authority of Kansas’s LLC Act:

Rights of judgment creditor. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. This act does not deprive any member of the benefit of any exemption laws applicable to the member’s limited liability company interest. The rights provided by this section to the judgment creditor shall be the sole and exclusive remedy of a judgment creditor with respect to the member’s limited liability company interest.

Kan. Stat. Ann. § 17-76,113 (emphasis added).

A charging order is a limited remedy – the creditor has only the rights of an assignee, i.e., the economic right to receive distributions, and no rights to participate in management. The Kansas statute also provides that the charging order is the exclusive remedy, so the creditor cannot attach or foreclose on the member’s interest and thereby take control. (The charging order provisions of some state LLC Acts are silent on whether the charging order is a creditor’s exclusive remedy. See my discussion of Florida’s Olmstead v. FTC case on charging orders, here.)

The court acknowledged the Kansas LLC Act’s clear statement that the charging order is the only remedy by which a member’s judgment creditor can reach the member’s LLC interest, and discussed the partnership law origins of the LLC charging order. In the case of partnerships, a creditor’s charging order against a partner will not entitle the creditor to participate in the management of the partnership. Meyer, 2011 U.S. Dist. LEXIS 118590, at *10.

But, said the court, the result is different in the case of an LLC with only one member. That’s because of a specific provision in the Kansas LLC Act:

If the assignor of a limited liability company interest is the only member of the limited liability company at the time of the assignment, the assignee shall have the right to participate in the management of the business and affairs of the limited liability company as a member.

Kan. Stat. Ann. § 17-76,112(f). That paragraph is not in the Act’s section on charging orders, but is part of a long section dealing with assignments of LLC interests.

Without discussion, the court simply assumed that the holder of a charging order not only has the rights of an assignee but actually is an assignee. The court then held that under Section § 17-76,112(f), “the assignee/creditor shall have the right to participate in the management of the business and affairs of the LLC as a member.” Meyer, 2011 U.S. Dist. LEXIS 118590, at *11. With those rights, the holder of a charging order against an LLC’s sole member can take over the LLC, make distributions to itself, and liquidate the LLC if it so chooses.

The problem with the court’s holding is that the creditor’s rights under a charging order are limited to satisfaction of the debt. Once the judgment debtor’s obligation is satisfied, the charging order is extinguished. An assignment, in contrast, is a permanent transfer of the property rights assigned. The charging order statute accordingly recognizes that the rights of the creditor are limited: “To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest.” Kan. Stat. Ann. § 17-76,113 (emphasis added). The Meyer court ignored the inherent limitations of charging orders. Its confusion between the limited economic rights granted under a charging order and the full transfer of rights granted under a true assignment led it to the wrong result.

Some states have added provisions to their LLC Acts to clarify this point and avoid a Meyer result. Thomas Rutledge recently blogged about the Meyer case, here, and pointed out that Kentucky has amended its LLC Act to provide that “[a] charging order does not of itself constitute an assignment of the [LLC] interest.” Ky. Rev. Stat. § 275.260(3).

Michigan similarly provides in its LLC Act that a charging order is not an assignment of the member’s interest, and that the holder of a charging order does not become a member of the LLC. Mich. Comp. Laws § 450.4507.

One recent publication that is a useful reference for investigating state LLC charging order laws is Carter G. Bishop, Fifty State Series: LLC Charging Order Statutes , Suffolk University Law School Research Paper No. 10-03 (Oct. 6, 2011) .

Fiduciary Duties of LLC Organizers Argued Before New York's Highest Court

Doug Batey — Tue, 29 Nov 2011 13:32:57 -0800

Last year the New York Appellate Division ruled that LLC organizers are fiduciaries of the investors they solicit to be members, and that as such they have a duty to disclose their self-dealing. Roni LLC v. Arfa, 903 N.Y.S.2d 352 (App. Div. 2010). I reported on the case, here.

The Roni decision was critiqued by New York lawyer Peter Mahler, who blogs on New York business law, here, and by law professor Larry Ribstein, here. To oversimplify a bit, the gist of the criticism is that the rule of the old corporate cases, on which the Roni court relied, (a) has been made unnecessary by the disclosure rules of federal and state securities laws, and (b) should not apply to LLCs because the contractual nature of the relationship between LLC members allows them to allocate risks and define duties inter se, which is not characteristic of corporations.

Roni has since been appealed to New York’s highest court, the New York Court of Appeals. Oral arguments in the case were heard by the court on November 15, 2011, and yesterday Peter Mahler blogged on the briefing and the oral arguments, here. His article is a fascinating review of the oral arguments before the high court. The judges’ questions apparently ranged widely from “Why should LLCs be treated differently?” to concerns over line-drawing and the reach of the Roni rule articulated by the Appellate Division.

So now we wait for the high court’s decision, which Peter Mahler predicts will likely be in the early months of next year. One can hope, if the Appellate Division ruling is upheld, that the court will provide some guidance on the scope of the Roni duty to disclose.