Collecting On Judgments Against A Member's LLC Interest

A lawyer has limited remedies to collect on a judgment from a defendant who is unwilling to pay.  If the defendant holds stock in a corporation, you can execute on the shares, take possession of them, and sell them. N.C. Gen. Stat. §1-324.3.  But if that ownership interest is in an LLC, a "charging order" is your only recourse (per G.S. §57D-5-03(d)).

If you don't know what a charging order is, it is a court order against an owner of an LLC interest which gives a creditor the right to receive any distributions that the owner of the interest would have received until the judgment is paid.

The Old LLC Act

Former Section 57C-5-03 of the General Statutes (which was repealed and replaced in January 2014 by the new North Carolina Limited Liability Act in Chapter 57D) said that:

On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interest.

But what exactly did the holder of the charging order receive under the Old LLC Act, and what did the LLC owner lose upon the issuance of a charging order?  Last week, the NC Court of Appeals wrestled with the question whether a charging order operates as an assignment of an LLC interest, in First Bank v. S&R Grandview, LLC.

First Bank had obtained a charging order against Donald Rhine, a member of S&R Grandview, an LLC.  The charging order said that the Plaintiff "shall hereafter have the rights of an assignee" of Mr. Rhine's interest of the LLC, and that Mr. Rhine then had no remaining membership interest in the LLC.  The charging order said that his membership right would "lie fallow" until the judgment against him was satisfied.

Mr. Rhine appealed, arguing that the charging order did not operate to assign his LLC interest.  First Bank rejoined that the effect of  the charging order under Section 57C-5-03 was that Mr. Rhine was no longer a member of the LLC to which the order applied.

There was some plausibility to First Bank's argument.  Section 57C-5-03 said that "[t]o the extent so charged, the judgment creditor has . . . the rights of an assignee of the membership interest." And Section 57C-5-02 said that "a member ceases to be a member upon assignment of all of his membership interest."

A Charging Order Does Not Work An Assignment Of An LLC Interest

The Court of Appeals disagreed with First Bank's position, holding that "[n]owhere in these provisions does the General Assembly mandate an assignment of membership interests from a debtor to a judgment creditor through a charging order." Op. 8.  It added that "[h]ad the General Assembly intended a charging order to assign all membership interests and terminate a debtor’s membership in an LLC, as plaintiff contends, it could have easily included language to that effect." Op. 8-9.

The changes in the LLC Act through Chapter 57D bolstered the Court's conclusion.  The new provision dealing with charging orders states that "this Chapter does not deprive any interest owner of a right."  N.C. Gen. Stat. §57D-5-03(c).  I'm not sure whether statutory interpretation lets a court look at the subsequent actions of a Legislature to determine what the Legislature meant the first time around.

But anyway, why did this Defendant care whether his LLC interest was assigned and whether he had lost his membership rights?  Remember that an LLC member has an ownership interest that includes both an economic interest and a right to participate in the management of the LLC.  N.C. Gen. Stat. §57D-1-03(25).

A charging order can affect only the economic interest.  The charging order in First Bank went too far.  It took away Mr. Rhine's management rights.

What happens if those with management rights in the LLC decide to defer distributions from the LLC because of a dislike for the judgment creditor?  That's undoubtedly a risk, and it will probably be the subject of a yet to be decided court decision.

Why Should You Care About The Old LLC Act?

The NC General Assembly repealed the Old LLC Act, in Chapter 57C and replaced it with the New LLC Act through Chapter 57D.  That change became effective three months ago, on January 1, 2014.

Do you need to worry about the repealed Act?

Maybe.  In the "Savings Provisions" in the New Act, the General Assembly said that "[a]ny proceeding commenced before January 1, 2014, may be completed in accordance with the law then in effect."  N.C. Gen. Stat.  §57D-11-03(d)

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Fourth Circuit On LLC Law And Fried Chicken And Waffles

The Fourth Circuit doesn't get into matters of LLC law very often, but it did last week in Painter's Mill Grille, LLC v. Brown. The LLC and its members were suing their landlord for discriminating against them on the basis of race.

The LLC was operating a restaurant which served an African-American clientele. The Plaintiffs said that the Defendants became hostile to them as a result and referred to their business in a racially disparaging way and interfered with their sale of the business.

One of the comments by the Defendants, when the Plaintiffs attempted to sell their business, was whether they were going to open another "chicken and waffle shack."

