Ward on Iowa Limited Liability Company Law

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

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

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).

Professional Plaintiffs Beware

Judge Cote of the Southern District of New York recently entered an order that should be of some relief to the beleaguered investment banks, such as there are.  It seems that whenever a financial crisis strikes sleazy law firms and equally contemptible professional plaintiffs slither from under the rocks to bring derivative claims against financial institutions.  That is not to say there are not legitimate derivative claims, there are, but there are far too many involving professional plaintiffs looking for a fast buck.

In re JPMorgan Chase & Co. Derivative Litigation, 2008 U.S. Dist.. LEXIS 71353 (September 19, 2008) is case arising out of the subprime mortgage fiasco.  The outcome of this case revolves around Federal Rule of Civil Procedure 23.1(a) requires a plaintiff in a derivative action to "fairly and adequately represent the interests of shareholders."

In this case, the plaintiff, Robert L. Garber, clearly did not.  He alleged that officers and directors of JPMorgan had violated the Securities Exchange Act of 1934, breached their fiduciary duties to JPMorgan, wasted corporate assets , and unjustly enriched themselves at the expense of the shareholders.  As it turned out, Garber is a professional plaintiff in about 25 similar lawsuits, he had never met his lawyers until the day before his court-ordered deposition, never signed a retainer agreement with one firm and with the other firm only the day of his deposition.  He was "appallingly ignorant of the many derivative actions that were filed in his name.  And the court noted "this litigation has been controlled by counsel with absentee plaintiffs."  Garber never provided the court with information that would allow it to conclude that he could fulfill his responsibilities to the shareholders and the corporation.

Based upon this record, the court dismissed the case.

Who Has the Right to Bring Derivative Claims?

A recent New York Supreme Court case, Billings v. Bridgeport Partners, LLC, 2008 N.Y. Misc. LEXIS 5506 (September 19, 2008) (remember, that a NY supreme court is the equivalent to our district courts) highlights an issue that can vex members who think they have been harmed by the actions of the other members.

The New York Court of Appeals (the highest court in the state) ruled earlier this year that although the New York LLC statute was silent members of New York LLCs had a common law right to bring derivative claims (Tzolis v. Wolff, 10 NY 3d 100(2008)).  Tzolis did not decide whether a plaintiff had to be a member of the LLC at the time of the alleged wrongdoing and when the lawsuit was brought or whether a demand first had to be made on the LLC management to bring action on behalf of the LLC.

The Billings case gave the lower court an opportunity to rule on these open issues.  Billings was not a member when he brought the lawsuit and had not made demand on the company to bring the action in its name.  The defendants moved to dismiss 5 of the 7 counts on this basis.

The court ruled that based on Tzolis and a 1904 case, Hanna v. Lyon, 179 NY 107 (1904)) (old law is good law!) a member of an LLC must have been a member of the LLC at the time of the offending conduct and at the time he or she brings the lawsuit.  The judge did not rule directly on whether a demand had to be made first, but in dicta didn't see why not.

So what does Iowa law say about this?  Its mixed.

Under the current LLC law (Iowa Code 490A.1001) demand must be made (no futility exception) and the member must be a member of the LLC at the time of the bringing of the action and at the time of the challenged transaction or, and here is language I had a hand in writing but am not sure what it means, "the plaintiff's status as a member of the limited liability company thereafter devolved upon the plaintiff pursuant to the terms of the articles of organization or an operating agreement from a person who was a member at such time."

The new Iowa LLC law (Iowa Code 489.902 and 903) says a member may maintain a derivative action if demand is first made (futility and irreparable injury exceptions) and it is rejected or 90 days go by without rejection and the plaintiff is a member at the time the action is commenced.  There is no requirement that the person have been a member at the time of the alleged misconduct.

Compare this to the Iowa Business Corporation Act (Iowa Code 490.741 and 742).  A demand must be first made upon the corporation (no futility exception, but one for irreparable injury) and it is rejected or 90 days go by without rejection. A plaintiff must have been a shareholder at the time of the act or omission complained of or became a shareholder by operation of law from one who was a shareholder at such time, but not at the time the action is filed.

Under the Iowa Uniform Limited Partnership Act (Iowa Code 488) the demand test is the same as under the new Iowa LLC Act but the plaintiff must have been a partner at the time of the alleged misconduct (or his or her status as a partner devolved by operation of law from such a person meeting this test) and when the action is commenced.

So, if you define the Demand Test as "A", the Owner at the Time Test as "B" and the Owner When the Suit is Filed Test as "C" you get the following:

Current Iowa LLC Law: Tests A (no exceptions), B and C must be met.

New Iowa LLC Law:  Tests A (futility and injury exceptions) and C must be met.

IBCA:  Tests A (injury exception) and B must be met.

ULPA: Tests A (futility and injury exceptions), B and C must be met.

This makes a lot of sense!

-Marc Ward