Ward on Iowa Limited Liability Company Law

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

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

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

Delaware Refines the Breach of the Duty of Loyalty

In Lyondell Chemical Company v. Ryan, 2009 Del. LEXIS 152 (March 25, 2009) the Delaware Supreme Court clarified what it means for directors to breach their duty of loyalty by failing to act in good faith.  Recent decisions on this issue include In re Walt Disney Co. Deriv. Litig., 906 A.2d 27 (Del. 2006) and Stone v. Ritter, 911 A2d 362 (Del. 2006).

Lyondell concerns the sale of the company, at the time the third largest independent publicly traded chemical company in North America, to Basell AF, a private Luxembourg company.  Basell first made an overture to the Lyondell in April 2006; an overture that was rebuffed by the Lyondell CEO out of hand.  About a year later, in May 2007, Basell made a 13D filing with the SEC indicating its interest in acquiring Lyondell.

The Lyondell board immediately held a meeting to discuss the 13D filing and decided that although the company appeared to be "in play" to adopt a "wait and see" approach.  Two months went by with the Lyondell board doing nothing further regarding the company's potential sale.

On July 9, 2007 discussions between the two CEOs heated up resulting in an offer of $48 per share, no financing contingency, a $400 million break up fee and a requirement to sign a merger agreement by July 16.

On July 10 and 11 the Lyondell board met twice for no more than an hour each time to review the proposal, the possibility that others might be interested in buying the company, and to retain a financial advisor.

On July 12 the board met again to instruct the CEO to seek a higher price, a go-shop clause, and a reduction in the break-up fee.  These negotiations resulted in only the break-up fee being reduced to $385 million.

On July 16 the board met again, this time to review the financial advisor's opinion that the $48 per share offer was fair as well as its belief that no other entities would top this offer.  The board approved the merger and recommended it to the shareholders.

Because Lyondell's charter contained a section 102(b)(7) exculpatory provision protecting the directors from personal liability for breaches of the duty of care, the plaintiff alleged a breach of the duty of loyalty.  Since the board was found to be independent and not motivated by self-interest or ill will, the breach of the duty of loyalty claim was further narrowed to whether the directors failed to act in good faith.  The Chancery Court concluded they had.  The Supreme Court reversed.

Applying Walt Disney and Stone, the question, according to the Supreme Court, was whether the board's actions were an "intentional dereliction of duty, a conscious disregard for one's responsibilities" (quoting Walt Disney).  Under this standard the court could only impose liability if there is "a showing that the directors knew that they were not discharging their fiduciary obligations" (quoting Stone).

The Delaware Supreme Court also noted that the Chancery Court misapplied Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A2d 173 (Del. 1986).  It did this by applying the Revlon duties (maximize shareholder value) before the board had decided to sell the company or the sale had become inevitable.  Further, the Chancery Court wrongly concluded that Revlon imposed a set of requirements on a board that must be met during the sale process.  And third, the court had wrongly concluded that failure to meet the Revlon standard was the equivalent of "a knowing disregard of one's duties that constitutes bad faith."  (It is a breach of the duty of care.)

The Chancery Court had determinedthat the inaction of the Lyondell board between May and July was the key to the finding of a breach of the duty of loyalty.  The Supreme Court disagreed.  The Revlon duties to find the best price do not kick in when a company is "in play" but when a sale becomes inevitable.  In this case, the Revlon duties did not begin until July 10.  The Supreme Court noted that it was possible that the Revlon duties might not have been met since the board did not conduct an auction or a market check to get the best price, but these were due care considerations when the only legal issue was whether the board failed to act in good faith.

The Supreme Court found a "vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties."   It takes "an extreme set of facts" to make a claim of disloyalty stick.  In this case the failure of the directors to do all they should have done might be a breach of the duty of care, but they would have had to "knowingly and completely failed to undertake their responsibilities" in order to have breached their duty of loyalty.

This case is a very important explanation of Walt Disney and Stone (as well as In re Lear Corp Shareholder Litig., 2008 LEXIS 121).  It seems the Court realized it had not been clear enough or had left the impression in those earlier cases that the standard for finding a breach of the duty of loyalty for failure to act in good faith was not as high as it clearly is in Lyondell.

-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

Del. Case Looks at the Bad Faith Test for Breach of the Duty of Loyalty

In re Walt Disney Co. Derivative Litigation, 900 A. 2d 27, 66 (Del. 2006) created bad faith conduct as a breach of the duty of loyalty.  The court made clear that there is a distinction between bad faith and gross negligence.  Id. at 64.65.

The Chancery Court recently had an opportunity to test this distinction in McPadden v. Sidu, et al., 2008 Del Ch. LEXIS 123 (August 29, 2008).  The facts are extraordinary and require a reading of the entire case, but to summarize briefly, the board of directors of i2 sold a subsidiary (TSC) to the management of TSC for $3 million who not too long after flipped it for $25 million.  There were a lot of facts that should have caused the board to know that the $3 million price tag was woefully inadequate, as the subsequent sale revealed.

The court concluded that this was a case of gross negligence, not bad faith, thus the portion of the case alleging breach of the directors' fiduciary duties was thrown out because Section 102(b)(7) of the Delaware Corporation Act exculpated directors for breach of the duty of care (gross negligence).

The distinction between gross negligence and bad faith seems like a rather thin one, but appears to rest on whether there is evidence of bad intent, that is intentional dereliction of duty.  Read the case!

-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

Sometimes Being Stupid can be as Bad as Being Greedy

"This case underscores the reality that it is not only greed that can inspire disloyal behavior by a business fiduciary.  In fact, when a business fiduciary lives a plush and comfortable life, derived from substantial distributions from family trusts, he can afford to place other considerations -- such as the achievement of a personal dream, a desire to prove himself a CEO, or a stubborn refusal to admit failure -- ahead of the prudent pursuit of maximum profit, having a silk-sheeted safety net to fall back upon.  In this case, that is just what happened." Venhill Limited Partnership v. Hillman, 200 Del. Ch. LEXIS 67 (June 3, 2008).

Well said!

-Marc Ward

The Duty of Good Faith as a Duty of Loyalty

On May 30, 2008, the United States of Bankruptcy Court for the District of Delaware handed down a significant decision involving the duty of loyalty that directors owe a corporation.  This has important ramifications to LLCs organized under the new Iowa LLC Act.  See In re Bridgeport Holdings, Inc., 2008 Bankr. LEXIS 1586 (Del. May 30, 2008).

The Delaware courts have recently expanded the duty of loyalty to include a duty to act in good faith.  See Stone v. Ritter, 911 A.2d 362 (Del. 2006).  Failure to act in good faith has been interpreted to mean a failure to act in the best interests of the corporation or abdicating directorial duties or demonstrating "faithlessness or lack of true devotion to the interests of the corporation and its shareholders."  See Ryan v. Gifford, 918 A. 2d 341 (Del. Ch. 2007).  It has also been described as "consciously and intentionally" disregarding the responsibilities of a director "by knowingly failing to make decisions critical to the company on an informed basis." See Boles v. Filipowski, 345 B.R. 426 (Bankr. D. Mass. 2006).

This sounds a lot like a breach of the duty of care to me, which is not surprising.  Many corporate statutes, and the new Iowa LLC Act, permit a corporation or LLC to eliminate or limit a director/manager's liability to the corporation/LLC for monetary damages except for "a breach of the duty of loyalty." See e.g. Iowa Code 489.110(7)(2009).  By using the concept of good faith to construe the duty of loyalty to be just another way of saying a breach of the duty of care the courts avoid this limitation on liability.  Another example of ignoring the plain language of a statute.

-Marc Ward