Source: http://www.llclawmonitor.com/articles/derivative-suits/
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Derivative Suits : LLC Law Monitor
Home > Derivative Suits > Utah Court Says Exception from Derivative Suit Requirements for Closely Held Corporations Applies to LLCs
Delaware Kerfuffle Over Exclusive Forum For Corporate Derivative Suits - Applicable To LLCs?
Posted on February 16, 2012 by Doug Batey
To prevent forum-shopping by plaintiffs in shareholder derivative suits, some Delaware corporations in the last couple of years have amended their bylaws to lock in the Delaware Court of Chancery as the exclusive forum for derivative suits. One study showed that as of the end of 2011, 195 Delaware corporations have adopted or proposed exclusive forum provisions in their bylaws or articles.
At least nine lawsuits have been filed this month by shareholders challenging the new bylaw provisions. The lawsuits seek to have the bylaw provisions declared invalid on grounds that (a) the forum of a derivative suit is an external matter and not a matter of internal corporate governance, (b) there was no mutual shareholder consent to the new forum rule, and (c) the new bylaws are overly broad and violate due process. The corporations have apparently threatened to sue any shareholders daring to bring a derivative suit outside of Delaware in violation of the new bylaw provisions.
Francis Pileggi and Professor Stephen Bainbridge have commented on these lawsuits, and I refer you to their reports for more details and commentary. Alison Frankel has also written about the lawsuits and includes links to some of the complaints, here.
What about limited liability companies? LLC managers observing the forum restrictions that many corporations have adopted might well consider implementing similar restrictions.
The concern would not be unfounded – derivative suits are available to members of LLCs. Delaware allows a member or an assignee of an LLC interest to bring a derivative action in the right of an LLC. DLLCA, § 18-1001. Washington has a similar provision in its statute, except that Washington only allows members, and not assignees, to bring the action. RCW 25.15.370.
Forum restrictions are contemplated by the Delaware LLC Act. A written LLC agreement can provide that its members consent to the exclusive jurisdiction of the Delaware courts. DLLCA § 18-109(d). (This is one of the few sections in the Delaware LLC Act where a provision of an LLC agreement must be in writing to be enforceable.)
Changing the rules for an existing LLC is not as easy as a corporate board’s amendment of the corporation’s bylaws. An LLC agreement is a contract between the members and can only be changed with their consent, so member consents would be required for an LLC to add a forum-limiting provision to its LLC agreement.
Whether or not the consent of all the members would be required depends on the terms of the LLC agreement, which may or may not allow amendments on the approval of less than all members. The Delaware LLC Act authorizes an LLC agreement to limit the voting or approval rights of any member or group of members. DLLCA, § 18-302(a). For example, an LLC could have two classes of members, voting and non-voting. The non-voting members would be presumed to have known their rights when they became parties to the LLC agreement, and under the policy in the Delaware statute of giving maximum effect to the principle of freedom of contract and to the enforceability of LLC agreements, a forum-limiting amendment to the LLC agreement, approved by only the voting members, should be enforceable. DLLCA, § 18-1101(b).
If the LLC agreement is silent on the subject of its amendment, unanimous approval of the members will be required for any change to the agreement, as with any other multi-party contract.
Tags: Derivative Suits, Forum Selection Clause, Forum shopping, LLC Agreements, Operating Agreements, amendments
Posted on September 7, 2011 by Doug Batey
During the past two months I have been on an extended vacation – very nice. Thanks to my colleagues Janet Jacobs and John Laney for guest-authoring posts, here and here.
Tags: CML V, LLC v. Bax, Delaware, Derivative Suits, Derivative suit, creditors, insolvency
Posted on November 16, 2010 by Doug Batey
The Delaware Court of Chancery decided earlier this month that a creditor of an insolvent LLC does not have standing to maintain a derivative suit in the name of the LLC against its managers. CML V, LLC v. Bax, No. 5373-VCL, 2010 Del. Ch. LEXIS 220 (Del. Ch. Nov. 3, 2010). The court’s lengthy opinion is nicely summarized by Francis Pileggi, here. This blog post focuses on only one aspect of the opinion – its treatment of the interplay between the LLC Act’s statutory provisions and the judicially-created, derivative-suit remedy available to the courts under their general equity jurisdiction. My thesis is that the court gave unduly short shrift to the equitable underpinnings of the derivative suit.