Let me say that I love [fried] chicken and waffles for breakfast. If you haven't tried that dish, Dame's Chicken & Waffles, in Greensboro's Southside neighborhood, is outstanding.  If you don't get the racial animus alleged to be behind that term, the dish is said to have originated with African-American southerners.

But could the LLC members, who alleged that they suffered "personal out-of-pocket losses" as a result of the Defendants' discriminatory conduct, state a claim against them?

No, said Judge Niemeyer, since they were LLC members.  He held that:

[i]n advancing their arguments [the members] failed to account for the fact that they elected to conduct their business through a limited liability company ("LLC") and that, just as they received protection of their personal assets from liability in doing so, they also assumed a role as agents for the company. At bottom, they gave up standing to claim damages to the LLC, even if they also suffered personal damages as a consequence. The Supreme Court’s decision in Domino’s Pizza, Inc. v. McDonald, 546 U.S. 470 (2006), forecloses just such claims.

Op. at 7 (emphasis added).

I wasn't familiar with the Supreme Court's decision in Domino's Pizza, but it rejected in that case a shareholder's personal claims for race discrimination, holding that they belonged solely to the corporation.  Justice Scalia held there that:

it is fundamental corporation and agency law—indeed, it can be said to be the whole purpose of corporation and agency law—that the shareholder and contracting officer of a corporation has no rights and is exposed to no liability under the corporation’s contracts.

546 U.S. at 477.

I will hold off on my pizza recommendations.

 

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.

 

 

The Business Judgment Rule Applies To Actions By Managers Of North Carolina Limited Liability Companies

It might seem self-evident that the Business Judgment Rule applies to decisions made by the managers of a limited liability company, but if you were looking for a North Carolina case to cite on that point before last week, you wouldn't have found one.

But now, we have Mooring Capital Fund, LLC v. Comstock North Carolina, LLCa November 13, 2009 decision from the North Carolina Business Court. The case addresses not only the business judgment rule, but also two other significant aspects of litigation involving LLCs.

The Business Judgment Rule And LLC Managers

Mooring Capital, a minority member of Comstock North Carolina, LLC, filed a lawsuit seeking an accounting and making derivative claims for a diversion of funds by the majority member and manager of the LLC, CHCI. CHCI contended that it was entitled to dismissal because it had limited liability as a member-manager.

Judge Jolly agreed that "member-managers generally are shielded from liability when acting as LLC managers," Op. ¶29, and further held that "the managers of an LLC may also be entitled to the protections of the 'business judgment rule.'" Op. ¶30. The Court based the business judgment rule portion of its ruling on G.S. §57C-3-22(b), which states that an LLC manager is bound to act "in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in the manner the manager reasonably believes to be in the best interests of the limited liability company."

The Court nevertheless denied the manager's motion to dismiss, holding that "while the business judgment rule limits the liability of member-managers when acting on behalf of an LLC, this liability is not limited when managers act outside the scope of managing the LLC." Op. ¶33. Dismissal of Plaintiff's claims wasn't warranted because the Complaint made allegations that the manager had taken "actions clearly in conflict with the interests of the LLC" and had "entered into transactions from which" the manager had "derived an improper personal benefit." Op. ¶36. Those included unauthorized distributions from the LLC to the manager and entities with which the manager it was affiliated.

Derivative Actions On Behalf Of LLCs, And Stays Pending Investigation

There are at least two other LLC-related litigation points worth noting in Mooring Capital. One involves the standing of an LLC member to make a derivative claim, the other involves the right of the LLC to a stay of the action while it investigates the charges.

On the first point, although the LLC Act doesn't specify that a demand be made before a member can file a derivative action, the statute does require that the complaint "allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the managers, directors, or other applicable authority and the reasons for the plaintiff's failure to obtain the action, or for not making the effort." N.C. Gen. Stat. §57C-8-01(b).

The Defendant claimed the Plaintiff hadn't made sufficient effort to have the LLC take action. The Court disagreed, referencing Plaintiff's contentions that "its minority status alone show[ed]" that it lacked the authority to cause the LLC to bring suit," and furthermore that it had made "repeated requests for financial information" to which the LLC had not responded.

