Quarterly State Compliance Review

In Ohio, House Bill 48, which was signed by the governor Feb. 2 and which goes into effect May 4, amended provisions of the general corporation law governing dissenters' rights, dissolution, indemnification and the number of directors, and amended provisions of the LLC law governing operating agreements, member withdrawals, assignments of interests, charging orders and fiduciary duties. In South Dakota, House Bill 1056, which was signed by the governor on Feb. 13, permitted a board of directors to issue shares for promissory notes or contracts for services to be performed in the future, and provided that shareholders may not cumulate their votes for directors unless the articles of incorporation so states. This bill will go into effect upon voter approval of an amendment to the State Constitution permitting the legislature to make such changes to the corporation law.

Recently introduced bills of interest include California Assembly Bill 2050, which, if enacted, would prohibit domestic corporations from making contributions to candidates for state or local office, Florida House Bill 757, which would authorize benefit corporations, Illinois Senate Bill 3596/House Bill 3983, which would reduce the fees for forming and registering LLCs, and Pennsylvania Senate Bill 1399, which would limit the liability of successor business entities for asbestos related injuries.

IN THE STATE COURTS

DE Chancery Court Holds That LLC Managers Owe
Fiduciary Duties by Default

In Auriga Capital Corporation v. Gatz Properties, LLC, C.A. No. 4390 (Del. Ch.), decided Jan. 27, 2012, the Delaware Chancery Court held that managers of Delaware LLCs owe their investors fiduciary duties of loyalty and care in the absence of a provision in the LLC agreement waiving or modifying those duties. In so holding, the court noted that the LLC Act explicitly states that the rules of equity govern any case not otherwise provided for and that Delaware's courts have consistently held that default fiduciary duties apply to managers of alternative entities. The court also pointed out that the LLC Act was amended to provide that a member's or manager's fiduciary duties may be eliminated in the LLC agreement. The court asked why the General Assembly would eliminate something unless there was something to eliminate.

The LLC in this case owned a lease to property upon which it built and operated a golf course. Minority members sued the manager, who was also the majority member, alleging he breached his fiduciary and contractual duties after he bought out the plaintiffs for a price well below market value. The court found that the LLC agreement did not eliminate the manager's fiduciary duties. Therefore, he owed the plaintiffs duties of care and loyalty. The court also found that the manager breached his duties by refusing to explore strategic options when it became clear the LLC's sublease with a golf course operator would be terminated, by refusing to consider an offer to buy the LLC from a credible third party, by making a low ball offer to sell the LLC to the plaintiffs based on misleading information, and by conducting a sham auction for the LLC. The court also found that the manager acted in bad faith and awarded partial attorneys' fees to the plaintiffs.

DE Chancery Court Examines Right to Indemnification and Meaning of 'Successful on the Merits'

In Hermelin v. K-V Pharmaceutical Company, C.A. No. 6936 (Del. Ch.), decided Feb. 7, 2012, the plaintiff, the former CEO of a drug company, sought a declaration that he was entitled to indemnification in connection with three proceedings that followed criminal and regulatory investigations into the company's distribution of oversized morphine tablets into the market.

The plaintiff and the company were parties to an indemnification agreement that made mandatory what were permissive indemnification provisions under the General Corporation Law. Consequently, to be entitled to indemnification the plaintiff had to show he succeeded on the merits in the three proceedings ' in which case he would be entitled to indemnification as a matter of law ' or that he acted in good faith, in which case he would be entitled to indemnification under the agreement.

One of the proceedings arose out of a criminal investigation by the U.S. Attorney's Office which led to the plaintiff pleading guilty to two misdemeanors. The plaintiff argued that by choosing to plead guilty, he was able to avoid expense, delay, distraction, disruption, and uncertainty and was therefore “successful.” The court rejected that argument, noting that a guilty plea to every charge, payment of a substantial fine and jail time could not constitute a successful outcome. The court also found the plaintiff was not successful in a regulatory action which resulted in his being banned from health care programs for 20 years. The court rejected the plaintiff's argument that he was successful because he was not required to make a payment. Therefore, the plaintiff was not entitled to indemnification for either of those proceedings.

In the third proceeding, the Food and Drug Administration (FDA) sought to prohibit the plaintiff and others from manufacturing, holding or distributing drugs until the company brought its operations up to standard. These restrictions were not applied to the plaintiff. Therefore, the court held that the plaintiff was successful, and he was entitled to indemnification.

The court acknowledged that although the plaintiff was not entitled to mandatory indemnification in two of the proceedings, he could be entitled to indemnification under the indemnification agreement if he acted in good faith. However, the court found that it needed to consider additional evidence to determine if he acted in good faith. The court further clarified that the additional evidence would be limited to the plaintiff's conduct underlying the two proceedings for which he sought indemnification.