The CML ruling is in contrast to the rule for corporations. Creditors of an insolvent corporation do have standing in Delaware to bring derivative claims. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). The CML conclusion surprised many practitioners. The court itself admitted the “awkward fact” that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing [a derivative] suit.” CML, 2010 Del. Ch. LEXIS 220, at *12. The result is surprising because it is inconsistent with the corporate rule and with the policy behind that rule. The policy of the corporate rule was noted by the court: “When a corporation is insolvent, the creditors become ‘the principal constituency injured by any fiduciary breaches that diminish the firm’s value.’” Id. at *6 (quoting Gheewalla, 930 A.2d at 102). That policy applies as much to an insolvent LLC as it does to an insolvent corporation. If the entity is insolvent, the members’ or shareholders’ economic interest in the LLC or corporation has been wiped out. The creditors then in effect stand in the shoes of the members or shareholders. The CML court’s conclusion turned on its analysis of Sections 18-1001 and 18-1002 of the Delaware LLC Act:
§ 18-1001. Right to bring action. A member or an assignee of a limited liability company interest may bring an action in the Court of Chancery in the right of a limited liability company to recover a judgment in its favor if managers or members with authority to do so have refused to bring the action or if an effort to cause those managers or members to bring the action is not likely to succeed. § 18-1002. Proper plaintiff. In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and: (1) At the time of the transaction of which the plaintiff complains; or
(2) The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transaction. (Emphasis added.) The court characterized Section 18-1001 as creating a statutory right, and Section 18-1002 as mandating that the plaintiff must be a member or an assignee of a member. CML, 2010 Del. Ch. LEXIS 220, at *7-8.
The court also did not discuss in any detail the equity-court origins of the derivative-suit remedy. The court’s disregard of the history of the derivative suit led it to conclude that Sections 18-1001 and 18-1002 are the sole source of authority for an LLC derivative suit. CML, 2010 Del. Ch. LEXIS 220, at *8-9. That analysis contrasts with the court’s view of Section 327 of the Delaware General Corporation Law (DGCL). Section 327 states: “In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law.” The CML court characterized Section 327 as not creating the right to sue derivatively and as not saying that only stockholders can sue derivatively. CML, 2010 Del. Ch. LEXIS 220, at *10 (citing Schoon v. Smith, 953 A.2d 196, 204 (Del. 2008)). The reason why Section 327 does not create the right to sue is that the derivative-suit remedy was a judicial creation. Schoon describes at length how the right of shareholders to sue derivatively originated in the equity courts in order to prevent a failure of justice, and how the shareholder derivative suit was later restricted by Section 327 to prevent strike suits. Schoon, 953 A.2d at 201-03. Delaware courts have applied equitable remedies to LLCs even when the remedy is not set forth in the LLC Act, pursuant to the courts’ general equity powers. E.g., Ross Holding & Mgmt. Co. v. Advance Realty Group, LLC, No. 4113-VCN, 2010 Del. Ch. LEXIS 184 (Del. Ch. Sept. 2, 2010) (appointment of a receiver). Consistent with those cases, Delaware presumably would have applied the derivative-suit remedy to LLCs even if Delaware’s LLC Act made no mention of derivative suits.
The long history of the derivative-suit remedy and the courts’ willingness in general to assert equitable remedies imply that the LLC Act should not be viewed as the sole authority for LLC member derivative suits. And if so, one should read Sections 18-1001 and 18-1002 together, interpreting them much as DGCL Section 372 has been interpreted. Under that reading, the “must” in Section 18-1002 is seen as applying the contemporaneous ownership requirement to the subset of derivative suits instituted by an LLC member, and Section 18-1002 does not close the courthouse doors to a creditor bringing a derivative suit in the name of an insolvent LLC. The CML court was troubled by the fact that “virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” CML, 2010 Del. Ch. LEXIS 220, at *12. The court never answered the obvious question – why is that? The answer is that the court’s perfunctory treatment of the history of the derivative-suit remedy and its disregard of its own general equity jurisdiction resulted in an outré and anomalous conclusion. Tags: CML V, LLC v. Bax, Derivative Suits, Derivative suit, Gheewalla, Schoon v. Smith, equity, insolvency
Posted on October 5, 2009 by Doug Batey
The Oregon Court of Appeals has clarified when and how members of an Oregon LLC can maintain a derivative suit in the name of the LLC. Bernards v. Summit Real Estate Mgmt., 229 Or.App. 357, 213 P.3d 1 (July 1, 2009). Oregon’s LLC Act allows member derivative suits, but the court imposed additional pleading requirements on the complaint. The court also found that a requirement in the LLC’s operating agreement of unanimous member approval before commencing any suit in the name of the LLC was subject to the agreement’s standard of care and to the implied duty of good faith and fair dealing.