On the point of the LLC's right to a stay pending its investigation, the LLC had retained PriceWaterhouseCoopers to investigate some of the matters raised by Plaintiff. The LLC said that it therefore was entitled to a stay per G.S. §57C-8-01(b). The Court denied the stay, however, noting that it had concerns about the scope of the accounting firm's investigation. The engagement letter between the LLC and PWC said that the accounting firm would perform a review of the LLC's financial statements, but did not speak to an investigation of other allegations made by the Plaintiff in its Complaint.

Brief in Support of Motion to Dismiss

Brief in Opposition to Motion to Dismiss

Brief in Support of Motion to Stay

Brief in Opposition to Motion to Stay

Donovan v. Huffman, July 6, 2009 (Diaz)(unpublished)

The Court partially granted an LLC member's motion for an accounting, ordering the LLC to provide the member with periodic "(1) information regarding the status of the business and the financial condition of [the LLC] including a summary of all funds disbursed and spent and all revenue generated from 1 January 2009 to the present, and (2) a copy of [the LLC's] federal, State, and local income tax returns as filed for each year the company has been in business."

Full Opinion

Default Entered Against LLC Even Though Its Derivative Action Had Been Dismissed

Can you have a default entered against you if you aren't a proper party to the lawsuit?  The answer is yes, at least on the unique facts before the Business Court in its opinion Friday in the derivative action Regional Property Development Corp. v. Carpenter.

Regional Property, a member of Lancaster Industrial Park, LLC, had filed a derivative action on behalf of the LLC against three other members of Lancaster, and also the lender to the LLC, Regions Bank. 

In a March 25th Order, the Business Court dismissed the derivative claims, ruling that Regional Property wasn't entitled to sue on behalf of Lancaster because of it hadn't made a demand on the managers of the LLC to file the suit.  The Court allowed Regional Property leave to amend to assert demand futility.

But right before that ruling, Regions Bank had counterclaimed against Lancaster, asserting that Lancaster was in default on its loan obligations to the Bank.  Lancaster, whose derivative claim had been dismissed by the time the answer deadline had run, didn't answer.  (Or rather, Regional Property, which had brought the lawsuit, didn't answer on behalf of the LLC).  Regions Bank then moved for entry of default.

The other defendants, the members who had moved to dismiss the derivative action, objected to the Motion for Entry of Default and said that default was not proper because the LLC wasn't a party to the litigation.  They said in their Opposition that "Lancaster cannot be in default in this matter for the simple reason that it is not a party."  They also argued that Regions Bank should be estopped from arguing that Lancaster was a party, because it also had taken the position there was no authority for Regional Property to file the lawsuit on behalf of Lancaster.

Judge Diaz entered default over that objection.  He said that once the counterclaims were filed, Lancaster "was bound to respond to the counterclaims or risk default, regardless of whether it should have appeared in the action to begin with."  Also, given that Regional Property had moved after the dismissal of its derivative action to amend the Complaint to excuse its lack of demand, the Court held:

where a party seeks to pursue a claim derivatively on behalf of a limited liability company, the LLC is a necessary party and is normally joined as a defendant. See generally Russell M. Robinson, II, Robinson on North Carolina Corporation Law § 17.05[2] (7th ed. 2008) (citing relevant cases with respect to derivative actions filed on behalf of a corporation). Thus, even if Lancaster now disavows any role in this case as a party-plaintiff, because Regional Property’s Second Amended Complaint asserts derivative claims on Lancaster’s behalf, Lancaster remains a party.

If you are going to fire off a derivative action, you need to be prepared to defend against whatever might get shot back in the way of a counterclaim. 

[Update: The Court set aside this entry of default in an Order dated September 23, 2009, permitting the members of the LLC to adopt after the fact a response to the counterclaims filed by the Plaintiff when it did not have authority to act for the LLC in filing the lawsuit].

Law Firm Breakups: Whether It's A Withdrawal Or A Dissolution Can Make A Big Difference

Whether the departure of three partners from a law firm LLC was a withdrawal or a dissolution of the LLC was the issue in Mitchell, Brewer, Richardson, Adams, Burge & Boughman, PLLC v. Brewer, 2009 NCBC 10 (N.C. Super. Ct. March 26, 2009), decided today by the North Carolina Business Court.

The characterization of the nature of the Plaintiffs' departure determined whether they were entitled to proceeds from contingent fee cases generated after their departure.