NJ Supreme Court: Acquired Company's Auditor Is
Not Liable to Non-Client Acquiror

In Cast Art Industries, LLC v. KPMG LLP, A-51/52-10 (N.J. Supreme Ct.), decided Feb. 16, 2012, the plaintiff acquired a company in a merger. The defendant was an accounting firm that audited the acquired company's financial statements. The defendant was already performing the audit when the merger discussions began. After the merger, the plaintiff went bankrupt and was liquidated. It then brought a suit alleging that the defendant was negligent in performing the audit and that if it had performed a proper audit it would have uncovered fraudulent accounting activity that was taking place and the plaintiff would not have proceeded with the merger and gone bankrupt. The trial court found the defendant liable to the plaintiff and the appellate court affirmed.

However, the New Jersey Supreme Court reversed. The court noted that the New Jersey Accountant Liability Act sets forth preconditions to imposing liability on an accountant to a non-client party. One of the preconditions is that the accountant knew at the time of the engagement by the client, or agreed with the client thereafter, that the accountant's services would be provided to that third party for a specific transaction. In this case the defendant began auditing the acquired company's financial statements before the merger discussions began. Therefore, according to the court, the defendant could not have known, when it agreed to perform the audit, that the plaintiff would decide to acquire the client and would be obtaining copies of the completed audits to provide them to its lender.

The plaintiff argued that the phrase “at the time of the engagement” should be construed to mean at any time during the period of the engagement, and not at the outset of the engagement. The court rejected the plaintiff's interpretation. The court relied on the language of the statute, legislative intent, statutes and case law from other states, and the nature of an engagement letter to conclude that the phrase “at the time of the engagement” meant at the outset of the engagement. Here, the plaintiff failed to establish that the defendant knew at the outset or thereafter agreed that the plaintiff could rely on its work in proceeding with the merger. Therefore, the plaintiff failed to satisfy the requisite elements of the Accountant Liability Act and the defendant was entitled to judgment.

Sandra Feldman, a member of this newsletter's Board of Editors, is a publications and research attorney for CT Corporation, part of Wolters Kluwer Corporate Legal Services (www.ctlegalsolutions.com).

This edition of the Quarterly State Compliance Review looks at some enacted and pending legislation of interest to corporate lawyers. It also analyzes some recent cases of interest, including two decisions from the Delaware Chancery Court.

IN THE STATE LEGISLATURES

There were several bills of interest that either went into effect or were signed into law during the period between Jan. 1 and April 1. In New York, Senate Bill 79, effective Feb. 10, authorized the formation of a benefit corporation. A benefit corporation is a for-profit corporation, formed under the Business Corporation Law, that has the purpose of creating a general public benefit and whose directors and officers, in taking actions, are required to consider non-financial interests such as the effect on employees, customers, and communities.

In Ohio, House Bill 48, which was signed by the governor Feb. 2 and which goes into effect May 4, amended provisions of the general corporation law governing dissenters' rights, dissolution, indemnification and the number of directors, and amended provisions of the LLC law governing operating agreements, member withdrawals, assignments of interests, charging orders and fiduciary duties. In South Dakota, House Bill 1056, which was signed by the governor on Feb. 13, permitted a board of directors to issue shares for promissory notes or contracts for services to be performed in the future, and provided that shareholders may not cumulate their votes for directors unless the articles of incorporation so states. This bill will go into effect upon voter approval of an amendment to the State Constitution permitting the legislature to make such changes to the corporation law.

Recently introduced bills of interest include California Assembly Bill 2050, which, if enacted, would prohibit domestic corporations from making contributions to candidates for state or local office, Florida House Bill 757, which would authorize benefit corporations, Illinois Senate Bill 3596/House Bill 3983, which would reduce the fees for forming and registering LLCs, and Pennsylvania Senate Bill 1399, which would limit the liability of successor business entities for asbestos related injuries.

IN THE STATE COURTS

DE Chancery Court Holds That LLC Managers Owe
Fiduciary Duties by Default

In Auriga Capital Corporation v. Gatz Properties, LLC, C.A. No. 4390 (Del. Ch.), decided Jan. 27, 2012, the Delaware Chancery Court held that managers of Delaware LLCs owe their investors fiduciary duties of loyalty and care in the absence of a provision in the LLC agreement waiving or modifying those duties. In so holding, the court noted that the LLC Act explicitly states that the rules of equity govern any case not otherwise provided for and that Delaware's courts have consistently held that default fiduciary duties apply to managers of alternative entities. The court also pointed out that the LLC Act was amended to provide that a member's or manager's fiduciary duties may be eliminated in the LLC agreement. The court asked why the General Assembly would eliminate something unless there was something to eliminate.

