An Important Opinion On Assigning LLC Interests From The NC Business Court

Today's post is really a thank you to Judge Gale for delivering the Christmas gift I requested in last week's post: a decision from the North Carolina Business Court on an open question of North Carolina's corporate law to write about because I was tired of writing about Delaware law on this North Carolina blog.

The gift came in the decision in Blythe v. Bell, 2012 NCBC 60, decided Monday by the Business Court.  The Blythe opinion is the first decision under North Carolina's Limited Liability Company Act construing the effect of a transfer of an LLC interest by an LLC member.

What's Included in a LLC Member's Interest

The definition of a membership interest is in G.S. §57C-1-03.  As Judge Gale observed, the statute recognizes the distinction between a member's 'economic interest' (the right to receive distributions from the LLC) and the member's 'control interest' (the right to vote or to participate in the management of the LLC).  Op. 27. 

Assigning an LLC Member's Interest Doesn't Make The Assignee A New Member Of The LLC

The LLC Act deals in N.C. Gen. Stat. §57C-5-02 with "assignment of membership interests."  Section 57C-5-04(a) covers the "right of assignee to become a member."

It's worth a look at the statutes, which you can read by clicking on the links, as they were too long to quote.  As Judge Gale observed, Section 57C-5-02 makes it clear by its wording that "an assignment in and of itself does not entitle the assignee to become a member or to exercise a
member’s rights if he is not already a member. "  Op. 33.  

If there is an assignment of an LLC interest to someone who is not already a member of the LLC, then Section 57C-5-04(a)(2) requires the unanimous consent of the other members before the assignee can become a member.

What Happens To The Control Interest When There's An Attempted Assignment To A Non-Member?  

The issue of the control interest's assignability was the nub of the Blythe case.  One of the Defendants, Joseph, had assigned his membership interest in an LLC to HBI, which was not a member of the LLC.  Plaintiff said this meant that neither Joseph nor the assignee had a right to vote the 30% interest.

The effect of this argument, if accepted, was that the Plaintiff's control interest went from 40%  to 57% (based on 40% of the 70% remaining with Joseph's 30% out of the equation).  That turned a minority member into the controlling majority member.

Judge Gale rejected that argument focusing on the LLC Act as a whole.  He said that the control rights continued to reside with the assigning member until the assignee was admitted as a new member per the terms of Section 57C-5-04.  In particular, he relied on G.S. §57C-5-06, which prohibits a member from voluntarily withdrawing from the LLC without an express agreement from the other members allowing the withdrawal.  Accepting Plaintiff's argument would have allowed a member to withdraw via assignment which Judge Gale found to be contrary to the Act.

The effect of this ruling was that Joseph had transferred his economic interest, but he remained a member of the LLC with voting rights unless and until until his assignee was admitted as a member by unanimous consent. 

It's worth noting that the same result would have been reached under the terms of the Revised Uniform Limited Liability Company Act, Section 502(g).

There's A Difference If The Assignment Is To An Existing LLC Member

 Here's another part of the ground-breaking LLC news from Blythe:  Judge Gale held that he "interprets the Act to allow members, absent a contrary agreement, to transfer both their economic and control membership interests to existing members without unanimous member consent."  Op. 44. 

How Do You Avoid This Type Of Problem?

Is there a way to avoid this type of wrangling over assignments of LLC interests?  Of course.  The default provisions of the LLC Act control "unless otherwise provided in the articles of organization or the operating agreement of a North Carolina LLC."  Op. 24.  The LLC in Blythe had no operating agreement.  If there had been one, the assignment provisions of the LLC Act might have been varied.

 

 

Parol Evidence Rule Barred Defendants' Interpretation Of Earn-Out Provision

Premier, Inc. v. Peterson, 2012 NCBC 59, decided last Friday by Judge Murphy, turned on a strict application of the parol evidence rule.

At issue was whether the defendants were entitled to a substantial earn-out payment under a Stock Purchase Agreement.  The Plaintiff had purchased the Defendants' software business of selling a Web-based surveillance and analytic services to healthcare providers.

Interpretation of the Contract

The Stock Purchase Agreement called for the earnout payment to be made on a series of five year anniversaries of the acquisition date.  The calculation was to be based on the number of hospitals at which a "Product Implementation" of the software products purchased by the Plaintiff had occurred.

