Ward on Iowa Limited Liability Company Law

Restraints on Alienation

The Bankruptcy Appellate Panel for the Sixth Circuit handed down a decision recently that at first blush might give business lawyers pause.  In re Hake, 2009 Bankr. LEXIS 3825 (November 4, 2009) holds that an agreement among shareholders requiring the consent of the other shareholders before stock can be transferred is an unreasonable restraint on alienation under Ohio law.  Curiously, the decision was rendered on the basis of a 1945 Ohio Court of Common Pleas opinion and a 1910 Ohio Supreme Court opinion without referencing the Ohio corporate law statute.  What the panel fails to point out is that this restriction was voluntarily entered into by the owners of the enterprise and was now being undone by the court.  What about freedom of contract?

 

Iowa lawyers have no reason to fear this decision, however.  We here in the Hawkeye state take a much more modern view of stock or unit transfers.  The new Iowa LLC Act only makes one reference to transfer restrictions.  In 489.502(6) the law says “A transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement or another agreement to which the transferor is a party is ineffective as to a person having notice of the restriction at the time of transfer.”  Restrictions are thus implicitly recognized in Chapter 489 and since 489.110 dictates that the operating agreement governs the relations of members as members it is safe to say that the operating agreement restrictions on transfer will control. In addition, unlike Ohio, I could not find an Iowa court opinion striking down a stock transfer restriction on the basis of restraint of alienation.  And Iowa corporate law offers strong evidence that requiring the consent of the other members/shareholders before a transfer is valid would be upheld in Iowa.

Iowa Code Section 490.627 says that the articles, bylaws or agreement among the shareholders may impose restrictions on stock transfers so long as the restriction is for a reasonable purpose and lists as one persmissable restriction requiring the corporation, the holders of shares or another person to approve the transfer “if the requirement is not manifestly unreasonable.” 

Not sure how to balance “reasonable purpose” against a restriction that is not “manifestly unreasonable” but it seems to me that a restriction recognized by statute has to be given a presumption of validity and not wanting unknown outsiders to become part owners of a company is certainly reasonable and one of the main underlying reasons for entering into such restrictive agreements.

So, what does manifestly mean?  One author has noted, although "numerous cases apply the concept they rarely explain why a provision is found manifestly unreasonable.” The Official Comments to the UCC suggest that a "manifestly unreasonable" provision might be equated to an "obviously unfair" provision. Other commentators say it is falls somewhere between "unreasonable and unconscionable" or "passing beyond the outer limits of permissiveness."  Perfectly clear, right?

 

-Marc Ward

Another Worrisome Piercing Case

This time it's the US District Court for the Southern District of Georgia that is the culprit.  Let's hope the context of this ruling is important.  The issue was one of venue, not liability.  Here are the relevant facts.

Rayonier Wood Products bought a lumber grading system from ScanWare. FinScan, a Finnish company, was not a party to the contract  and at the time was only a minority owner of ScanWare.  About 15 months later FinScan acquired 100% of the stock of ScanWare. 

As you might imagine, Rayonier was not happy with the performance of the grading system and sued ScanWare and FinScan.  Because the contract between Raynoier and ScanWare contained a choice of law provision, Rayonier filed the action in Georgia.  I'm going to skip over the procedural details to tell you simply that there was a dispute over the proper venue for the case and the question came down to whether FinScan was bound by the choice of law provision in a contract it didn't sign and at a time when it was only a minority shareholder to one of the signatories.  Of course, I wouldn't be writing this if the answer was anything but YES.

The court in Rayonier Wood Products. LLC v. ScanWare, Inc.,2009 U.S. Dist. LEXIS 110753 (Ga., 11/30/09) gave short thrift to the fact that at the time of the contract FinScan was just a minority shareholder.  What the court found dispositive instead were these facts:

1. FinScan later became the sole shareholder of ScanWare;

2. Rayonier and FinScan employees regularly communicated with each other (presumably regarding ScanWare business, but not clear);

3. FinScan's president was also ScanWare's president and he tried to resolve Rayonier's concerns with the ScanWare product;

4. The system sold by ScanWare was basically a FinScan product.

Based on these facts, the court held that "ScanWare was an instrumentality or alter ego of FinScan when the contract was signed.  Although it was not a signatory to the contract, FinScan is bound by the terms of the contract."

Keep in mind that each of these facts occurred after the contract was signed.  Like I said at the outset, let's hope the standards are lower for piercing the veil to find the proper venue than to impose monetary liability.

-Marc Ward

When Shall Doesn't Mean Shall

The courts seem to be throwing curve balls lately on the interpretation of some rather common words. In my previous post I discussed the interpretation of "if" by the Idaho Supreme Court.  TonightI am writing about the Iowa Court of Appeals ignoring the word "shall" in ruling that Wild Rose Entertainment, L.L.C. did not breach a contract with John Pavone and Signature Management Group, L.L.C. (Pavone v. Kirke, No. 9-412/08-0180, Ia. Ct. Apls., Nov. 25, 2009).

Wild Rose and SMG entered into an agreement regarding the operation of a casino in Ottumwa (the "October Agreement").  This agreement contained a provision stating that if the Ottumwa project was completed "Wild Rose shallenter into an exclusive management agreement with [Pavone]...This Management Agreement shall provide for an annual management fee equal to four percent (4%)...The terms of the Management Agreement shallbe similar to...the gaming development agreement between Wild Rose and the City of Ottumwa, Iowa."

The court's opinion notes that the parties orally agreed that this agreement would also apply to a possible casino in Emmetsburg.  Presumably then with respect to Emmetsburg the references to Ottumwa should be changed toEmmetsburg.  The Ottumwa casino was rejected by gaming authorities, but the Emmetsburg casino was approved.

The jury found for Pavone and awarded him $10 million. The district court refusedto issue a JNOV.  the court of appeals reversed the trial court and held that this section of the agreement was nothing more than an agreement to agree and was therefore unenforceable.

First, the court held that the October Agreement was a consulting agreement, not a management agreement.  It is not clear why the characterization of this contract is relevant.  Whether the October Agreement is a management agreement or a consulting agreement is not the point.  Pavone was contending that Wild Rose was required to enter into a management agreement because the Emmetsburg casino was approved.