The LLC in this case owned a lease to property upon which it built and operated a golf course. Minority members sued the manager, who was also the majority member, alleging he breached his fiduciary and contractual duties after he bought out the plaintiffs for a price well below market value. The court found that the LLC agreement did not eliminate the manager's fiduciary duties. Therefore, he owed the plaintiffs duties of care and loyalty. The court also found that the manager breached his duties by refusing to explore strategic options when it became clear the LLC's sublease with a golf course operator would be terminated, by refusing to consider an offer to buy the LLC from a credible third party, by making a low ball offer to sell the LLC to the plaintiffs based on misleading information, and by conducting a sham auction for the LLC. The court also found that the manager acted in bad faith and awarded partial attorneys' fees to the plaintiffs.

DE Chancery Court Examines Right to Indemnification and Meaning of 'Successful on the Merits'

In Hermelin v. K-V Pharmaceutical Company, C.A. No. 6936 (Del. Ch.), decided Feb. 7, 2012, the plaintiff, the former CEO of a drug company, sought a declaration that he was entitled to indemnification in connection with three proceedings that followed criminal and regulatory investigations into the company's distribution of oversized morphine tablets into the market.

The plaintiff and the company were parties to an indemnification agreement that made mandatory what were permissive indemnification provisions under the General Corporation Law. Consequently, to be entitled to indemnification the plaintiff had to show he succeeded on the merits in the three proceedings ' in which case he would be entitled to indemnification as a matter of law ' or that he acted in good faith, in which case he would be entitled to indemnification under the agreement.

One of the proceedings arose out of a criminal investigation by the U.S. Attorney's Office which led to the plaintiff pleading guilty to two misdemeanors. The plaintiff argued that by choosing to plead guilty, he was able to avoid expense, delay, distraction, disruption, and uncertainty and was therefore “successful.” The court rejected that argument, noting that a guilty plea to every charge, payment of a substantial fine and jail time could not constitute a successful outcome. The court also found the plaintiff was not successful in a regulatory action which resulted in his being banned from health care programs for 20 years. The court rejected the plaintiff's argument that he was successful because he was not required to make a payment. Therefore, the plaintiff was not entitled to indemnification for either of those proceedings.

In the third proceeding, the Food and Drug Administration (FDA) sought to prohibit the plaintiff and others from manufacturing, holding or distributing drugs until the company brought its operations up to standard. These restrictions were not applied to the plaintiff. Therefore, the court held that the plaintiff was successful, and he was entitled to indemnification.

The court acknowledged that although the plaintiff was not entitled to mandatory indemnification in two of the proceedings, he could be entitled to indemnification under the indemnification agreement if he acted in good faith. However, the court found that it needed to consider additional evidence to determine if he acted in good faith. The court further clarified that the additional evidence would be limited to the plaintiff's conduct underlying the two proceedings for which he sought indemnification.

NJ Supreme Court: Acquired Company's Auditor Is
Not Liable to Non-Client Acquiror

In Cast Art Industries, LLC v. KPMG LLP, A-51/52-10 (N.J. Supreme Ct.), decided Feb. 16, 2012, the plaintiff acquired a company in a merger. The defendant was an accounting firm that audited the acquired company's financial statements. The defendant was already performing the audit when the merger discussions began. After the merger, the plaintiff went bankrupt and was liquidated. It then brought a suit alleging that the defendant was negligent in performing the audit and that if it had performed a proper audit it would have uncovered fraudulent accounting activity that was taking place and the plaintiff would not have proceeded with the merger and gone bankrupt. The trial court found the defendant liable to the plaintiff and the appellate court affirmed.

However, the New Jersey Supreme Court reversed. The court noted that the New Jersey Accountant Liability Act sets forth preconditions to imposing liability on an accountant to a non-client party. One of the preconditions is that the accountant knew at the time of the engagement by the client, or agreed with the client thereafter, that the accountant's services would be provided to that third party for a specific transaction. In this case the defendant began auditing the acquired company's financial statements before the merger discussions began. Therefore, according to the court, the defendant could not have known, when it agreed to perform the audit, that the plaintiff would decide to acquire the client and would be obtaining copies of the completed audits to provide them to its lender.

The plaintiff argued that the phrase “at the time of the engagement” should be construed to mean at any time during the period of the engagement, and not at the outset of the engagement. The court rejected the plaintiff's interpretation. The court relied on the language of the statute, legislative intent, statutes and case law from other states, and the nature of an engagement letter to conclude that the phrase “at the time of the engagement” meant at the outset of the engagement. Here, the plaintiff failed to establish that the defendant knew at the outset or thereafter agreed that the plaintiff could rely on its work in proceeding with the merger. Therefore, the plaintiff failed to satisfy the requisite elements of the Accountant Liability Act and the defendant was entitled to judgment.

Sandra Feldman, a member of this newsletter's Board of Editors, is a publications and research attorney for CT Corporation, part of Wolters Kluwer Corporate Legal Services (www.ctlegalsolutions.com).