The plaintiffs (Bernards) were minority members of two member-managed LLCs. Each of the LLCs owned apartment buildings and entered into management contracts with the defendant management company (Summit). Bernards claimed that Summit and one of its officers (McKenna) had embezzled the LLCs’ funds, and demanded that the other members approve lawsuits by the LLCs against Summit and McKenna to recover the funds. (The operating agreements for the LLCs required the unanimous approval of the members to bring legal action in the name of the LLCs.) The other members refused to approve a lawsuit without giving any reasons for their refusal, even though McKenna had admitted embezzling substantial amounts from the LLCs. Bernards then brought derivative suits against Summit, McKenna and the other members, alleging that the other members had breached their duty to the LLCs by refusing to approve the lawsuits against Summit and McKenna. Oregon’s LLC Act authorizes derivative proceedings by a member in the name of an LLC. Or. Rev. Stat. § 63.801(1). The statute requires that the complaint allege with particularity either that a demand to file the suit was made of the managers (or members in the case of a member-managed LLC), or why a demand was not made. Or. Rev. Stat. § 63.801(2).
The statute does not explicitly refer to any requirement of wrongdoing by the members that refused to approve the lawsuits. The court nonetheless held that when the members have refused the demand for litigation, the complaint must allege facts showing wrongdoing by the refusing members. Bernards, 229 Or. App. at 364.
The court analogized LLC derivative suits to corporate derivative suits. The court had previously held that Oregon’s almost identical corporate statute required, albeit in a demand-futility case, that the complaint in a shareholder derivative suit plead facts showing wrongful conduct by the directors. The court in Bernards applied the corporate rule, holding that in order to rebut the presumption that the members were exercising their business judgment, the complaint must allege facts showing wrongful conduct by the members.
Section 63.801(2) of Oregon’s LLC Act allows the LLC’s operating agreement to vary the statutory pleading requirements. The court therefore looked to the operating agreements and applied their standard of care as the definition of wrongful conduct—gross negligence, fraud or willful or wanton misconduct.
The other members argued that the operating agreements’ requirement of unanimous member consent trumped the pleading requirements of Or. Rev. Stat. § 63.801(2). The court disagreed and held that the requirement of consent was not equivalent to giving every member the unfettered authority to withhold consent. The right to consent was subject to the express standard of care in the operating agreement and the implied duty of good faith and fair dealing. The court noted that the requirement of unanimous member consent meant that the plaintiffs had to allege facts demonstrating that all of the member defendants refused wrongfully. “[I]f even one of them refused to proceed and had a valid business reason for doing so, the LLCs could not bring legal action against McKenna and Summit.” Bernards, 229 Or. App. at 367-68.
The court concluded that the facts alleged by the plaintiffs were not adequate to demonstrate wrongdoing. Yes, there was a clear right to recover the embezzled funds (one defendant had admitted the embezzlement). Yes, the other members refused to sue when a demand was made. Yes, the other members had not provided an explanation for their refusal. Yes, one member had stated that he would not authorize legal action against McKenna and Summit “no matter how much money they had embezzled.” Bernards, 229 Or. App. at 362. But, said the court, it was not alleged, for example, that the members had refused to provide an explanation, or that they had a personal financial interest in McKenna or Summit, or that they were driven by some personal animus against the plaintiffs. The result was that the court affirmed the trial court’s dismissal of the complaints.
The Bernards opinion is noteworthy not only because it answered an open question under Oregon law, but also because it reasoned by analogy and applied Oregon’s corporate law of derivative actions to LLCs. And the result here was clearly right--why should a minority member be able to sue in the name of the LLC to initiate litigation when the other members have decided that the LLC should abstain, without alleging some facts showing that that there was something wrong with the other members’ decision, such as a conflict of interest? Also noteworthy is that the court applied the business judgment rule, while implicitly recognizing that an LLC’s operating agreement could change the rule for that LLC.
Tags: Bernards v. Summit Real Estate Mgmt., Derivative Suits, Derivative suit, Oregon, business judgment rule, operating agreement