Ward on Iowa Limited Liability Company Law

Bankruptcy Courts Weigh in on the Fiduciary Duties of Directors

A lot of corporate law is being made in bankruptcy court these days.  Take for example In re Midway Games Inc., 428 B.R. 303 (Bankr. Ct. Delaware 2010).  A committee of unsecured creditors challenged the actions of the board of directors of Midway for obtaining additional financing for the company instead of filing for bankruptcy.  The company was insolvent at the time and presumably an earlier bankruptcy would have benefited the unsecured creditors while the additional financing provided the company with some needed cash but only prolonged the company’s agony.  Along the way the majority shareholders also sold their 87% interest in the company and $70 million in debt to an individual for a mere $100,000.

The bankruptcy court reaffirmed the Delaware courts’ objection to the “deepening insolvency” theory (essentially that a board of directors must look to help the creditors over the interests of the company once a company becomes insolvent and stop the bleeding.)  Delaware law is clear that directors are not liable for taking actions to make a corporation viable once it is insolvent.  A board “does not have a duty to protect creditors of an insolvent corporation at the expense of the corporation and its shareholders."  Thus, the court found no breach of the duty of care by the board.

Next, the court looked at the duty of loyalty that directors owe to a corporation.  Although it held in the directors favor, this case does serve as a reminder to directors that they cannot become complacent about their role because they have an affirmative duty of oversight encapsulated in the duty of loyalty they owe to the corporation.  If directors fail to act in the face of a known duty to act and they demonstrate “a conscious disregard for their responsibilities" as directors, then they have breached the duty of loyalty.  I have noted in earlier posts that this breach of the duty of loyalty looks an awful lot like the duty of care and may have been constructed to get around the exculpatory clauses found in many articles of incorporation that prohibit monetary damages being assessed against directors for the breach of the duty of care, but so far no one else has taken up that banner.

So what about the sale of the 87% interest and $70 million in unsecured notes for $100,000?  The court found nothing wrong there either because the shareholders/noteholders “had the unfettered right to dispose of their Midway interests as they saw fit.  The board was not involved in the transaction and could not prevent it.  The stockholders qua stockholders owed no duty to the corporation.

-Marc Ward

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

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

Yes, You Can Eliminate/Alter Fiduciary Duties of Officers

As you had better know in 8 days, Iowa Code Section 489.110(4) permits an operating agreement, so long as it is not manifestly unreasonable, to restrict or eliminate the duty of loyalty and "alter" the duty of care or any other fiduciary duty.  "Alter" means to make different, to change or modify, but implicitly not to eliminate.  Section 489.110(7) permits an operating agreement to eliminate a manager's liability to the LLC and the members for a breach of the duty of care (with certain exceptions).

The Delaware LLC law (18-1101(e)), similarly, also permits an operating agreement to eliminate any and all liability for a breach of any  fiduciary duty of a member, manager or other person.

This provision was put to the test recently in In re Heritage Organization, L.L.C., 2008 Bankr. LEXIS 3230 (N.D. Tex December 12, 2008).  The bankruptcy trustee attempted to hold two officers of the debtor liable for breach of their fiduciary duties to the company.  However, taking its cue from 18-1101(e), the Delaware LLC's operating agreement contained a shield from liability for its manager which said "The Manager shall not be required to exercise any particular standard of care, nor shall he owe any fiduciary duties to the Company or the other Members."  Several fiduciary duties were identified in a non-exhaustive list including the duty of care and the duty of loyalty.

The officers argued that because they acted as agents of the Manager (a corporation), the exculpatory language applied to them.  The trustee, naturally, argued that the exculpatory clause only applied to the manager, not the officers.  The court noted that it found the officers' agency theory "unpersuasive at this juncture" because from the record it was not clear if the individuals acted as agents of the manager "and thus protected pursuant to the terms of the exculpation clause itself" or as officers.

The court then went on to exam the operating agreement in terms of the duties owed by officers of the LLC.   The operating agreement permitted the Manager to appoint a president, one or more vice presidents, etc., and such "officers shall have such authority and perform such duties" as provided in the operating agreement.  Later, the operating agreement described the president to be "subject to the same duties and powers granted to the Manager."  The manager was also empowered to delegate any duties or powers upon such terms as may be designated in a written instrument."

As the court saw it, any duties imposed on the officers had to pass down from the manager.  Because there was no evidence that the manager had granted, prescribed or delegated any duties to the officers, the court was left with the provisions of the operating agreement.  The court concluded that the Heritage operating agreement "clearly contemplates that Heritage officers only owed those duties to Heritage that were either delegated or prescribed by Heritage's Manager or president."  Since no such delegation existed, there was no duty to breach.