Next, the court found that the October Agreement failed to contain many key terms regarding the management agreement including the hiring and firing of key personnel, the term of the agreement and the scope of services.  However, as the district court pointed out in its ruling, the referenced agreement with Ottumwa contained all of these terms and it was reasonable to assume that management included the hiring and firing of key personnel.

The fact that the district court and the court of appeals could come to different conclusions should have been enough to find that a jury could too, but I find it very interesting that the use of the word "shall" was never discussed.  Lawyers choose their words carefully.  What did they mean when both sides agreed to the use of the word "shall"?

Dictionary.com says it means "must or is obliged to."  Merriam-Webster's says it is used to express what is mandatory.  That is how I use the word. Apparently, the Iowa Court of Appeals thinks otherwise.  So what are lawyers now supposed to think it means?

-Marc Ward

It Depends on the Meaning of "If"

Consider a partnership or LLC Agreement that says a partner/member may withdraw from the partnership/LLC "at any time if" (a), (b), (c) or (d) occur and if a partner/member withdrew for one of the four reasons, then specific consequences would result (termination of the partnership/LLC interest, etc.) Would you consider the four events to be the only reasons a partner/member could withdraw? Or does it just describe what happens if one of these four events occurs, leaving open the possibility that a partner/member may withdraw for other reasons without violating the partnership/LLC agreement?

In St. Alphonsus Diversified Care, Inc. v. MRI Associates, LLP, 2009 Ida. LEXIS 198 (Idaho Supreme Court, October 21, 2009), the court held the latter.  The court concluded that "if" was not exclusive, but really meant "in the event that."  With this meaning the pertinent provision of the partnership agreement merely described what happened under four circumstances resulting in a withdraw.  It did not prohibit other reasons for withdrawal.  The court went on to conclude that the partner's withdraw was not wrongful under the RULPA because it did not violate an "express provision" of the partnership agreement (same language can be found in the Iowa RULPA and the Iowa LLC Act, Section 489.601(2)(a)).

Based on this decision, to write an ironclad operating agreement provision limiting the right of a member to withdraw from an LLC do not use "if" but instead use something like this "A member shall not withdraw from the LLC except...." or "A member may only withdraw from the LLC under the following circumstances..."

-Marc Ward

Series LLCs, Better than Parent-Subsidiary?

There is a line of thought circulating among LLC commentators suggesting that Series LLC formed under the Delaware LLC Act not only creates a liability shield for the LLC against claims against a series (like a traditional parent-subsidiary corporate/LLC format) but also shields each series against claims against the LLC (not available to parent-subsidiary).

Take a look at Delaware LLC Act Section 18-215(b) and see what the fuss is about:

"...none of the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to the limited liability company generally or any other series thereof shall be enforceable against the assets of such series."

Fortunately or unfortunately, Iowa's new LLC Act does not have this language.  And of course, there is no case law on the subject.

-Marc Ward 

When Duties Shift - Cash Out Mergers

Shenker v. Laureate Education, Inc., (2009 Md. LEXIS 837, November 12, 2009) provides an interesting example of when the duties of a board shift from the corporation to the shareholders.  Most of the recent case law regarding the duties owed by boards of directors is derived from the Delaware business corporation act.  This case is an interpretation of the Maryland business corporation act which is very similar to the Model Business Corporation Act.  Therefore helpful in interpreting the Iowa Business Corporation Act.  Due to the sparsity of Iowa case law interpreting Chapter 490, we can use the help.

In Shenker the Board chair proposed that he would acquire the company by means of a cash out merger.  The Board established a committee of independent directors with the power to retain independent advisors to assess the offer.  After rejecting an initial offer and some further jousting between the offerors and several large institutional shareholders, the final offer was found to be fair by the independent advisors, Merrill Lynch and Morgan Stanley.  The special committee and the Board approved the offer.

A shareholder lawsuit ensued but was dismissed because it was filed as a direct action, not as a derivative action.  The lower courts held that the Board's statutory fiduciary duty ran only to the company and not the shareholders; any claims for breach of fiduciary duties must be brought derivatively.

The Maryland Court of Appeals disagreed. With the Delaware decisions in Revlon and Paramount Communications as a back drop, the court held that there are common law shareholder duties that are triggered once the decision to sell the corporation has been made.  The statutory duty of care regards the Board's duties in managing the corporation and is not exclusive of other duties.  In the case of a cash-out merger the Board assumes responsibilities to the shareholders and assume the duties of candor and maximizing the consideration paid for the stock. 

Important in the court's decision, as it points out, is the fact that because success in a derivative claim would benefit the corporation and hence all of the shareholders, the majority shareholders who were the alleged transgressors would have benefited as well.  This apparently didn't sit well with the court.

Of course in Iowa we have 490.202(2)(d) which, if properly reflected in the articles of incorporation precludes monetary liability on the part of directors for any of their actions or inactions unless the conduct (1) resulted in the directors receiving an improper financial benefit, (2) was an intentional infliction of harm, (3) resulted in an improper distribution or (4) was an intentional violation of criminal law.  Unless this section of the Code is found to be limited to the duty of care or only to statutory duties, Shenker will have little purchase in Iowa.

-Marc Ward

Derivative versus Direct Action

Imagine you are a 13% owner of an LLC.  The other two members own 60% and 27% of the LLC interests, respectively.  Your LLC owns and operates a restaurant.  You learn much to your dismay that two new restaurants open in surrounding communities.  Curious, you drop in for a meal at these establishments.  Lo and behold, the menus look surprisingly similar to your restaurant.  You dig a little further and discover that the owners of these new restaurants are also the members of your LLC.  Not only do the menu ideas appear derivative, you believe some of the assets and trade secrets from your restaurant are being used by the new ones.  Not happy, you bring a direct claim against your business colleagues.  They in turn move to dismiss because you lack standing to sue them directly.  Will their motion be successful?

In Ward v. Gamble, (2009 Conn. Super. LEXIS 2091) the court faced with these facts (I indulged in a little artistic license in my recounting of them) granted the motion to dismiss.  Unlike Iowa law, which I will get to in a minute, the Connecticut LLC Act does not address derivative actions so the court had to rely on a statute regarding corporate and unincorporated associations derivative actions. The court recited well-settled Connecticut law that in order to have standing the plaintiff must "demonstrate a specific, personal and legal interest in [the subject matter of the challenged action], as distinguished from a general interest" and this interest has been adversely affected by the actions of the defendants.

