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March 19, 2010

Local Judge Opines that an LLC is an Express Trust for Non-Dischargeability Purposes

This is a tentative ruling I copied off the calendar of one of our local judges.  It's a pretty schocking ruling to my way of thinking but she really supports it with lots of 9th Circuit and California law.  I'm going to have to update my Summary of Bankruptcy Law book.  I was going to edit the tentative but it really all needs to be there to understand it. 

The tentative:

The complaint filed by Nature's Wing Fin Design, LLC (NWFD) against debtor under 11 U.S.C. sections 523(a)(2) and (a)(4) alleges nondischargeability of a state court judgment entered on 8/19/05 in the amount of $849,754 (later reduced to $778,000) for breach of fiduciary duty in debtor's fulfillment of his role as a majority shareholder and manager of NWFD. The underlying complaint was filed derivatively by the minority shareholders and the judgment was entered after a three-week trial, and is now final as all avenues on appeal have been exhausted.

Specifically, the judgment was granted on the causes of action for breach of fiduciary duty, constructive trust, permanent injunction, and accounting.  Detailed findings are contained in the statement of decision filed on 8/18/05 ("SOD") and include the following:  debtor made improper distributions to himself before paying back investor funds, allowed an unauthorized investment in NWFD, commingled funds, interfered with a forensic audit, and improperly removed directors.  In addition, the state court found that debtor "was not acting in good faith" (SOD, p.20-21).  However, no punitive damages were awarded due to lack of proof of "sufficient reprehensibility or fraud" (SOD, p.22).

Collateral estoppel applies to findings made by the state court for purposes of section 523(a)(4) which show that debtor's acts constituted defalcation while serving in a fiduciary capacity and embezzlement, and the full faith and credit clause bars this court from reviewing the judgment. Debtor's opposition fails to include a statement of genuine issues of material fact.

For purposes of defalcation while acting in a fiduciary capacity, debtor was a fiduciary because in California LLC managers owe the same fiduciary duties as those owed by a partner to a partnership and its partners. In re Lewis, 97 F.3d 1182, 1185-86 (9th Cir. 1996). Defalcation occurs when, as here, debtor cannot account for the res, commingles funds and uses the company's money for personal benefit. Id. at 1186-87.  Section 523(a)(4) requires that (1) the res was rightfully in the possession of the nonowner, (2) the nonowner appropriated the property for a use for which it was not entrusted and (3) circumstances indicate fraud. In re Littleton, 942 F.2d 551, 555 (9th Cir. 1991). These elements are met in this case and, although the findings do not include fraud, the state court found bad faith and fraudulent conduct which amounts to circumstances indicating fraud.

Debtor's opposition:
Summary judgment cannot be granted because there are genuine issues of material fact as to both elements of section 523(a)(4).  First, whether an express preexisting trust was created as required by California law.  Second, the three amounts at issue which constitute the judgment ($520,670.16 for a company loan for defense costs, $105,245 for mandatory distributions and $94,500 for a share transfer transaction) are dischargeable because they were proper, authorized and accounted for, and thus no defalcation occurred.  Moreover, triable issues of material fact exist as to the Sommers transaction because the trial court did not consider all of the evidence.

Applicable Law:
In re Bigelow, 271 B.R. 178, 186-87 (9th Cir. BAP 2001), thoroughly discusses the elements that must be met to establish nondischargeability under section 523(a)(4).  A debt is nondischargeable under § 523(a)(4) where “‘1) an express trust existed, 2) the debt was caused by fraud or defalcation, and 3) the debtor acted as a fiduciary to the creditor at the time the debt was created.’” In re Niles, 106 F.3d 1456, 1459 (9th Cir.1997) (citations omitted). “Defalcation is defined as the ‘misappropriation of trust funds or money held in any fiduciary capacity; [the] failure to properly account for such funds.’... Under section 523(a)(4), defalcation ‘includes the innocent default of a fiduciary who fails to account fully for money received.’ ” In re Lewis, 97 F.3d 1182, 1186 (9th Cir.1996) (citations omitted).

1. Existence of fiduciary relationship
State law is relevant to the inquiry whether a fiduciary relationship exists. In re Pedrazzini, 644 F.2d 756, 758 (9th Cir.1981). Cal. Code of Corp. section 17153 provides that "[t]he fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners of the partner." The word "manager" is defined in Cal. Code of Corp. 17001(w) as somebody identified as such in the articles of organization. Under California law, partners are trustees of the partnership's assets. Ragsdale v. Haller, 780 F.2d 794, 796-97 (9th Cir.1986).