The SPA contained a definition of "Product Implementation," and Judge Murphy not surprisingly held that "[b]ecause the goal of construing a contract is to arrive at the intent of the parties when he contract was executed, where a contract defines a term, 'that definition is to be used.'"  Op. 31(quoting Woods v. Nationwide Mut. Ins. Co., 295 N.C. 500, 505-06, 246 S.E.2d 773, 777 (1978)).

The definition called for the hospital in question to have subscribed to or licensed the product and to have implemented it as well.  A representative of the sellers said that notwithstanding the definition, the parties had agreed during  the negotiations that a "Product Implementation" would include instances where the product was merely provided to the hospital, even without a subscription or license.

Judge Murphy rejected this argument, holding:

 this agreement, at best, adds to the unambiguous terms of the contract requiring a
subscription or license. As such, the parol evidence rule bars consideration of this
proffered agreement, and the Court must enforce the language as written. In doing
so, the Court concludes that Plaintiff’s interpretation construes all the terms
harmoniously, giving effect to the entire provision. Therefore, the Court concludes
that the language is unambiguous, and that Plaintiff has presented a reasonable
interpretation of “Product Implementation.”

 Op. 35.

Attorneys' Fees?

Maybe you are thinking that the Defendants' argument was so beyond the pale of the parol evidence rule that the Plaintiff should have been awarded attorneys' fees.  And the Stock Purchase Agreement called for fees to be awarded to the "prevailing party."

So were fees awarded to the Plaintiff?  No, because of the NC Supreme Court's decision in Stilwell Enter. v. Interstate Equip Co., 300 N.C. 286, 266 S.E.2d 812 (1980), in which it held that:

[e]ven in the face of a carefully drafted contractual provision indemnifying a party for such attorneys' fees as may be necessitated by a successful action on the contract itself, our courts have consistently refused to sustain such an award absent statutory authority therefor.

Id. at 289, 266 S.E.2d 815-16 (emphasis added).

Statutory authority?  Wait a minute.  What about N.C. Gen. Stat. sec. 6-21.6(c), which says that:

If a business contract governed by the laws of this State contains a reciprocal attorneys' fees provision, the court or arbitrator in any suit, action, proceeding, or arbitration involving the business contract may award reasonable attorneys' fees in accordance with the terms of the business contract.

No to attorneys' fees, said Judge Murphy, notwithstanding Section 6-21.6.  That statute applies only to business contracts entered into on or after that statute's effective date, which was October 1, 2011.  This Stock Purchase Agreement was entered into five years before that effective date, in 2006.  Op. ¶46 & n.2.

 

 

 

Delaware Law On Derivative Actions And Fiduciary Duties

If you are a derivative action plaintiff, and you make a demand on an LLC to take action which is then considered and rejected, may you still pursue your claims?  Judge Murphy answered that question, and others relating to derivative actions under Delaware law in this week's opinion in  Scott v. Lackey, 2012 NCBC 58.

By the way, the reason that I am writing today about Delaware law, instead of North Carolina law, is that the entities involved in the Scott case were formed in Delaware, so Judge Murphy ruled that Delaware law controlled.

Derivative Action After Rejected Demand

In North Carolina, the answer is in G.S. §57C-8-01. If the Court appoints a committee of "two or more disinterested managers, directors, or other disinterested persons, acceptable to the limited liability company, to determine whether it is in the best interest of the limited liability company to pursue a particular legal right or remedy."  Then, if the committee determines that it would not be in the best interests of the LLC to pursue the claim, the Court can dismiss it.

In Delaware, the answer is a bit more complicated, as borne out by the Business Court's decision  in the Scott case. 

Delaware law in this niche implicates the business judgment rule.  Three issues arise:

'(1) whether the [managers] acted independently and not self interestedly; (2) whether the [managers] reasonably investigated the basis for the proposed litigation; and (3) whether the [managers] refused to act in good faith.  Seaford Funding Ltd. P’ship v. M & M Assocs. II, 672 A.2d 66, 70 (Del. Ch. 1995) (citing Spiegel, 571 A.2d at 777).

Op. ¶52.

in Delaware, by making a demand, the derivative plaintiff "tacitly concedes the independence of a majority of the board to respond."  Op. ¶52.  But Delaware law does not imply a concession that the managers of an LLC will act in a disinterested way in considering a demand.  Op. ¶53.