It then applied the general derivative statute to conclude that the plaintiff must bring a derivative action because the alleged injuries are not separate and distinct from those suffered by the LLC and its other members, even though the only other members of the LLC were the alleged wrong-doers.

Iowa Code 489.901 addresses direct actions by LLC members.  A member may bring a direct action against another member, manager or LLC "to enforce the member's rights and otherwise protect the member's interests.  The member must plead and prove injury that is not solely the result of an injury suffered by the LLC.

-Marc Ward

Special Merger Protections for Minority Shareholders

In 2005 John Q. Hammons Hotels, Inc. was sold to a private company.  The minority shareholders received $24 per share for their 24% interest and John Q. himself received different consideration for his 76% stake.  Hammond's consideration included a small stake in the buyer with a preferential buyout, a line of credit and other consideration.  The parties disagreed on whether his consideration was worth more or less than $24 per share.

The plaintiffs brought a class action alleging that Hammons and the board of directors breached their fiduciary duties by negotiating different consideration and allowing the merger to be approved through a deficient process, respectively.  In re John Q. Hammons Hotels, Inc. Shareholder Litigation (Del. Ch. October 2, 2009).

The plaintiffs argue that Kahn v. Lynch Communication Systems, Inc. is the controlling case.  In Lynch the Delaware court held that when a controlling shareholder makes a cash out merger offer to the minority the standard of review is entire fairness of the transaction and the burden is on the controlling shareholder.  The burden shifts to the plaintiff when the approval of the cash-out merger is required of (1) an independent committee of directors or (2) an informed majority of minority shareholders.  The defendants countered that the business judgment rule should apply because of the safeguards built into the deal.

The court in Hammons declined to find Lynch controlling because John Q was not the purchaser (i.e. not on both sides of the transaction. But it did find that the business judgment rule could not be invoked because the merger process was deficient. 

To make a long story short, in merger transactions involving a controlling shareholder (but not as buyer)the business judgment rule will not be available and instead entire fairness (fair dealing and fair price) will be applied unless (1) an independent committee of disinterested directors approve the deal and (2) a majority of the minority shareholders (not just those voting) approve the merger in a vote that is not waivable by the independent directors.  The court made clear that it was not enough that the committee did not waive even though they could have or a majority of all minority shareholders approved the merger even though only those attending the meeting were required to.  The form controls the substance in this regard.

-Marc Ward

Vermont's Virtual Farce: Corporate Law Changes Are No Improvement

The state of Vermont is getting some undeserved credit for adopting amendments to its corporate statute that permit so-called virtual corporations.  It is much ado about nothing.

A visiting law professor at New York Law School who doesn't know much about corporate law, David Johnson, is touting the changes as unique in the country.  They are not.  He makes a big deal out of the fact that Vermont corporations will no longer be required to hold face-to-face annual meetings (I can't help but think of the Town Hall meeting episode from "Newhart").  Iowa has permitted telephonic and video conference meetings for years, and written actions without a meeting have been around even longer.

Iowa, and many other states I am sure, is also ahead of Vermont when it comes to filing annual reports online and permitting electronic signatures.

There are unique aspects to the Vermont law.  Start with the name of the legislation, H.0888 Miscellaneous Tax Documents.  Yep. That is the name of the act.  In Iowa it would be unconstitutional.

But it gets better.  Vermont goes off the deep end in a number of places.  Notice to a shareholder can now be delivered by voice mail. (Is it delivered if not listened to?) And, get this, and I quote: "terms of shares may be made dependent upon facts objectively ascertainable outside the articles of incorporation."  Say What?  Are they serious or did the maple syrup ferment?

If anyone wants to read this zany bill you can get it here.

-Marc Ward

Pay Me Now or Pay Me Later

The Iowa Court of Appeals opinion in Builders Kitchen and Supply Co. v. Moyer, N0. 0-655/09-0194 (September 2, 2009) is a deceptively simple case.  On the one hand it represents the folly of not having even run of the mill contracts reviewed by lawyers before they are signed.  And on the other hand, it is a warning to lawyers that things aren't as simple as they appear.

Frank Moyer signed a contract with Builders Kitchen for the purchase and installation of some kitchen cabinets and countertops.  The contract was just two pages long.  On the first page there was a place for the name of the business and a little later a space to indicate the type of entity.  Moyer filled in the name of his business, Crystal Creek Development, but neglected to indicate that it was a corporation.  He signed the contract as "Frank Moyer, Pres."  The second signature line, presumably for the guarantor, was left blank.

Unfortunately for Moyer the contract contained a clause that said "I hereby personally guarantee to pay on demand any and all sums due that my/our company shall fail to pay."  Of course, I wouldn't be writing this post if Crystal Creek Development had paid the amount due.

Because it didn't Builders Kitchen sued the company and Moyer personally.  The district court found Moyer to be personally liable and the Court of Appeals affirmed finding that Moyer's signature was both in his representative capacity and personally.  To find otherwise, both courts said, would negate the language of the contract. 

This raises some interesting questions.  First, is this also true if a document is signed as ABC, Inc. by John Doe, President and the other signature line for the guarantor is left blank?  What if a lower level officer, not the owner of the company, had signed the contract?  Would that poor son of a gun be personally liable?  Does this mean that signatories to contracts are also parties to the contracts, unless "party" is defined to exclude the signatories? (thus, references to "the parties agree/represent/warrant/ etc." now bind the individuals signing the contract?)  And how does this ruling jive with Iowa Code 554.3402(2) which says:

2.  If a representative signs the name of the representative to an
  instrument and the signature is an authorized signature of the
  represented person, the following rules apply:
a.  If the form of the signature shows unambiguously that the
  signature is made on behalf of the represented person who is
  identified in the instrument, the representative is not liable on the
  instrument.

Maybe this case is not so simple after all.

-Marc Ward

Another Roadblock for Series LLCs

For me Series LLCs are an enigma.  It is not clear to me why one would take on the uncertainty that Series LLCs face when you can accomplish just about the same thing with multiple LLCs owned by a holding LLC.