Taking into consideration the California law background as stated above, federal law ultimately determines whether there is a fiduciary relationship within the meaning of § 523(a)(4). In re Hemmeter, 242 F.3d 1186, 1189 (9th Cir.2001). The parties have not presented and the court has been unable to locate a case directly on point. However, the Ninth Circuit has held that "California partners are fiduciaries within the meaning of [section] 523(a)(4)." Haller, 780 F.2d at 796-97. Thus, reading section 17153 in conjunction with Haller compels the conclusion that an LLC manager is a fiduciary for purposes of section 523(a)(4).

On the other hand, an officer of a corporation is not a fiduciary for purposes of section 523(a)(4) because s/he is more akin to an agent. In re Cantrell, 329 F.3d 1119, 1127-28 (9th Cir. 2003). In addition, at least one bankruptcy court has rejected the proposition that a controlling majority shareholder is automatically a fiduciary of the corporate res and subject to liability by the minority under section 524(a)(4). In re Bangerter, 106 B.R. 649, 654 (Bankr. C.D. Cal. 1989).

2. Defalcation
"Defalcation is defined as the 'misappropriation of trust funds or money held in any fiduciary capacity; [the] failure to property account for such funds.'" Lewis, 97 F.3d at 1186, quoting Black's Law Dictionary 417 (6th ed. 1990). This includes innocent, intentional or negligent defaults. Id. (omit cit.). "An individual may be liable for defalcation without having the intent to defraud." Id. at 1187. It is no longer the law that there must be some showing of bad faith or reprehensible conduct. Id. at 1186-87 (overruling In re Martin, 161 B.R. 672 (9th Cir. BAP 1993)). Lewis concerned a dispute between partners where one partner contributed funds, while two others contributed time and labor. The unrefuted evidence showed that the partners running the enterprise failed to provide a complete accounting and commingled funds, and this was enough to grant summary judgment against them. Although the question of defalcation in Lewis was decided under Arizona law, the court noted that Arizona and California law are identical on this point.

The complaint requests relief under sections 523(a)(2) and (a)(4); the motion is made pursuant to (a)(4) only. To the extent that Mr. McCarthy is trying to get this court to relitigate what has already been decided in state court, now that all avenues on appeal have been exhausted, this is impermissible under the Rooker-Feldman doctrine. Thus, this court will not examine evidence that has been or should have been presented in state court. Instead, this court will focus its inquiry on the issue of collateral estoppel and needs to decide the following:
(1) whether the issues are identical as those decided in the former proceeding; (2) whether the issues have been actually litigated; (3) whether the issues have been necessarily decided; (4) whether the decision is final and on the merits; and (5) whether the parties are the same or in privity. In re Harmon, 250 F.3d 1340, 1245 (9th Cir. 2001).

The state court judgment is based on debtor's breaches of fiduciary duty, as is the complaint for nondischargeability; thus, the issues are identical. It is clear that the issues have been actually litigated since the state court conducted a three-week bench trial which resulted in extensive findings of fact and conclusions of law. The judgment is final and the parties are the same. Thus, the only question for this court to decide is whether the elements required under section 523(a)(4) have been necessarily decided, or whether this court must make additional findings for the debt to be deemed nondischargeable.

1. Fiduciary relationship
It is undisputed that the operating agreement discussed and quoted on pp.3-8 of the SOD is the document controlling the relationship between the parties. Under that agreement, debtor was in charge of "generally operating the business" and had "fairly broad managerial powers" (SOD p.3, para.9). The state court also found that at the time the improper acts took place, debtor was the sole manager and 59% owner of NWFD and that under Cal. Code of Corp. section 17153, "LLC managers owe the same fiduciary duties of care and loyalty as are owed by a partner to a partnership and its partners" (SOD p.2, para.2 & p.19, para.2), concluding that debtor was a fiduciary under California law (SOD p.20-21).

California law outlines the fiduciary duties of a partner which constitute an "express" or "technical" trust relationship, and this court is instructed to follow that determination. See Ragsdale, 780 F.2d at 797 ("[i]f state law makes clear that a partner necessarily is a trustee over partnership assets for all purposes, then that partner is a fiduciary within the narrow meaning of 523(a)(4)"). See also In re Stanifer, 236 B.R. 709, 715 (9th Cir. BAP 1999); Collier on Bankruptcy, para. 523.10[1][d], at 523-74 (16th ed. 2009). Trust relationships created by statute fall into this category. Pedrazzini, 644 F.2d at 758 n.2.

As outlined by the state court in its SOD, p.19-20, LLC managers have specific duties under Cal. Corp. Code section 16404 which clearly impose trust-like obligations on the debtor. The debtor was required to perform those obligations under the operating agreement (SOD, p.3-4; 20-21). In essence, the debtor was like the sole manager of a joint venture as described in In re Short, 818 F.2d 693 (9th Cir. 1987)(debtor in charge of joint venture affairs who had duty to act as trustee under agreement and statute held to be fiduciary for purposes of section 523(a)(4)). Therefore, this court finds that the required express trust relationship existed in this case and that debtor was a fiduciary for purposes of section 523(a)(4) at the time the improper acts took place.