It is also important to point out that the court dismissed the trustee's argument that there were common law fiduciary duties owed by the officers.  As "a creature of contract" the court noted, the operating agreement was controlling.

The lesson here is to consider officers when contemplating whether or not to impose fiduciary duties, including liability for breach, on the management of LLCs.

-Marc Ward

Recent Delaware Cases on Director Liability

It is interesting to watch the Delaware Chancery Court struggle with the Disney concept of the breach of the obligation of good faith which results in the breach of the duty of loyalty by boards of directors.  

A quick recap.  The breach of the duty of care usually requires a finding that the board of directors' actions rose to the level of gross negligence.  It has been defined as "reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason."  Tomczak v. Morton Thiokol, Inc., 1990 Del Ch. LEXIS 47 (Del. Ch. April 5, 1990).

The breach of the obligation of good faith means the board "consciously and intentionally disregarded [its] responsibilities."  In re Walt Disney Co. Deriv. Litig., 825 A.2d 275, 289 (Del. Ch. 2003).

Application of these test matters because Delaware corporations can exculpate boards from the breach of the duty of care by inclusion of the proper provision in the certificate of incorporation.  Thus, the board is off the hook if they are merely recklessly indifferent but liable if they consciously and intentionally disregard their responsibilities.  See the difference?

Check out these three recent Delaware cases regarding the duty of loyalty.  Ryan v. Lyondell Chemical Co., 2008 WL 2923427 (Del. Ch. Jul. 29, 2008); McPadden v. Sidu, 2008 WL 4017052 (Del. Ch. Aug. 29, 2008); and In re Lear Corp. Shareholder Litigation, 2008 WL 4053221 (Del. Ch. Sept. 2, 2008).

-Marc Ward

Recent Fiduciary Duty Case Applying Delaware Law

The United States District Court in Maine applies Delaware law in denying the plaintiffs motion for summary judgment on breaches of the duty of loyalty, care and good faith (ugh) in Baldwin v. Bader, 2008 U.S. Dist. LEXIS 56236 (July 23, 2008).

-Marc Ward

Liability of the Majority to the Minority, the Assumption of Fiduciary Duties

A recent decision by the North Dakota Supreme Court may have implications for Iowa LLCs when the new Iowa LLC Act takes effect on January 1, 2009.

The holders of a majority of the limited partnership interests in two North Dakota limited partnerships decided they were not happy with the performance of the partnerships and through a written action without notice to the minority owners removed the general partner in both partners and appointed its replacement.  The majority took a number of other actions in asserting control over the limited partnerships.  Things went from bad to worse, naturally, and the minority owners sued the majority for, among other things, a breach of their fiduciary duties owed by the majority limited partners to the minority limited partners.

The majority limited partners argued that they could not be held liable for breach of fiduciary duties because the North Dakota limited partnership act declares that a "limited partner is not liable for the obligations of a limited partnership unless...the limited partner participates in the control of the business [and in such case]...the limited partner is liable only to persons who transact business with the limited partnership...."

The equivalent provision of the new Iowa LLC Act is 489.304 (2009) which states that the debts, obligations, or other liabilities of a limited liability company are solely the responsibility of the LLC and do not become the responsibility of a member solely by reason of the member acting as a manager.

The North Dakota Supreme Court held that the limited partnership act provision cited above did not address fiduciary duties owed to the other limited partners, but only those obligations of the limited partnership.  Red River Wings, Inc. v. Hoot, Inc. et al, 751 NW 2d 206 (N.D. 2008).

The Court went on to hold that when the majority limited partners took control and dominated the partnerships for their own benefit they "violated the fiduciary duties of good faith, fair dealing, loyalty, and care...."  The Court appears to have gone a little overboard in its enthusiasm for holding the majority liable to the minority and created two additional fiduciary duties in the bargain.

The Court also held that minority limited partners are entitled to bring a direct action against the majority for breach of these fiduciary duties.   The equivalent new Iowa LLC Act provision that supports the concept of direct action for breach of fiduciary duties is 489.901 (2009).  It provides that a member may maintain a direct action against another member to protect the member's interests under the operating agreement or the LLC Act or "arising independently of the membership relationship."

Red Wing is a warning to majority owners that taking control of an LLC without due regard to the operating agreement and the rights of the minority could lead to liability to the minority members for breach of fiduciary duties.