In this regard the SEC released on September 1, 2009 a staff opinion shooting down the use of a Series LLC with respect to a broker-dealer arrangement in which the Master Series LLC would have no assets but would create two series, one for retail operations and the other for institutional customers.

The Financial Industry Regulatory Authority (FINRA) asked the SEC to bless such an arrangement.  Because the structure would run afoul of capital requirements and several financial disclosure regulations, the SEC rejected the idea.  Rather than go into the details I'll attach the relatively brief letter here in a little while.

-Marc Ward

Guidance for LLC Derivative Claims

If you’re looking for persuasive authority as to what constitutes an LLC derivative action under Iowa law, consider Weihs v. Carver et al., LACV 018772 (Shelby County).  In Weihs, former Iowa Supreme Court Justice Jeffrey L. Larson, who currently hears cases in the Fourth Judicial District in Western Iowa, dismissed a suit which purported to be a suit brought by LLC unit holders as individuals, but which was, in reality, a derivative suit in which the plaintiffs had failed to satisfy the statutory requirements to proceed derivatively.

Plaintiffs sought injunctive relief, declaratory relief and damages for breach of the duty of good faith and fair dealing and breach of fiduciary duties of loyalty and care.  Three unit holders brought the suit, naming as Defendants the Directors of the LLC.

Plaintiffs argued that they could bring the action against the Directors as individuals, because Plaintiffs claimed that they were owed a special duty and that they had injuries which were separate and distinct from those suffered by other unit holders in the LLC.  Specifically, Plaintiffs claimed that the Defendants owed the Plaintiffs a duty under the LLC Operating Agreement, and that the Directors had breached their duty by failing to call a requested meeting to remove the Defendants as directors.  Plaintiffs argued that because they were the only three members calling the special meeting and were ignored, that they suffered an injury separate and distinct from the other members.  Plaintiffs also argued that additional ownership interests that had been issued at a board meeting by the Defendant Directors negatively affected the Plaintiffs’ majority control of the LLC’s voting interest, such that the Plaintiffs had suffered a separate injury.

Judge Larson held that the Plaintiffs had failed to show that they were owed a special duty, or that they had suffered an injury separate and distinct from the other unit holders.  First, the Operating Agreement did not create any special duty running to the Plaintiffs, even if the Plaintiffs were the only unit holders requesting the meeting.  Moreover, dilution was an injury felt by all unit holders.  The Court also rejected Plaintiffs’ reliance upon language in the Operating Agreement which said that the Company and the non-breaching Members were entitled to injunctive relief in certain instances, as the Court held that the language did not create any right in the Plaintiffs as individual unit holders.

 

 

-Mollie Pawlosky

mpawlosky@dickinsonlaw.com

On the Road Again

I just finished two days of LLC seminars in Des Moines and Cedar Rapids and will be appearing at the ISBA's Travelling Seminar in Sioux City on Tuesday, September 29.  Mark your calendars for the Iowa Law School's Corporate Law Seminar on November 6.  I'll be discussing the latest LLC developments at that seminar too.

-Marc Ward

Ethics Committee Issues Opinion 09-03 Affecting Business Lawyers

The issue addressed by Ethics Opinion 09-03 is whether a law firm can represent a client in litigation arising out of a business transaction in which the firm also represented the client.  The Opinion applies two tests for determining whether a lawyer can continue her representation of the client.  The first concerns whether the representation will be materially limited by the personal interest of the lawyer to defend her own work product.  The second test concerns whether the lawyer will be a necessary witness in the trial.  The thrust of the opinion leans towards finding a conflict of interest in such cases.

Here is a link to the opinion: http://tinyurl.com/ksn65l.

-Marc Ward

Tax Court Recognizes Single Member LLCs for Valuation Discounts

Joe Kristan writes: "In a rare decision by the full court, the Tax Court yesterday ruled that single-member limited liability companies, which are ignored for income tax purposes under the "check-the-box" rules, are to be respected under the gift tax rules. This opens up the door to using single-member LLCs to obtain estate and gift tax valuation discounts."

Read more about this important case at Joe Kristan's Tax Blog: 

http://www.rothcpa.com/taxupdates.php

McGinnis v. Iowa Clinic: Fiduciary Duties in Closely-Held Corporations

The Iowa Court of Appeals addressed whether shareholders in a closely-held corporation, in this case a professional corporation of physicians, owed fiduciary duties to one another and whether the claims for breach of those duties could be brought directly rather than derivatively.  On both points the Iowa Court of Appeals said no.  McGinnis v. Iowa Clinic, P.C., 2009 WL 2424643 (Iowa App., August 6, 2009).

Senate File 413 Must be Defeated

I know it seems early to be concerned with the 2010 Iowa Legislature, but there is a bill carried over from last year that the Bar Association and others have been told will certainly become law if something isn't done about it.  And it is a bill that should not become law.

Why am I so concerned with SF 413?  Because by creating a new Iowa Code Section 91A.15 it imposes personal liability on officers of corporations, members and managers of LLCs and partners in partnerships "for a judgment obtained against an employer for failure to pay wages dues pursuant to Iowa Code Chapters 91A or 91D (Wage Payment Collection and Minimum Wage, respectively).  It is such a poorly written bill that it excludes corporate directors and shareholders, but includes LLC managers and members, the drafter apparently not realizing that they are practically interchangeable concepts.  It is also unclear whether it applies to LLPs and LLLPs.

Subsection 2 of this proposed new 91A.15 attempts to soften the liability exposure of subsection 1 by limiting it to persons (a) who control, supervise or have authority over wages and (b) who have a controlling interest or ownership in the entity and knowingly violate 91A or 91D.

This is not as limiting as it might seem because none of the terms are defined.  What is "control"?  Is being a manager having "authority for"?  What does it mean to "knowingly" violate?

If this law is passed you can kiss LLCs in Iowa good-bye.  The Legislature will also make it very difficult for out-of-state businesses organized as LLCs to do business in this state.  In other words, the preferred business entity, chosen by 77% of all new businesses in the State of Iowa, will be persona non grata.  Don't let any legislator who votes for this bill try to tell you they are pro-business or an advocate of business development in Iowa because they are not.

