Ward on Iowa Limited Liability Company Law

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

Missouri's Piercing Formulation

The Missouri courts have developed a nice formulation for applying the piercing the veil to corporations and LLCs.  It's a three-part test: (1) A showing of control, complete domination of not only finances, policy and business practices (the alter ego test); (2) a breach of the duty of the controlling party not to use such control to perpetrate a statute or commit a dishonest and unjust act; and (3) the breach was the proximate cause of the plaintiff's injury or unjust loss.  See Carpenters' District Council of Greater St. Louis v. J&J Contractors, LLC, 2009 US Dist LEXIS 36607 (April 29, 2009) quoting Mobius Management Systems, Inc. v. West Physician Search, LLC 175 SW 3d 186, 188-89 (Mo. Ct. App. 2005).

Unfortunately, there is a reference in the Mobius quote to undercapitalization that suggests undercapitalization at the time of the wrong doing may be a breach of this duty.  Such a holding would upset the concept of limited liability.

Although the court doesn't identify it as such, a good example of the application of this formulation to the parent-subsidiary relationship from another jurisdiction can be found in Transition Healthcare Associates, LLC v. Tri-State Health Investors, LLC, 2009 US App. LEXIS 636 (6th Cir. January 9, 2009).

-Marc Ward

Court of Appeals Applies BJR to LLCs

In Terminal Properties, Inc. v. Hampton Propane Terminal, L.C., 2009 Iowa App. LEXIS 231 (March 26, 2009) the Court of Appeals applied the Business Judgment Rule to LLCs formed under Iowa Code Chapter 490A.  The BJR protects corporate boards of directors from liability for their actions if they are disinterested, informed and there is a rationale basis for the actions.  It is not applicable to partnerships.  There probably wasn't much doubt that the rule applied to LLCs in light of the many similarities between the entities (limited liability, often centralized management, perpetual existence) but this case removes all doubt.

This is not important news to 489 LLCs because the BJR was codified in Iowa Code Chapter 489.409(7).

By the way, the trial court used a delightful phrase one will only find in Iowa when he likened the plaintiff's claims of conflict of interest to a "frog calling a garter snake green."  I believe that is the English translation of pari delicto.

-Marc Ward

The Distinction btwn "Company" and "Corporation" is not complicated

Why do so many people including the IRS and now the U S Supreme Court continually refer to unincorporated LLCs as "limited liability corporations"?  To wit:

" As a part of the scheme, respondents invested in various stock warrants through newly created limited liability corporations (LLCs), which are also respondents in this case."

-Justice Scalia, Arthur Anderson LLP v. Carlisle, 2009 US LEXIS 3463 (May 4, 2009)

There is clearly a flaw in the Harvard Law School curriculum.

The Duty of Loyalty and Manifest Unreasonableness

As you may know, Iowa Code 489.409(2) identifies three duties that constitute the duty of loyalty.  It is not an exhaustive list so there may be more, but for now let's leave it at three.  Section 489.110(4) says that so long as it is not "manifestly unreasonable" the duty of loyalty can be eliminated in an operating agreement.  I discussed somewhat tongue in cheek what that means a few months ago.

In a seeming contradiction, Section 489.110(7) prohibits an operating agreement from eliminating a manager's liability for monetary damages for the breach of the duty of loyalty.  But it is no contradiction at all because 110(4) deals with what constitutes a breach of the duty of loyalty and 110(7) concerns the consequences for breaching that which has been defined as a breach of the duty.

When is it "reasonable" to eliminate the duty of loyalty?  Although it is a Delaware corporate law case and not directly on point for LLCs, Sutherland v. Sutherland, 2009 Del. Chancery 46 (March 23, 2009) is instructive.  Sutherland involved a family corporation, a sister sued her two brothers and a cousin who were directors of the family corporation for using corporate funds for personal benefit.  ( I once represented two brothers in defense of breach of duty claims brought by their mother and sister, a very awkward role to play, but I digress).

The directors sought dismissal of the claims because the certificate of incorporation contained a clause they claimed eliminated the duty of loyalty in toto for the directors.  The court rejected that argument because it would "effectively eviscerate the duty of loyalty for corporate directors as it is generally understood under Delaware law."  The court then cited a Delaware corporate law provision very similar to 489.110(7).  But as I said, this type of provision is concerned with the consequences of a breach, not what constitutes a breach. 

But the broader point is this, a blanket elimination of the duty of loyalty didn't work in the context of a Delaware corporation and probably won't work with an Iowa LLC even when that possibility hangs tantalizingly within the framework of 489.110(4).  So don't use a meat cleaver when a scalpel is more effective.  Precise exclusions from the duty of loyalty are more likely to be upheld.

-Marc Ward