LLC Operating Agreement Defeats Unjust Enrichment and Breach of Fiduciary Duty Claims

WOSS, LLC v. 218 ECKFORD, LLC, 102 AD 3d 860 - NY: Appellate Div., 2nd Dept. 2013 - Google Scholar:

The plaintiff LLC was a member of the defendant LLC 218 Eckford. It then brought numerous claims against the defendant LLC on the ground that it had not received the appropriate share of profits. Plaintiff's claims were entirely defeated because plaintiff was a member of 281 Eckford and signed the operating agreement. Plaintiff could not bring a claim for unjust enrichment because the operating agreement (a written contract) controlled the outcome. Plaintiff could not bring a claim for breach of fiduciary duty because plaintiff did not allege a fiduciary relationship.

Comment: the lesson here is that the operating agreement was thoughtfully drafted. The provisions of the operating agreement are a contract that governed the parties' business relationship. There were no holes in the agreement (at least according to the court) for the plaintiff to run through to bring a cause of action.

In sum, where there is more than one person involved in a business venture or undertaking, the operating agreement is crucial. It governs the parties' business relationship. This is where legal work is most valuable to the entrepreneur. The lawyer can draft the agreement to reflect the client's wishes and can avoid many pitfalls.

Edward X. Clinton, Jr.

'via Blog this'

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Corporate Law - Dissolved Corporation Lacks Standing To Sue For Claims Arising After Dissolution

Sometimes a client asks whether a dissolved corporation can bring a lawsuit. The answer is not clear. If the claim accrued before the corporation was dissolved, the corporation can sue. However, under this case (see below) a dissolved corporation cannot sue if the claim "arose" after it was dissolved.

Corporations are dissolved usually when the corporation fails to pay its annual fee to the Illinois Secretary of State.

The case is A Plus Janitorial Co., v. Group Fox, Inc., 2013 Il App (1st) 120245. In the A Plus case, the plaintiff attempted to bring a breach of contract claim against another party. Section 12.80 of the Illinois Business Corporation Act states that the dissolution of a corporation does not "take away or impair any civil remedy available to or against such corporation...." The court reasoned that the statute preserves any claims that were in existence (or which had accrued) before the corporation was dissolved. However, the A Plus court held that the dissolved corporation does not have the ability to sue for a claim that arose after it was dissolved.

Since the alleged breach of contract occurred after dissolution, the corporation could not sue.

Comment: This is a case of careless behavior by the plaintiff. A corporation can be reinstated by paying a fine and the past due fees to the Illinois Secretary of State. At most, the fees would run a few hundred dollars. Failing to pay these fees wasted years of work on the litigation that followed. The lesson here is simple - if there is any doubt about corporate status, clean it up before filing.

Edward X. Clinton, Jr.

www.clintonlaw.net

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Seventh Circuit Holds That A Demand on the Board of Directors Was Not Required

In a shareholder derivative lawsuit, the plaintiffs are the shareholders of the company. They bring a lawsuit against someone for wrongdoing. Because the proceeds of the case really belong to the corporation, a doctrine of corporate law has developed under which the plaintiffs must first "demand" that the directors of the corporation bring the lawsuit themselves. What happens when the directors themselves are accused of wrongdoing? Can they really be expected to comply with a demand that they sue themselves for money? Thus, under this exception, courts have held that the "demand" requirement is "excused" in certain cases. The Seventh Circuit has recently decided one such case.

See Westmoreland County Employee Retirement System v. Parkinson, Jr. et. al. No.12- 3342  (August 16, 2013).

According to the opinion, Baxter International had severe problems with a medical device called Colleague Infusion Pump (Pump). The Pumps were used to deliver intravenous fluids to patients. The Pumps had a range of difficulties over a period of years. At first Baxter worked diligently to fix the problems but then its efforts allegedly tapered off.  The FDA sent a series of warning letters to Baxter.

The plaintiff shareholders filed their lawsuit several years after the problems became known. By that time, about 200,000 Pumps were in use throughout the country. Plaintiffs sued 13 directors of Baxter and several corporate officers.  Plaintiffs made no demand before filing the lawsuit that the directors take action. According to the District Court the plaintiffs failed to show that demand was not necessary.  The district court dismissed the lawsuit.

The Seventh Circuit reversed and reinstated the case.



The defendants were directors and a few interested officers. The complaint alleged that the  defendants breached their fiduciary duties by consciously disregarding their duties to bring Baxter in compliance with a consent decree and applicable law.
 According to the court demand is necessary unless there is reasonable doubt that the directors are disinterested or the action was otherwise the product of a valid exercise of business judgment.

According to the Court if a director breaches his duty of loyalty he can not rely on the business judgment rule. The 7th circuit said that the Defendants gave up in trying to fix the pumps and threw in the towel. Baxter began to focus on the development of a new pump  and to a great extent did not continue to fix the problems with the old pump despite warnings of the FDA.