I appreciate what the sponsors of this bill are trying to do, but there is a better way to do it: Codify the elements of piercing the corporate veil.  Doing so will give clear guidance to owners and courts alike and see that people are punished for their conduct, not merely their ownership.

-Marc Ward

The Duty of Loyalty in the Context of a Law Firm Break-Up

It is not often you run across a RUPA case and a rare find when it is a duty of loyalty case to boot.  What makes In re Brobeck, Phleger & Harrison LLP, 2009 Bankr. LEXIS 2076 (July 2, 2009) particularly interesting is the RUPA provision in the case is nearly identical to the duty of loyalty provision found in the new Iowa LLC Act.

Brobeck, Phleger & Harrison LLP was a prominent law firm with over 900 attorneys.  The law firm fell into economic trouble causing the partners to take steps to ensure an orderly dissolution and winding up of its affairs.  Just prior to dissolution, the partners agreed upon a Final Partnership Agreement that addressed the "unfinished business rule" and the results of Jewel v. Boxer, 156 Cal. App. 3d 171 (1984).

The unfinished business rule says that unless the partners have agreed otherwise, they have a duty to account to the dissolved partnership and their former partners for the profits they earn on the dissolved firm's "unfinished business."  Jewel added emphasis to the UBR by making it clear that the partners can and should agree in advance to waive their rights to unfinished business (a "Jewel Waiver").

This unfinished business agreement/Jewel Waiver waived any claims the firm would have against its partners or that the partners would have against each other to account for the profits from unfinished business at the time of the dissolution of the partnership. In other words, it guided what happens between partners qua partners and between partners and the partnership.

The court did not end its analysis with the UBR and Jewel Waiver, but went on to determine whether the modifications to the partnership agreement (i.e. identifying the activities that did not violate the duty of loyalty) were manifestly unreasonable.

When I first saw the reference to "manifestly unreasonable" I was hoping I had finally come across the definitive definition.  No such luck.  The judge noted that no cases defined the term and not even a dictionary had one, so he concluded he must rely on his own common sense.  Great.  The good news is he found the law firm's Jewel Waiver not to be manifestly unreasonable.

You would think the opinion would end at this point, but the UBR and Jewel Waiver only affected the partners and the partnership.  There were other actors in this play, the creditors.  The bankruptcy trustee, on behalf of these creditors, asserted that the Jewel Waiver was an actual or constructive fraudulent transfer.

As to actual fraud, the court found none in light of the fact that the California courts encouraged partners to enter into Jewel Waivers.  Constructive fraud was another matter.  The court found that the partnership received nothing of value in exchange for the unfinished business it gave up to the partners.  The activities the partners listed as consideration for the unfinished business were either pre-existing duties or ethical obligations under the California Rules of Professional Conduct. 

Accordingly, the transfer of the unfinished law firm business was effective among the partners, but because nothing of reasonably equivalent value was given up by the partners in exchange for the partnership giving up its property right in the unfinished business, that exchange was a fraudulent transfer, albeit a constructive one, and the creditors were entitled to judgment against the partners and their new law firms.

 

-Marc Ward

IRS Dealt a 1-2 Punch on Applicability of Passive Loss Rules to LLCs

Two cases decided three weeks apart have made it very clear that LLC membership interests are not limited partnership interests under the passive activity loss rules of IRC Section 469.  This determination is important because if an LLC interest is treated as a limited partnership interest the member would be limited in his or her ability to claim material participation in the business operations.  Material participation is critical to ordinary loss treatment for tax purposes.  Ordinary loss treatment is better than passive activity loss treatment because the latter can only offset passive activity income.

In Garnett v Commissioner, 2009 U.S. Tax Court LEXIS 18, 132 T.C. 19 (June 30, 2009) the Tax Court ruled that the LLP and LLC interests of the petitioners (it just so happens they entities in question were Iowa LLPs and LLCs) were entitled to be treated as general partnership interests and not subject to the special rule of IRC Section 469(h)(2).  Instead, the seven factor test of Temp. Reg. Sec. 1.469-5T(a) would be used to determine whether the taxpayer materially participated in the business operations.

The Federal Court of Claims went further in Thompson v. US, No: 06-211 T (July 20, 2009).  Garnett was unwilling to simply conclude that LLCs are not partnerships therefore LLC interests are not limited partnership interests.  Instead, the opinion relies on the general partnership exception found in the regulations to hold an LLC interest to be a general partnership interest.  Thompson shared no such reluctance.  The IRS regulations say that "a partnership interest shall be treated as a limited partnership interest if...[t]he liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized." Treas. Reg. Sec. 1.469-5T(e)(3)(i)(B) (emphasis added by the court).  The court was compelled to enforce the "plain meaning" of the regulation.  An LLC is not a limited partnership.  Therefore an LLC interest could not be a limited partnership interest.  QED.

The Thompson opinion goes on for six more pages with a rather anticlimactic discussion about whether limited liability or participation in management was more important to the determination of limited partnership status.  Didn't the court just conclude that it didn't matter?

-Marc Ward

Words of Wisdom from the Solo and Small Firm Seminar

Last Friday Steve Roy, Frank Carroll and I spoke to the Solo and Small Firm Seminar about the new LLC law.  It is always good to hear from others in the profession about a subject that has a lot of open questions.  Here are some pearls of wisdom from the panel:

1.    Read the operating agreement.  This gem is from Frank Carroll.  He noted that he has run across a lot of lawyers including in-house counsel that will read a particular section of the act, such as the provision that calls for unanimous votes to amend the operating agreement, and assume that it is the new law in the Tall Corn State.  Of course readers of this blog should know otherwise.  The operating agreement will still control if it speaks to the issue.  The statute is the default rule in the absence of words to the contrary in the operating agreement.  Which leads me to the second pearl.

2.    The default rules stink.  Steve Roy delivered this line.  And it is so true.  Imagine an LLC that shares distributions on a per member basis regardless of the investment by the members, that requires the members to manage the company with each member having one vote on all matters that come before them, and requires unanimous consent to change the "operating agreement" that can be oral, written or implied.  I am afraid there might be quite a few out there already and they don't even know it.