2. Defalcation:
The findings made by the state court show that debtor made improper distributions in violation of the operating agreement (SOD 20), improperly obligated the company (SOD 35), lied to the board about the cause for overpayments (SOD 37), used and lied about using company funds for personal expenses (SOD 37-38), commingled funds (SOD 39), interfered with an audit (SOD 41), and acted fraudulently and in bad faith to remove board members (SOD 58). Akin and beyond the facts of Lewis, the underlying judgment contains sufficient findings of improper activity to satisfy the element of defalcation under section 523(a)(4).

3. Debtor's case law:
Mr. McCarthy relies on the Ninth Circuit case of Cantrell. Although Cantrell contains applicable statements of law, its facts are inapposite in that it dealt with a default judgment against a corporate officer, not a judgment on the merits against a controlling shareholder and manager of an LLC. As such, Cantrell's holding is limited to its specific factual scenario and does not apply in this case. Further, Mr. McCarthy relies on the case of In re Niles, 106 F.3d 1456 (9th Cir. 1997). Niles is inapplicable because the holding in relevant part deals with who bears the burden of proof in a section 523(a)(4) proceeding; plaintiff was not asserting collateral estoppel based on findings already made in conjunction with a final state court judgment after trial, but instead was proceeding with trial in the bankruptcy court. Here, the state court has already conducted a trial and made detailed findings, and the bankruptcy court does not have to retry the case if it finds those findings sufficient for purposes of section 523(a)(4).  However, the case is instructive to the extent that the relationship between the parties under state law (defendant was plaintiff's real estate broker and property manager) is expressly controlled by statute and thus was determined to be an express trust.

In addition, Mr. McCarthy relies on In re Abrams, 229 B.R. 784 (9th Cir. BAP 1999), aff'd, 242 F.3d 380 (9th Cir. 2000). Again, this case is distinguishable because it does not deal with the effect of a state court judgment, but instead focuses on the sufficiency of evidence presented during trial in the bankruptcy court in a nondischargeability proceeding under sections 523(a)(2) and whether the bankruptcy court properly decided that second-tier general partners are held to the same fiduciary obligations as first-tier general partners under California common law, and therefore are fiduciaries for purposes of section 523(a)(4). Mr. McCarthy points out that the court in Abrams examined the level of control exercised by the general partners to make its findings on the issue of whether they were fiduciaries; however, this court will not do so when sufficient findings have already been made by the state court judge who in this case relied on statute and not California common law (per Abrams, the court could have relied on either, depending on the existence of a statute on point).

Finally, the California Supreme Court case of Bainbridge v. Stoner, 16 Cal.2d 423 (Cal. 1940)(holding that a corporate director is an agent rather than a fiduciary) does not speak to the situation here which deals with Mr. McCarthy as manager of the LLC who not only had broad managerial powers but also used those powers to his personal benefit, as reflected in the state court's findings. Similarly, the California cases cited in Bainbridge refer to corporate shareholders and members of a limited liability company, but not a LLC manager empowered with broad managerial powers by an operating agreement. Bainbridge also discusses the two required elements for an express trust to exist under California law: (1) an explicit declaration of trust and (2) transfer of res to the trustee. Mr. McCarthy argues that no such transfer ever took place and therefore no express trust was created. Even if the court were to go this way and revisit these facts (which it is not), it must be noted that Bainbridge is a 1940 case which does not implicate a California statue clearly stating that a LLC manager owes the same fiduciary duties as a partner (Cal. Corp. Code section 17153) and another statute listing those duties (Cal. Corp. Code section 16404). The Ninth Circuit has since held that, in conjunction with these California statutes, partners are fiduciaries for purposes of section 523(a)(4). Ragsdale, 780 at 796-97.

Finally, Mr. McCarthy argues that certain admissions were made by NWFD in its third amended complaint which were not considered by the state court judge and which show that certain meetings and the votes taken during those meetings were invalid because Mr. McCarthy was not in attendance. Again, this is something that would have to be considered by the state court on a motion for a new trial or reconsideration. The whole section claiming that no defalcation or embezzlement occurred (p.37-59 of the opposition) discusses alleged error by the state court; again, this is not the proper forum to appeal these issues.

Since all of the elements of collateral estoppel have been met and it is fair to apply the doctrine in this case to prevent further unnecessary litigation that would not produce a different result in light of the fact that the state court's findings are sufficient to satisfy section 523(a)(4), summary judgment is proper and should be granted.

March 19, 2010 in 9th Circuit Briefs | Permalink


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Colorado used to impose quasi-fiduciary duties on officers and directors of insolvent entities under case law, but this duty was expressly removed through legislative action. This is certainly a notable addition to veil piercing law.

Posted by: ohwilleke | Mar 24, 2010 7:29:59 PM

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