According to the 7th Circuit, the defendant directors actions fell outside the protection of the business judgment rule. The Court said ”the directors knew of the problem, having been warned but took no steps to remedy the situation.” The Court went on to say that there was a reasonable probability of a finding of bad faith by the directors.

The judgment of the district court was reversed.

Cases holding that the demand requirement was excused are rare, but significant.

Edward X. Clinton, Sr.

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Ninth Circuit Rejects Securities Fraud Claim By Purchasers of Hard Rock Hotel Condominiums

The case is captioned Salameh v. Tarsadia Hotel. It is an investment contract case, where the plaintiff alleges that certain contracts he signed were really securities and that the securities should have been registered under the Federal Securities laws.

The facts, from the plaintiffs' complaint, were as follows:

Forty plaintiffs signed contracts to purchase condominium units in a Hard Rock Hotel then under construction. Plaintiffs alleged that they were obligated also to sign Rental Management Agreements with Defendant Tarsadia in which Tarsadia would be the exclusive management agent for the hotel.

Plaintiffs alleged that they were not given keys to the units purchased and could not occupy the units for more than 28 days each year. Therefore, according to plaintiffs, the purchase should be viewed as an investment contract, not a purchase of real estate.

Plaintiffs alleged that Defendants did not comply with the Securities Act of 1933, Sections 12 (a) and Section 10 B of the Securities  Exchange act of 1934, the California Securities Law and were guilty of common law fraud.   

The District Court held that the defendants did not sell securities. It reasoned that the contract to purchase the condominium and the contract under which the hotel was to be managed were two separate contracts signed 15 months apart.

The 9th Circuit affirmed.

The 9th Circuit acknowledged that the both the Securities Act of 1933 and the Securities Exchange Act of 1934 defines the term security to include the  term “investment  contract” . The Court also noted that the term “investment contract” has been interpreted to include novel, uncommon devices.” The investment contract concept embodies a flexible rather than a static principle, one that is capable of adaptation to meet countless and variable schemes  by those who seek the use of the money of others  on the promise of profits. SEC v. Howey 328 U.S.281. The Court went on to say whether a real estate transaction is a security, substance governs, not label, or form. However, the Court held that the Condo Purchase and Management Agreements were not offered  as a package.

The material delivered to plaintiffs do not allege that management agreement forthcoming.  The Court said that there was a significant time gap between the execution of the Condo Purchase Agreement and the Management Agreement The Court said that the two transactions were distinct. The Court went on to say that there was no reason why there could not be a market for ownership of a condo as a short term vacation home.

The Court said that taking all nonconclusionary allegations as true, Plaintiffs did not sufficiently allege claims under federal or state securities laws. The Court also went on to reject the common law fraud claims.

Although the Court made passing reference to  the amicus brief of the SEC,  it was not persuaded. The well-written and thoughtful brief of the SEC stated in part :

“The Commission believes that the district court, in determining that the hotel-room sales did not  sales of investment contracts, failed to give effect to the economic realities of the transaction as required by Supreme Court and Ninth Circuit precedents.

The Commission is concerned that the district court’s holding on the investment contract issue, unless reversed, would seriously erode the investor protection of the securities laws. It would impermissibly allow a promoter to avoid the coverage of these laws by (1) artificially dividing a single investment into ostensibly separate parts and (2) including a written disclaimer that falsely state that there is no investment exception.”

The brief also stated that (1) the sales agreements left the plaintiffs with so little use or control that it was obvious from the beginning that the defendants would exercise exclusive control to rent and operate the rooms; the reality of the defendant’s plan made if obvious from the outset that these  rooms would be necessary to serve as the hotels guest rooms; and  the hotel was under construction during the entire period, making the time gap between the room sales  and rental program inconsequential.

The Ninth Circuit rejected the arguments of the SEC:


"Plaintiffs' strongest argument that the two contracts, signed about a year apart, form a single transaction is their assertion that the "economic reality" shows that the two transactions are part and parcel of one scheme. They contend that the Purchase Contract, combined with external factors, such as the zoning ordinance, gave them no choice but to sign the Rental Management Agreement when it was later presented. This argument has some force. See Hocking, 885 F.2d at 1461; see also Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). But to accept this argument, we not only would have to ignore the large time gap between the two transactions that were executed with different entities, but also the fact that Plaintiffs' complaint is void of any allegation that they were induced to buy the condominiums by the Rental Management Agreement. The economic reality as we see it is that these two transactions were distinct. Moreover, Plaintiffs' economic-reality argument rests on the implicit assumption that the only viable use for the condominiums was as an investment property, but there is no plausible reason why there cannot be a viable market for owner-occupied hotel-condominiums for use as short-term vacation homes. See Brief of Amici Real Estate Roundtable & National Association of Realtors 3-6. This conclusion undercuts Plaintiffs' economic assumptions. See Forman, 421 U.S. at 858 (holding that a security does not exist "where [a consumer] purchases a commodity for personal consumption or living quarters for personal use")."

In my opinion, this is an unfortunate result that is not consistent with precedent Doubtless there were substantial losses suffered by the investors.

Edward X. Clinton, Sr.

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