3.    Read Section 110, read it and understand it.  This section explains how the operating agreement interacts with the Act.  Understanding section 110 is critical to drafting an operating agreement.

4.    Try to get your clients to focus on their fiduciary duties.  Because the duties of care and loyalty can be altered and in some cases eliminated, bringing this issue up early with your clients is of critical importance.  It is also difficult in practice if you are dealing with neophytes.  I've run into cases where the clients' eyes glaze over as you talk about their fiduciary duties and how they should consider addressing them up front.  They just want to sign the papers and start making money (hopefully).

5.    Clients need to deal with single member LLCs carefully.  The casebooks, at least figuratively in this digital world, are full of cases of the veil being pierced when the LLC or corporation is owned by only one person.  Dot the i's and cross the t's when organizing them and for God sake keep the money separated between the company and the owner.

-Marc Ward

Court Affirms Charging Order as the Exclusive Remedy

It's just a hunch, but I am willing to bet the bank's lawyer in this case forgot to read the Illinois LLC Act, hence this opinion, In re Michael E. Lahood, 2009 Bankr. LEXIS 1832 (Bkrptcy. Ill. C.D. July 16, 2009).

Heartland Bank and Trust obtained a general lien on the personal property of the debtor.  It didn't, however, obtain a charging order with respect to the debtor's distributional interest in an LLC.  When it realized its mistake the bank tried a number of arguments to get its hands on the only asset with value in the debtor's estate.

First, it argued that the distributional interest in the LLC was subsumed in the general lien it had on the assets. That is, its broader more general lien included the LLC interest. The court said no, the legislature was very specific that the charging order was the exclusive remedy for an LLC distributional interest, the LLC interest was not a subpart of a general lien.

Then the bank argued that "exclusive" didn't really mean exclusive, but just one way to have a lien on an LLC distributional interest; its general lien was another (which sounds a lot like its first argument).  Nope, said the court, if the bank didn't obtain a charging order it had nothing but air in terms of the LLC interest.

-Marc Ward

Interesting PLR Involving LLCs and S Corps

IRS Private Letter Ruling 200927014 (March 20,2009), presents an interesting fact pattern.   The two individuals who own all of the shares of X, an S corporation, will each transfer their shares to two LLCs. They will manage their LLCs and retain all rights to profits, losses and distributions.  But each of them will also transfer certain management rights to Y.  It is not clear whether Y is an individual or an entity.  These rights include the right to participate in management of the LLCs, the right to vote on their business activities, merger or sale of substantially all of their assets, borrow money, make distributions, liquidate the LLCs, amend their operating agreements, and transfer their interests to others.  Y would also appoint new managers if the shareholders die while acting as managers. All of these actions would indirectly affect the S corporation.  Y is not a member of either LLC.

The IRS held that the transfer of the S corporation's shares to the LLCs and the role of Y in the management of the LLCs would not cause the corporation to lose its S corporation status. For tax purposes Y is not considered a member of either LLC and each LLC will be treated as owned, respectively, by the two former shareholders of X.  The shares of X are treated as owned directly by the two individuals.  The LLCs will be disregarded entities for tax purposes.

It appears from the ruling that Y will participate in management but not have sole responsibility for management.  It is not clear if Y has control, but the tenor of the ruling suggests that the outcome was not be dependent on control, but on the determination that for tax purposes membership status is based solely on the right to the economic interest in the LLC.

-Marc Ward

A Way Around the Successor Liability Doctrine?

Our sagging economy is resulting in a lot of business foreclosures.  This will mean a lot of litigation and quite a bit of new law.  Tredit Tire & Wheel Co. Inc. v. Regency Conversions, LLC et al, 2009 US Dist. LEXIS 50323 (E. D. Mich, June 12, 2009) is one example.

Tredit Tire supplied specially designed and manufactured tires to Regency for the conversion vans it created.  Regency was owned by TAG, its sole member.  TAG defaulted on its loan from WB Automotive Holdings, Inc. ("WBAH").  WBAH foreclosed and became the owner of all of TAG's assets including its membership in Regency.

WBAH loaned Regency $1 million and replaced its president with its own employee.  Its efforts to save Regency failed, however, and Regency ceased making payments to its vendors.

One of those vendors was Tredit Tire.  It sued Regency and WBAH for breach of contract alleging that it was holding $350,000 of inventory made specifically for Regency and was owed $195,000 for tires already delivered to Regency.  It sued WBAH on several theories including piercing the corporate veil.

The piercing claim was based on the fact that WBAH exercised control over Regency (replacing the president with its own employee) and made all of the tactical and strategic decisions for the company, including the decision to liquidate Regency and which vendors to pay and which to stiff.

WBAH contended that the Tredit Tire allegations were defeated by the successor liability doctrine which holds that a successor to another company's assets does not assume responsibility for its liabilities unless done so expressly or implicitly.

The court applied Michigan law which will pierce the corporate veil if (1) the subsidiary is a mere instrumentality of its parent, (2) the parent committed fraud or wrong, and (3) the plaintiff suffers an unjust loss.

The court concluded that the allegations, if proven, could show that Regency was a mere instrumentality of WBAH due to the control the parent asserted over its new subsidiary.  It also held that breach of contract was a sufficient "wrong" to meet the second test.  Finally, the third prong, an unjust loss, could be proven if the facts bear out plaintiff's contention that it was led to believe that its debts would be repaid by Regency once WBAH took over.

The defendant's contention that the successor liability doctrine should apply was turned aside by the court.  It found that the allegations, if proven, would mean that the piercing the corporate veil doctrine tests were met and liability could be imposed on WBAH.  In effect, the court said that the piercing doctrine trumps the successor liability doctrine.

This is dangerous ground for creditors.  If a creditor takes over 100% ownership of a debtor's subsidiary, who else is to make the tactical and strategic decisions for the subsidiary but its only owner?  A lot of the focus of this case suggests that installing its own employee as president of Regency was a mistake.  An outsider might have been a better choice.  But what if the outsider doesn't do what the sole owner expects?  Will replacing him or her also result in liability?  Scary stuff.

-Marc Ward

Was Time or Price Really "Of the Essence"?

Forgive me for being cynical, but in the case that follows it seems to me that price was the issue, not timely performance.