Judge Murphy found a "reasonable doubt" as to whether two of the managers had acted in good faith in responding to the demand.  He noted that they had refused to meet with the Plaintiff to discuss his concerns.  He also observed that they stood to benefit directly from the challenged transactions, and he denied the Motion to Dismiss the derivative claims.

Adequacy Of Derivative Plaintiff

A Delaware derivative Plaintiff "must be qualified to serve in a fiduciary capacity as a representative of a class, whose interest is dependent upon the representative's adequate and fair prosecution."  Op. ¶93.

The Defendants in the Scott case said that Scott was an inadequate Plaintiff because he had a personal interest in gaining control of the LLC.

Judge Murphy disagreed, holding that "selfish motives alone will not mandate Plaintiff's disqualification as an inadequate representative."  Op. ¶96.  He added that "it is hardly unusual for derivative plaintiffs to have their own interests in mind when bringing a derivative action."  Id.

The Defendants pointed to a defamation claim lodged against them by the Plaintiff as evidence of Plaintiff's vindictiveness towards them.  Judge Murphy shot down that argument as well, again looking to Delaware law:

absent some concrete fact revealing a conflict between Plaintiff and BHCM, 'amorphous hostile feelings against defendants [are] not in [themselves] relevant.' Emerald Partners, 564 A.2d at 677 (quoting Vanderbilt v. Geo-Energy Ltd., 590 F. Supp. 999, 1001 (E.D. Pa. 1984)).

Op. ¶99.

Defendants also argued that the Plaintiff's derivative action did not have the support of other members of the LLC.  That too was an insufficient argument  Judge Murphy observed that "[a] derivative claim may be maintained . . . without the support of a majority or ownership or even the support of the entire minority."  Op. ¶100.

 

Breach of Fiduciary Duty

Judge Murphy found that the Defendants owed a fiduciary duty to the Plaintiff, stating that "unless otherwise stated in the LLC agreement, 'the member-managers of a Delaware limited liability compan[y] owe traditional fiduciary duties to the LLC and its members."  Op. ¶69.

For a long time, that appeared to be the law of Delaware, but recent developments show that it is not.  In Gatz Properties LLC v. Auriga Capital Corp., No. 148, 2012 (Del. Supr. Nov. 7, 2012), the Delaware Supreme Court said that the issue of a "default fiduciary duty" remained an "open question," 

It chastised the Chancey Court Judge for saying otherwise, stating 

We feel compelled to address this dictum 'because it could be misinterpreted in future cases as a correct rule of law,' when in fact the question remains open. Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 167 (Del. 2002).

Gatz, supra, at n.62 (emphasis added).

Would it have made a difference to Judge Murphy's opinion if Delaware law had been clear on the fiduciary duties of managers?  Probably not, as it seems inevitable that the Delaware Supreme Court will reach the conclusion that managers have a fiduciary duty to their LLC.  The North Carolina Court of Appeals  ruled three years ago that LLC managers owe such a fiduciary duty to the LLC, in  Kaplan v. O.K. Technologies, LLC.

I wrote about the differences between Delaware and North Carolina on the point of LLCs and fiduciary duty in April 2009.

*   *   *

If you are wondering what I want for Christmas, it would be a decision from the North Carolina Business Court on an open question of North Carolina's corporate law to write about.  I'm tired of writing about Delaware law.  

 

Does A Trial Judge Have The Discretion To Deny Costs To A Prevailing Party?

If you've ever made a Motion for Costs following a win at summary judgment or a win at trial you know that the law on such motions is a quagmire.   Does the trial court have discretion in determining whether to award costs to a prevailing party?  Section 6-20 of the General Statutes implies that the Court always has discretion (it's titled "Costs allowed or not, in discretion of Court"), but the answer is muddy.

Judge Gale ruled in a post-judgment ruling last Friday in Dunn v. Dart that the costs listed in and allowed by G.S. N.C. Gen Stat.§7A-305(d) must be awarded to a prevailing party, and that a trial judge lacks any discretion in determining to deny them.  He interpreted a less than year old Court of Appeals decision, Khomyak v. Meek, 720 S.E.2d 392 (2011), "[t]o eliminate that discretion and to compel awarding the prevailing party those costs allowed by N.C. Gen Stat.§7A-305(d)"

The Khomyak case represented an admirable effort by Judge McCullough of the Court of Appeals to harmonize the cases laying in the "troublingly divergent path" taken by the COA  in ruling on motions for costs that have come to it on appeal.