-Marc  Ward

The Duty to Disclose Under Delaware Law

Delaware's Chancery Court recently ruled once again that directors/managers have an affirmative duty to disclose material information when asking their investors to take action.  In Marie Raymond Revocable Trust v. MAT Five LLC, et al, 2008 Del. Ch. LEXIS 77 (June 26, 2008) the court also suggested that when a company is asking its members to release it, and its officers, employees and agents from all claims the investors may have against them for essentially taking the company down the tubes, the company has a duty to describe the underlying reasons the release is being sought.

To sustain a a claim for breach of the duty to disclose a plaintiff must identify material information that was reasonably available but omitted from the disclosure document (in this case a tender offer, but it could also be proxy materials).  The standard for materiality is whether a reasonable investor would consider it important in making a decision or would find that the information would alter the "total mix" of information available.

There will be more on this case soon since the hearing on the plaintiff's motion for a preliminary injunction is scheduled for tomorrow.

-Marc Ward

Words Matter When Drafting Operating Agreements

Not many state LLC Acts are like the one Iowa has adopted effective January 1, 2009, but the Illinois statute is very similar.  How Illinois courts interpret its LLC law will likely have a great deal of impact on Iowa courts and Iowa LLCs.

Federalpha Steel LLC Creditors' Trust v. Federal Pipe & Steel Corp. et al, 368 B.R. 679 (N.D. Ill. 2006) is worth your time to read.  It illustrates how a third party (the court) may interpret provisions of an operating agreement differently than the drafters (the members) intended.

It is a lengthy opinion, but let me give you one example.  The operating agreement between two members provided that a member may not "voluntarily withdrawal" and such withdrawal would be considered a wrongful dissociation under the Illinois LLC Act.  Most lawyers, I think, would interpret that to mean a unilateral withdrawal.

Not so fast.  The two members and the LLC subsequently entered into a Withdrawal Agreement in which one of the members withdrew from the LLC.  The court concluded based on the terms of the operating agreement that such withdrawal might be wrongful and even a breach of its fiduciary duty.

-Marc Ward

Duties owed by Directors of Insolvent Entities

Occasionally reading one case sends me off in an unexpected direction to another case and then another.  Such was the case, so to speak, recently.

While skimming a run-of-the-mill breach of fiduciary duty case I eventually ended up reading North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A 2d 92 (Del. 2007) and Trenwick America Litigation Trust v. Ernst & Young et al, 906 A 2d (Del. Ch. 2006).

North American Catholic reminds us that when a corporation is solvent the shareholders may enforce the directors' fiduciary duties owed to them and the corporation by derivative action.  When a corporation is insolvent the creditors "take the place of the shareholders" and have standing to bring a derivative claim against the directors for breaches of fiduciary duty.  North American Catholic, 930 A 2d at 101.  This case stands for the additional proposition that creditors do not have a direct claim against directors for breaches of fiduciary duty.  Id. at 94.

Trenwick nips in the bud another cause of action creditors have tried to advance lately; the claim of "deepening insolvency."  Trenwick, 906 A 2d at 174.  As Judge Strine put it in a delightful, if lengthy, 36 page opinion, "Put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent."  Id.

I recommend both opinions to those interested in the impact of insolvency on the duties of directors.

-Marc Ward

Exculpatory Provision? What Exculpatory Provision?

Modern corporate and LLC statutes (including the New Iowa LLC law) permit corporations and LLCs to limit or exclude the personal liability of directors and managers for money damages for breach of a fiduciary duty.  There are exceptions, of course.  In the case of the New Iowa LLC law the exceptions are (i) any breach of the duty of loyalty, (ii) deriving a personal benefit for which the manager was not entitled, (iii) an improper distribution, (iv) an intentional infliction of harm on the LLC or member or (v) an intentional violation of criminal law.

You might think that such a clause in an operating agreement (or the corporate articles) would exculpate a director from liability for a breach of the duty of care.  You would be wrong.

Returning to In re Bridgeport Holdings, Inc., 2008 Bankr. LEXIS 1586 (May 30, 2008), the court refused to dismiss a claim of breach of the duty of care even though the the corporation's certificate of incorporation contained the appropriate exculpatory clause.  The court cited a number of Delaware cases in support of its decision.  The rationale in this and the other cases was the presence of other claims by the plaintiff, notably a claim of breach of the duty of loyalty.

Since a breach of the duty of loyalty claim can be constructed to look and smell like a breach of care claim, as opposed to what one would naturally think would be a breach of the duty of loyalty (improper personal benefit, conflict of interest, competing with the LLC...See Iowa Code 489.409(2)(2009)), there does not appear to be much left of this supposed exculpatory provision.  And you thought legislation was supposed to mean something.

-Marc Ward