In High Development Corp. v. Star of the West Company, 2009 Iowa App. LEXIS 561 (June 17, 2009) the Iowa Court of Appeals held that "time is of the essence" provisions in real estate contracts must be read literally and restrictively.  High Development agreed to buy from Star of the West property located at 1101 Old Marion Road in Cedar Rapids.  The closing was scheduled for August 30.  High Development was not able to close on the 30th, but did tender payment the following day.  Star of the West refused to close on the 31st and kept the $5,000 down payment.  Within two weeks it had entered into another contract to sell the property to someone else.

High Development sued for specific performance and attorney fees.  The real estate contract provided that if the buyer failed to perform the seller may forfeit the contract under Iowa Code Chapter 656 or proceed by an action at law or equity.  Star of the West did neither.

The trial court concluded that the forfeiture clause in the contract was controlling and the sole remedy of the seller.  Because the buyer tendered the consideration the next day the ability of the seller to forfeit the contract was cut off.  The lower court granted the request for specific performance and awarded attorney fees to the buyer.  The court of appeals reversed.

The appellate court first concluded that Iowa Code Section 656.1 does not mean what it says when it states that the buyer's rights under a real estate contract if it fails to perform shall "not be forfeited or canceled except as provided in this chapter."  Statutory forfeiture is not the only remedy available to the seller.  The court interpreted Chapter 656 to apply to real estate installment contracts where the buyer has an equitable interest in the property as a result of having made several installment payments. In the case of a "one-time closing," according to the court of appeals, Chapter 656 is just one of several remedies available to a seller notwithstanding the language of 656.1.  The court fails to explain the difference between several installment payments and one down payment. 

In support of this conclusion the appellate court cites just one Iowa Supreme Court case.  However, in Passehl Estate v. Passehl, 712 NW 2d 408, 414 (Iowa 2006) the supreme court referred to Chapter 656 as "irrelevant" to the case and in the related footnote said the forfeiture provision "is inapplicable because the arguments in this case do not center on this provision and do not call for a forfeiture of the subject property."  To cite this case as authority for the proposition that statutory real estate foreclosure is just one of several remedies available to a seller in the event the buyer fails to perform is just simply wrong.

After interpreting one provision of the contract and the related Iowa Code provision loosely, the court of appeals shifts gears and interprets "time is of the essence" strictly and narrowly.  The closing date was August 30.  Period.  If buyer missed the date by even a day, which it did, the contract was breached because time was of the essence.  Recall that payment was tendered the very next day.  Seller refused and a couple of weeks later sold to someone else.  If time really was "of the essence" wouldn't seller have taken the money the very next day?  Or did it get wind of a better offer and was happy to "forfeit" the contract on a technical breach?  "Essence" according to my well-worn American Heritage dictionary means "the intrinsic or indispensable properties that identify something."  Subsequent events seem to prove that time was neither intrinsic nor indispensable to this deal.

The trial court should have been affirmed.

-Marc Ward

Attorney-Client Privilege and the Independent Contractor

In a case more interesting for its facts than the law, the US District Court for the Middle District of  Alabama recently considered whether the attorney-client privilege extended to an independent contractor of the client.  Hope for Families v. Warren, 2009 US Dist. LEXIS 46009 (April 21, 2009).  It's a good refresher and relies particularly on an Eight Circuit case for its ruling.  In re Bieter Co., 16 F.3d 929 (8th Cir. 1994).  The general answer is yes it can.

Now for the facts.  The independent contractor was a former state senator and lieutenant governor hired by a bingo parlor to (1) secure a document signed by the county sheriff authorizing Lukcy Palace to operate a bingo parlor (2) find an opponent to run against the sheriff and (3) run the campaign.  Apparently the lawsuit involved claims that the sheriff was conspiring with others to create a bingo monopoly in the county.  Think big Macon.  Sheriff Warren was re-elected.

-Marc Ward

A Pint is a Pound the World Around...

... and so is a deal.  That old saw was taught to me by a client years ago.  I haven't forgotten it, but sometimes businesspersons do.  If you ever have a client that feels he or she has been slighted by another party when the apparent "gentlemen's agreement" turns to nothing does your client have legal recourse?  In Iowa, maybe not.  But in Maryland, yes.

Take the case of Giant Food, Inc. v. Ice King,Inc., 536 A. 2d 1182 (Md. App. 1988).  The court held that despite the lack of a contract between the parties Ice King could recover damages for negligent misrepresentation by Giant Food.  For several months Ice King and Giant Food discussed the possibility of Ice King supplying ice to Giant Food.  All along, unbeknownst to Ice King, Giant Food was planning to build its own ice plant.  Ice Food believed it had a commitment to supply ice based on 30 or 40 communications between the parties, including authorization by Giant for Ice King to inform its bank of their "deal."

The court concluded that in light of the more than casual response of Giant Food "a businessman in [the Ice King representative's] shoes might have reasonably relied on the informal 'deal or gentlemen's agreement.'" In fact, Ice King had "the right to rely upon Giant, and Giant owed a duty to give the correct information."  When Ice King learned about the possibility of a new Giant ice plant and attempted to learn the truth the court held that it was incumbent on Giant to provide the "true facts."  When instead the Giant representative said "everything was all right" the assurance "was, at the very minimum, negligent."

So the next time a client believes he had a deal and was double-crossed, remember this case and supporting cases from New York and Prosser and Keeton on the Law of Torts, Section 107 (1984) and the Restatement (Second) of Torts, Section 552 (1977).*

-Marc Ward

*The research of Allison Miller, a second year law student at the University of Iowa and Dickinson summer associate, is the source of this case and analysis.

Members of 490A LLCs May Owe Fiduciary Duties to Each Other

In Bushi v. Sage Healthcare PLLC, 203 P. 3rd 694 (Idaho 2009), the Idaho Supreme Court held that members of Idaho LLCs owe one another fiduciary duties.  The court reached this conclusion even though the applicable Idaho LLC Act was silent on the issue (like Iowa, Idaho is transitioning from an original LLC statute to a new one, the latter providing that members do owe each other the fiduciary duties of care and loyalty).

