XVI. Resolving Disputes Among the Llc Members

• Library: South Carolina Limited Liability Companies (SCBar) (2020 Ed.)

XVI. Resolving Disputes Among the LLC Members

What if a member believes that another member (or manager) has been engaged in fraudulent conduct which has injured him as a member or has injured the LLC? What if a member believes that another member has been disloyal or has breached a duty of care owed to the LLC? How does the member get redress? Can he bring an action directly against the other member? If so, what is the form of the action? Can such a problem only be redressed by the LLC itself? If so, can or must the member bring a derivative suit?

A. Direct Suits by Members - Are They Permitted?

Assume that a member has, in violation of her duty of loyalty, taken a business opportunity which belongs to the LLC. If the profits which this opportunity generated were put back into the LLC, these profits should be reallocated among the members in whatever ratio they share profits. In essence, improper conduct by one member will in most instances have a direct impact on each of the other LLC members. Each member's capital account will be reduced by the wrongful diversion. Therefore, in most instances the LLC member should have the right to directly sue the wrongdoer, and should not be relegated to bringing a derivative claim.

Although there are sound arguments why a member should be permitted to directly sue a co-member (or manager) when the defendant has breached duties owed to the other members, the evolving case law, contrary to what the leading commentators argue, suggests otherwise. There is a substantially growing body of law which concludes that when one member or manager breaches a fiduciary duty, this breach only directly injures the LLC as an entity, and thus only "derivatively" injures the other members.³⁶ The members, not being directly injured may therefore only bring their claim as a derivative suit. From a plaintiff's perspective this is a severe disadvantage. Forcing an LLC member to bring a derivative suit probably almost always favors the defendants.

However, often disputes among the LLC members will simply proceed as a direct suit. Jordan v. Holt, 302 S.C. 201, 608 S.E.2d 129 (2005), is an example of this. Four individuals formed a racing-theme restaurant as an LLC with no operating agreement. The restaurant closed in two years, and two of the members (basically the investors) brought an action seeking dissolution, an accounting, and included causes of action for breach of fiduciary duty, civil conspiracy, breach of contract, misappropriation of assets, breach of duties of good faith and fair dealing, fraud, negligent misrepresentation, and gross negligence. The circuit court dissolved the LLC (awarding petitioners the difference between the amount of their initial contributions and the amount each would receive at dissolution), but also awarded punitive damages against two of the members, which was affirmed by the South Carolina Supreme Court.

An excellent resource, for both defense and plaintiff's counsel regarding the problem of whether a claim must be brought derivatively, and the issues associated with this choice is found in Larry E. Ribstein & Robert R. Keatinge,1 Rtbstein & Keatinge on Limited Liability Companies, Vol. 1, Chapters 9 & 10 (2019).

B. If Defendant Asserts a Derivative Suit Is Required, What Test Will Be Applied?

If a defendant asserts that the plaintiff's claim must be brought derivatively, what "test" will be used by the court to determine if the particular claim can be brought directly or must be brought derivatively? The LLC jurisprudence, generally without giving much thought to doing so, has generally simply adopted corporate principles to determine if the claim should be derivative and not direct. One Florida opinion describes three tests that have been used, the Direct Harm, Special Injury, and Duty Owed — then seems to combine all three into the "Florida" test.³⁷ Many jurisdictions probably follow the Delaware test: first, who suffered the alleged harm, the LLC or its member, and second who would receive the benefit of any recovery or other remedy, the LLC or its members, individually. In answering these questions, the court looks to the nature of the wrong alleged, not merely at the form of words used in the complaint. Further, in Delaware, the member is no longer required to show that the individual plaintiff's injury is different from those suffered by other members.³⁸

South Carolina seems to follow the Delaware approach, but with one major difference, the plaintiff LLC member or manager must still show that her injuries are different from those suffered by other members.