If a dissolution had occurred, Plaintiffs' rights were governed by N.C. Gen. Stat. §§57C-6-04(b) and 57C-6-05(3), which said that the law firm would continue in existence and that its managers would be obligated to obtain "as promptly as reasonably possible. . . the fair market value for the [LLC's] assets" and to distribute the recovery to the members of the LLC.  That interpretation might have yielded a significant distribution from the in-process contingent fee cases.

But if the actions of the Plaintiffs constituted a "withdrawal," the Plaintiffs' rights would be governed by N.C. Gen. Stat. §57C-05-07, and their final distributions would be limited to the fair value of their interest in the firm as of the date of withdrawal.  The value of the contingent fee cases was potentially nothing under this analysis.

Plaintiffs Had No Right To Voluntarily Withdraw

The law firm had no written operating agreement,  and the articles of organization were silent on the subject of withdrawal.  Plaintiffs argued that dissolution was the only remedy;but  the Defendants argued that this interpretation made it impossible for a member to withdraw. 

The Court held in what it described as a case of first impression that the LLC Act does not allow a voluntary withdrawal by a member unless the articles of organization or a written operating agreement provide for a withdrawal.  It rejected Defendants' arguments to cobble together an operating agreement from various documents, though it did hold that "it may well be in a given case, multiple documents viewed collectively could constitute a written operating agreement as contemplated by the Act."

Plaintiffs Were Estopped From Disputing Their Withdrawal

The Court nevertheless ruled that Plaintiffs were estopped from disputing that they had withdrawn from the LLC.  Judge Jolly held that estoppel is "kaleidoscopic," that it could arise "by conduct, deed, or misrepresentation," and that estoppel "is viewed as 'flexible' in its application." 

The factors he considered in concluding that estoppel applied were (a) the Plaintiff's oral and written representations that they intended to withdraw, including one Plaintiff's statement "I am out of here," (b) the treatment by all parties of Plaintiffs' departure as a withdrawal, (c) the Plaintiffs' formation of their own firm, (d) Defendants' detrimental reliance on Plaintiffs' representations of withdrawal, and (e) Plaintiffs' silence "on the pivotal issue [of whether there had been a dissolution or a withdrawal] for approximately one year."

The Court rejected Plaintiffs' arguments that they could not have withdrawn because they "did not appreciate the distinction between withdrawal and dissolution" at the time they left the firm.  Judge Jolly said that "when they unilaterally chose to leave the Firm, and characterized their leaving as a 'withdrawal,' the Plaintiffs were charged with knowledge of the consequences of their actions; and Defendants were entitled to rely and act upon those actions."

Judge Jolly held that "[t]he fact that the unilateral decision by Plaintiffs to leave the Firm subsequently turned out potentially to be to their economic disadvantage is regrettable, but not relevant to whether they are deemed to have withdrawn."

Brief in Support of Motion for Summary Judgment

Brief in Opposition to Motion for Summary Judgment

Reply Brief in Support of Motion for Summary Judgment 

Some Meaty (But Not North Carolina) Court Decisions On Business Issues

This post is about three significant business decisions from courts in other jurisdictions.  They involve an issue of attorney-client privilege for limited liability companies, whether an LLC member can waive his statutory right to seek dissolution of an LLC, and board duties in a merger context.

First, if there's litigation between a member-manager of an LLC and the LLC, does the LLC have an attorney-client privilege to assert against its own member-manager? This issue hasn't arisen in any case before the North Carolina Business Court, but it undoubtedly will. 

A federal court in Nevada confronted that question recently and held in Montgomery v. eTreppid Technologies, LLC, 2008 WL 1826818 (D. Nev. 2008), that the LLC should be treated, for privilege purposes, like a corporation.  It determined that the privilege belonged to the entity alone, and that the plaintiff was not entitled to discovery of privileged information even though he was a member of the LLC and a former manager.  Thanks to Peter Mahler and his New York Business Divorce Blog, where I read about this case.

Second, can a member of an LLC waive his or her right to dissolution by an anti-dissolution provision in the Operating Agreement?  The answer is yes, at least under Delaware law, as held by the Delaware Court of Chancery last week in R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del.Ch., Aug. 19, 2008).  You can read the summary of the case, from the Delaware Corporate and Commercial Litigation Blog, here.  The Court rejected the argument that a member's agreement not to seek dissolution violated the public policy of Delaware, stressing instead the freedom of contract afforded those forming a limited liability company.

