Tuesday, September 17, 2013
Okay, so maybe I am overstating that a bit, but it’s only a bit. This is not exactly timely, as the following case was decided in the December 2012, but I was recently reviewing it as I taught these cases and helped update Unincorporated Business Entities (Ribstein, Lipshaw, Miller, and Fershee, 5th ed., LexisNexis). (semi-shameless plug). Despite the passage of time, this case has, apparently, gotten me riled up again. So here we go . . .
Synectic Ventures I, LLC v. EVI Corp., 294 P.3d 478 (Or. 2012): several investment funds organized as LLCs (the Synectic LLCs or LLCs). The LLCs made a loan to the defendant corporation, EVI Corp. The loan agreement was secured by EVI’s assets, and provided that EVI would pay back $3 million in loans, plus 8% interest by December 31, 2004. The loan agreement provided that if EVI obtained $1 million in additional financing by December 31, 2004, the loan amount would be converted into equity (i.e., EVI shares) and the security interest would be eliminated. If the money were not raised by the deadline, the LLCs could foreclose on EVI’s assets (mostly IP in medical devices).
To make things interesting, the LLCs appointed Berkman the manager of the LLCs (thus, they were manager-managed LLCs). “At all relevant times, Berkman—the managing member of plaintiffs—was also the chairman of the board and treasurer of defendant [EVI].” In mid-2003, the Synectic LLCs' members sought to have Berkman removed, and Berkman signed an agreement not to enter into new obligations for the LLCs without getting member approval.
In September 2004, before he was replaced as manager of the LLCs, Berkman amended the loan agreement by extending the date for obtaining financing by one year, to December 31, 2005. He did so by signing a consent resolution for EVI, as a director, and as authorized the amendment for LLCs as manager. On December 29, 2005, EVI got a loan from another source for $1million, and the loan was converted into EVI shares to be held by the LLCs. “Because the conversion eliminated defendant's security interest in favor of plaintiffs, plaintiffs lost their opportunity to foreclose on defendant's property and were left as minority shareholders in defendant, holding less than five percent of the outstanding stock.”
In Synectic Ventures I, LLC v. EVI Corp., 251 P.3d 216 (Or. Ct. App. 2011), the lower court granted EVI summary judgment find that Berkman had extensive authority to control the LLCs under the operating agreement, but even if he breached duties to the LLCs, he had authority to act on the LLCs’ behalf because the operating agreement stated:
“Right to Rely on Managing Member. Any person or entity dealing with the Company may rely (without further inquiry) upon a certificate signed by the Managing Member as to any matter affecting the Company.”
The Supreme Court disagreed, finding a conflict of interest and finding that there was a genuine issue of material fact (making summary judgment improper). The court determined it was possible that the operating agreement did not grant authority for the LLC manager to proceed where there was a conflict of interest, and explained, “If the factfinder concludes that [the LLC manager’s] conflict of interest with plaintiffs deprived him of authority to approve the amendment to the loan agreement, then defendant knew about that conflict of interest, both in fact and as imputed by the knowledge of its agent. Because defendant would have known that [the LLC manager] had a conflict, defendant would have known that [the LLC manager, as a director of defendant,] lacked authority to enter into the amendment on behalf of plaintiffs.”
The Oregon Supreme Court got this wrong. Though I know there are those (in addition to the Oregon Supreme Court) who disagree with me, if you respect freedom of contract and LLCs as entities, the lower courts had this right. The contract permits the transaction and the outcome because the fiduciary duties have been expressly disclaimed and authority granted to Berkman. The Synectic LLCs' members made their bed, and they need to lie in it.
Note the following portions of the operating agreement:
“4.1 Management of Company.
“(a) The management and control of the Company and its business and affairs is vested exclusively in the Managing Member of the Company[.] . . . The Managing Member shall have the authority to undertake all actions on behalf of the Company without the consent of the other Members, except to the extent expressly provided in this Agreement. No Member other than the Managing Member shall have the authority to bind the Company. Without limitation of the foregoing, the Managing Member shall have the without obtaining the consent of the other Members, to (i) invest the funds of the Company in the securities of one or more issuers and to negotiate the terms of such investment . . . .”
3.2 Other Business of Members. Any Member . . . may engage independently or with others in other business and investment ventures of every nature and description and shall have no obligation to account to the Company for such business or investments or for business or investment opportunities. . . . The Members acknowledge that each Member may own securities issued by or participate in the management of companies in which the Company may invest and that neither the other Members nor the Company shall have any claim or cause of action against such Member arising from such ownership or participation.”
The Supreme Court argues that section 3.2 allows members to limit their fiduciary duties, but that this protection does not extend to a managing member. Instead, the court says the loan amendment is only acceptable if the amendment was “fair” to the plaintiffs, relying on Oregon RS 63.155:
(6) A member of a member-managed limited liability company may lend money to or transact other business with the limited liability company, provided that any loan or transaction between the member and the limited liability company must be:
(a) Fair to the limited liability company;
(b) Authorized by an operating agreement; or
(c) Authorized or ratified by a majority of the disinterested members or by a number or percentage of members specified in the operating agreement after full disclosure of all material facts.
Paragraph 9 of the same statute applies these requirements to managers (including member managers). Because the court (I think erroneously) determined the operating agreement did not permit the manager’s actions, the transaction thus need to be fair. The court doesn’t seem to think it is fair, either:
In this case, the amendment to the loan agreement that Berkman ultimately approved was at least arguably one-sided in favor of defendant: defendant avoided foreclosure and obtained a one-year extension of a 21–month loan, while plaintiffs received only an additional year's interest on the extension. As a result, there is a genuine issue of material fact whether the amendment was fair to plaintiffs.
Only a year’s interest? That is most certainly valid consideration for the extension and it is hardly uncommon to do such a thing. It’s not like he added a year extension and eliminated the foreclosure option. The foreclosure option went away when EVI fulfilled the obligation of adding additional funds to the company.
I can see why the court doesn’t love this arrangement, but I don’t see how they can say it was not exactly what was contemplated by the LLCs’ operating agreement. Berkman was a director of EVI when the whole thing started. There doesn’t seem to be any concern that the original loan transaction was beyond the scope of his authority. If it wasn’t, I don't see how the amendment is beyond his authority. If the LLCs’ members wanted to terminate him earlier and remove his authority, presumably they could have. They did not. Further, if there is common-law fraud or other bases for liability, of course the LLCs should pursue those. I just don't think they should be able to use the operating agreement as a defense.
Further, is the court saying essentially that this kind of arrangement is not permitted at all? Because Berkman did have fiduciary duties, presumably, to EVI, too. And as a corporation, it’s likely he could not have disclaimed them, at least not to the same degree (though the board could have approved his actions, I suppose). It would be a reasonable (though I think flawed) policy to say no such conflicts of interests can ever be allowed, but then it would mean Berkman could not have his roles with both EVI and the LLCs ever. And that’s not what is contemplated by the state LLC law as I read it, and plainly that's not what the LLCs’ members intended.
Maybe the court is saying it's a conflict of interest when LLC members get mad. That can’t be it, right?
As I have argued previously:
Courts should put forth cogent reasons for their decisions, rather than blindly applying corporate law principles in what are seemingly analogous situations between LLCs and corporations. . . . The members of an LLC chose the LLC as their entity, and they should enjoy both the benefits and burdens of that choice. Where courts refuse to acknowledge the distinct nature of LLCs, the promoters’ choice of entity is, at least in part, ignored. (footnotes omitted)
Here, the court has ignored the text of the operating agreement, the LLC act, and the unique nature of the LLC. And that’s why they got this one wrong.