That "troubling path" includes Smith v. Cregan, 178 N.C. App. 519, 632 S.E.2d 2006 (2006), which held that a trial court does have discretion whether to award costs:

this Court's decision explicitly holds that, for actions governed under section 6-20, such as negligence actions like the present case, the trial court has the discretion to determine whether or not to award costs to the prevailing party, and if the trial court chooses to exercise that discretion, then the trial court is confined to those costs expressly enumerated under section 7A-305(d) or any other statute." Id. at 222 (emphasis added).

Id. at 734, 596 S.E.2d 895.

Since one panel of the Court of Appeals can't overrule another, and since the North Carolina Supreme Court hasn't ruled on the discretion issue, the Smith case is still out there as good (but now questionable) law.

It doesn't take much reading between the lines of the one page Order in Dunn v. Dart to take away that Judge Gale did not look kindly on this  Motion for Costs.  In fact, he stated that "[i]f the court did have discretion to do so, it would exercise its discretion here to deny all costs."  

And he certainly exercised some discretion, in awarding only about five thousand dollars in costs against Defendants' request for more than $130,000 in fees and costs.  

Don't forget that this case is a fight between lawyers to carve up a big fat fee about which I wrote last year.  There's obviously no love lost between those lawyers, and maybe the Court of Appeals will get another chance to consider the law on Motions for Costs if there is an appeal of this ruling.

North Carolina Business Court Defers To Delaware Courts In Class Action Challenging Sealy Merger

Maybe one day North Carolina will be the center of the business litigation universe, but for now the center of that universe remains in  Delaware.  

The Order last week in Justewicz v. Sealy Corp., 2012 NCBC 57 -- in which the Business Court stayed a North Carolina class action in favor of parallel Delaware class actions -- illustrates that.

The Justewicz case challenges the validity of the sale of Sealy (the mattress company) to Tempur-Pedic, asserting that the sale is overly preferential to Tempur-Pedic and tp Sealy's board members.  Five similar class actions were filed in Delaware, one before the Justewicz case and the other four shortly thereafter.

The defendants in Justewicz moved to stay the case per N.C. Gen. Stat. §1-75.12, which says that: 

If, in any action pending in any court of this State, the judge shall find that it would work substantial injustice for the action to be tried in a court of this State, the judge on motion of any party may enter an order to stay further proceedings in the action in this State. A moving party under this subsection must stipulate his consent to suit in another jurisdiction found by the judge to provide a convenient, reasonable and fair place of trial.

G.S. §1-75.12(a).

In deciding to stay the North Carolina case, Judge Gale looked to several of the twelve factors identified by Judge Tennille in a 2007 decision, Levy Investors v. James River Group, Inc. (unpublished).

He ruled that the case presented an unsettled issue of Delaware law: whether a party could obtain a pre-closing injunction of a consent merger based on a defective process claim, and that this issue was better decided by a Delaware court.  

Also supporting the ruling was a finding that Delaware was at least as convenient a forum with an "equal or greater nexus to the controversy."  That was so even though Sealy is headquartered in North Carolina.  Judge Gale held that "[w]hile North Carolina does have an interest in the takeover of a business located in North Carolina, Delaware also has an interest in a corporation incorporated there and in the application of Delaware law."  Op. ¶34.

Judge Gale also found significant that the Defendants said that they would not protest Justewicz's right to participate in the Delaware cases, and that the Justewicz case had not advanced further than the Delaware cases.

Next, he noted that Delaware has a procedural mechanism allowing for direct review by the Delaware Supreme Court  He said that this "expedited appeal process could be useful."  If you aren't familiar with that expedited process (I wasn't), it is contained in Rule 25 of the Delaware Supreme Court Rules.

Substantial Injustice.  And finally, Judge Gale held that:

 requiring Defendants to defend essentially the same lawsuit in two different states will work a substantial injustice on Defendants and unnecessarily raises the possibility of inconsistent decisions.

Op. Par. 48.