These fiduciary duties can be breached even if the members act within the letter of the operating agreement.  In Bushi, the majority of the members, all save Bushi himself, amended the operating agreement to allow a member to be dissociated by majority vote and then promptly removed Bushi by a similar vote.  They contended that they had good reason to dissociate him because he was dating an employee and had used a company line of credit to pay personal expenses.  Bushi argued that he was dissociated in order to advance their personal financial interests.  Because taking an action that improperly advances their financial interests can be a breach of a fiduciary duty even if technically allowed by the operating agreement, the court concluded that a material factual issue remained that negated the entry of summary judgment.

The case also mentions a provision in the operating agreement that lawyers should consider inserting into their forms.  The operating agreement stated that "no Member shall have any vested rights in the [operating agreement] which may be modified through an amendment to the [operating agreement]."  This provision negated Bushi's assertion that he was denied the benefits of the original operating agreement.  In its original form the operating agreement did not permit the members to essentially expel another member.

-Marc Ward

Reverse Piercing Used to Defeat Fraud Claim

In a relatively novel approach, defendants in a bankruptcy proceeding asserted reverse piercing as a defense to a claim of fraudulent conveyance brought by the bankruptcy trustee.  The trustee was attempting to cause a third-party to pay $450,000 to the estate. In re Freelander Capital Management Corp., 2009 Bankr. LEXIS 1195 (US Bkrptcy. Ct., SD Fla, April 29, 2009).

The relevant facts are these.  On March 14, 2001 the debtor corporation loaned Designs, Inc. $500,000.  The debtor corporation was wholly-owned by Burton Freelander.  The sole shareholder of Designs was the debtor's second ex-wife.  On April 11, 2001 the ex-wife withdrew $500,000 from a Designs account and deposited the money in a joint account owned by Burton and this ex-wife.  A short time later Burton transferred $50,000 to the debtor's account.  In a nice twist, Burton used $375,000 of the money to pay off a judgment involving his first ex-wife.  All parties agreed that the second ex-wife thought the loan was from Burton and repaid to Burton.

The debtor filed Chapter 7 bankruptcy in 2003.  All involved agree that the second ex-wife never withdrew funds from the joint account, never deposited any more funds into the account, and believed the payment of the $500,000 was a repayment of the loan.  Nevertheless, the trustee asserted that the payment was a fraudulent conveyance and the second ex owed $450,000 to the debtor corporation.

The defendants, the second ex-wife and her corporation, Designs, Inc., asserted the doctrine of reverse veil piercing as their defense, claiming that the payment to the individual joint account was payment to the debtor corporation.  The bankruptcy court agreed.

Applying Connecticut law because the debtor was a Connecticut corporation, the court found that there was such a unity of interest between Burton and the debtor and dominance by Burton over the corporation that the independence of the corporation had ceased to exist.  The court further found that applying the doctrine of reverse piercing would achieve an equitable result and avoid unfair prejudice to the second ex-wife.  The point being that she had already made the payment, she would not be retaining anything of value, and the loss to the creditors (who had already received restitution or had weak claims) was outweighed by the hardship to her if she had to make a second payment of $450,000.

Key to the court's decision, it appears, is the fact that the trustee had little use for the money given the status of the creditors' claims.  Had there been substantial creditors with strong claims for the funds, the equities of the case might have caused a different result.

This as another example of the willingness of the courts to ignore the corporate form when it suits the equities of the situation.  Is that what the law is supposed to be about?

- Marc Ward

Fooling with the Shareholder Franchise Could Invite Judicial Scrutiny

As you all know, loan agreements include financial and non-financial covenants imposed on the borrower.  Failure to maintain a covenant leads to an event of default.  A financial covenant might be maintaining a certain debt-to-equity ratio.  A non-financial covenant might be preventing a change in control of the board of directors.  Changing the make-up of a board of directors, is of course, the right of the shareholders.  When a board of directors agrees that such a change could trigger a default under a loan it may be impermissibly intruding on the shareholders' franchise.

Here is what Vice Chancellor Lamb had to say on the subject in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., 2009 WL 1337150 (May 12, 2009):

“This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. In the context of the negotiations of a debt instrument, this is particularly troubling, for two reasons. First, as a matter of course, there are few events which have the potential to be more catastrophic for a corporation than the triggering of an event of default under one of its debt agreements. Second, the board, when negotiating with rights that belong first and foremost to stockholders (i.e., the stockholder franchise), must be especially solicitous to its duties both to the corporation and to its stockholders. This is never more true than when negotiating with debtholders, whose interests at times may be directly adverse to those of the stockholders. Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.”

The case is on appeal.

-Marc Ward

Some Black Letter Law on Claims Against Directors

An opinion last week issued by the US District Court for the Northern District of Illinois provides a nice primer on claims that can be brought against directors, in this case directors of a wholly-owned subsidiary.  Seidel v. Byron, et al, 2009 US Dist LEXIS 40712 (May 12, 2009).

Seidel, the bankruptcy trustee for Mosaic Data Solutions brought an action against the former directors and officers of the debtor for breach of fiduciary duty and similar claims.  The trustee alleged that improper management of the company by the directors and officers led to its insolvency.  Specifically, he claimed that pledging the assets of Mosaic Data for no consideration so that its parent corporation could obtain financing in its bankruptcy was a breach of their fiduciary duty.

This is what you will glean from the case:

1.    Wholly-owned subsidiaries under Delaware law are expected to operate for the benefit of their parent corporations unless the subsidiary is insolvent.

2.    Under the trust fund doctrine directors of insolvent corporations are liable for the debts of the corporation when they breach their fiduciary duties by improperly distributing the corporate assets.

3.    Corporate creditors cannot file direct actions against directors for breach of fiduciary duties but may bring derivative actions against the directors of insolvent corporations for the breach of such duties (the beneficiary of a derivative action is the corporation).

4.    A motion to dismiss pursuant to the business judgment rule can be overcome if the pleading establishes a "reasonable doubt" about whether the actions of the directors are protected by the BJR.  As you may recall, the business judgment rule protects the actions of a board unless it is proven that the board breached its duty of loyalty, the duty of good faith or the duty of care.  That is, "if directors act loyally and carefully, they are not liable even if the transaction goes awry." (quoting Alliant Energy Corp. v. Bie, 277 F. 3d 916, 918 (7th Cir. 2002))

-Marc Ward