Third, also from Delaware, is a decision late last month about director duties in a merger context, Ryan v. Lyondell Chemical CoThe Court of Chancery held that a shareholder could proceed to trial against the directors of Lyondell on a claim for breach of fiduciary duty, even though the action challenged was the consummated sale of the company for a "blowout" market premium.  The Court found a "troubling board process," in the board's determination after only seven days to approve the sale of the company without any market check, without any post-agreement "go shop" period, and their approval of a merger agreement with strong deal protection measures and a substantial breakup fee. 

The Court said it was unable to find on the summary judgment record that that Board had satisfied its Revlon duties, or that the deal protection measures were reasonable and necessary to secure the offer per Unocal.  This case is also courtesy of the Delaware Corporate and Commercial Litigation Blog.

The picture of the Cook Out hamburger at the top of this post is by my daughter, Juliet, a sophmore at UNC-Chapel Hill.

I've been having trouble recently with the pictures and links on my blog, so if they are not working when you first read this please check back later.

No Unfair And Deceptive Practices Claim From Law Firm Dissolution, And More

There's an old Jackson Browne album called "Lawyers in Love."  Lately, there have been a lot of cases involving lawyers out of love, and dissolving their firms.  One was decided by the Business Court on June 2nd, Walters & Zimmerman, PLLC v. Zimmerman.

Plaintiff, a lawyer in the dissolved law firm who was a manager of the Professional Limited Liability Company, brought claims on behalf of the PLLC and in her own name for breach of fiduciary duty and conversion.  She also asserted trade secrets claims and a claim for unfair and deceptive practices.  Defendant, another lawyer in the dissolved firm, moved to dismiss on a variety of grounds.

The only claim on which Defendant was successful was a claim for unfair and deceptive practices.  Judge Tennille held that the claims between the lawyers involved an "internal dispute," and that such disputes did not "affect commerce" as required by the statute. 

The roadblock to the other grounds asserted for dismissal was one of standing, and whether the proper parties were before the Court.  The members of the PLLC were not the individual lawyers themselves, but professional corporations that each of the individual lawyers had formed.  The Court found issues about whether the proper parties were before it, and directed the parties to consider the Court of Appeals' recent decision in Crouse v. Mineo, 2008 N.C. App. LEXIS 546, 658 S.E.2d 33 (N.C. Ct. App. 2008).  That case dealt with another law firm dissolution. 

That Court of Appeals held in Crouse that a manager of an LLC does not have the authority to bring suit on behalf of the LLC because such an action is not within the powers of a manager, which are limited to things necessary to "carry[] on in the usual way the business of the limited liability company."  Bringing a lawsuit against the LLC, the Court of Appeals held, was not within the course of usual business.  The Crouse court concluded, however, that the Plaintiff there had the right to make a derivative claim on behalf of the LLC under the circumstances presented.  You can click here for a more complete summary of the Crouse case. 

Turning back to the Walters & Zimmerman case, the Business Court also summarized when the moving party on a Motion to Dismiss can rely on documents outside of the pleadings.  It is good to know where the Business Court stands on that issue.  It held:

Furthermore, the Court may not consider “extraneous matter” outside the complaint, or else the Rule 12(b)(6) motion will be converted into a Rule 56 motion for summary judgment. See, e.g., Fowler v. Williamson, 39 N.C. App. 715, 717, 251 S.E.2d 889, 891 (1979). However, the Court may consider documents the moving party attaches to a 12(b)(6) motion which are the subject of the challenged pleading and specifically referred to in that pleading, even though they are presented to the Court by the moving party. See Oberlin Capital, L.P. v. Slavin, 147 N.C. App. 52, 60, 554 S.E.2d 840, 847 (2001) (considering a contract on a 12(b)(6) motion even though the contract was presented by the movant). The Court is not required to accept as true “any conclusions of law or unwarranted deductions of fact.” Id. at 56, 554 S.E.2d at 844. Thus the Court can reject allegations that are contradicted by the supplementary documents presented to it. See E. Shore Mkts., Inc. v. J.D. Assocs. Ltd. P’ship, 213 F.3d 175, 180 (4th Cir. 2000) (stating that the court “need not accept as true unwarranted inferences, unreasonable conclusions, or arguments”).

Brief in Support of Motion to Dismiss

Brief in Opposition to Motion to Dismiss

Reply Brief in Support of Motion to Dismiss