"An action seeking to remedy a loss to the corporation is generally a derivative one." Brown v. Stewart, 348 S.C. 33, 49, 557 S.E.2d 676, 684 (Ct. App. 2001) (citation omitted). An action regarding the fiduciary obligation of a director is ordinarily enforceable through a derivative action. Id. (citation omitted). "A shareholder may maintain an individual action only if his loss is separate and distinct from that of the corporation." Id. (citation omitted).
"If misconduct by the management of a corporation has caused a particular loss to an individual stockholder, the liability for the mismanagement is an asset of the individual stockholder." Id. (quoting Ward v. Griffin, 295 S.C. 219, 221, 367 S.E.2d 703, 703-04 (Ct. App. 1988)). "Of course, a suit based on the misconduct can be brought by the individual stockholder." Id. at 49, 557 S.E.2d at 684-85 (quoting Ward, 295 S.C. at 221, 367 S.E.2d at 703-04). "It becomes material, therefore, to inquire whether the acts of mismanagement charged to the directors affected the plaintiffs directly, or as their interests were submerged in the corporation whose assets were thus dissipated." Id. at 49, 557 S.E.2d at 685 (quoting Stewart v. Ficken, 151 S.C. 424, 427, 149 S.E. 164, 165 (1929)).
"Specifically, to distinguish a derivative claim from a direct one, the court considers: (1) who suffered the alleged harm, the corporation or the suing stockholders, individually, and (2) who would receive the benefit of any recovery or other remedy, the corporation or the stockholders individually." 19 Am. Jur. 2d Corporations § 1923 (2015). Direct and derivative claims may be brought simultaneously. 19 Am. Jur. 2d Corporations § 1922 (2015). "When determining whether a claim is derivative or direct, some injuries affect both the corporation and the stockholders; if this dual aspect is present, a plaintiff can choose to sue individually." Id. (citing Carsanaro v. Bloodhound Techs., Inc., 65 A.3d 618 (Del. Ch. 2013) ); see also Horizon House-Microwave, Inc. v. Bazzy, 21 Mass. App. Ct. 190, 486 N.E.2d 70, 74 (1985) (observing a shareholder may pursue both direct and derivative claims in a single action).³⁹

C. Using § 7.01 of the A.L.I. Principles of Corporate Governance to Avoid the Derivative Suit

Besides basing the requirement that the injured member must sue derivatively on the conclusion that fiduciary breach directly injures the LLC and only "secondarily" injures the other members, there are other arguments that may more reasonably justify this requirement - to only sue derivatively. If one member loots the LLC (a clear breach of fiduciary duty), this will not only injure the innocent members, but any creditors of the LLC. A direct suit by one member would not protect the creditor interests. Second, the looting will not only injure the one member who sues, it will injure all the innocent members, who would not be protected by a direct suit by only one of their own. Lastly, if one member brings a first suit, and then a second or third member then brings their own suits, the "looter" (assuming she has defenses) will face multiple suits. These three reasons reasonably suggest that there are good reasons not to allow one of many members to bring his or her own suit, to the exclusion of the others and injured creditors. The others are better protected (and the defendant will not be faced with multiple suits) if the plaintiff brings her claim as a derivative suit.

However, in dealing with a closely held business, these objections to a member bringing a direct suit can be dealt with through a less drastic procedure. If the member joins all the other "innocent" members in her direct claim against the looter, and if the innocent member can assert that there are no creditors in need of protection (either because there simply are none or that their interests are otherwise protected), then there should be no reason to object to the member's direct suit. This "principle" has been adopted by the American Law Institute, A.L.I. Principles of Corporate Governance § 7.01(d), has been clearly adopted in Georgia in cases involving close corporations (which raise the same considerations), and has been at least acknowledged in South Carolina as a possible reason why a plaintiff may not be required to bring a derivative suit, but can bring a direct suit naming all her co-owners as plaintiffs. See Babb v. Rothrock, 401 S.E.2d 418 (S.C. 1991), and Brown v. Stewart, 557 S.E.2d 676 (S.C. Ct. App. 2002). From a plaintiff's perspective, this is a much more satisfactory method to try and resolve a dispute with another member than is provided by the derivative suit.

However, it may not always be easy to assert a "7.01(d) claim, even if there are only two members of the LLC." Such was demonstrated in the Federal District opinion, Georgia Bank & Trust Co. Of Augusta.⁴⁰ In that opinion Judge Anderson noted that there was a creditor of the LLC, the IRS which was owed $268,140 by the LLC, that the LLC did not have the funds to pay this debt, and therefore the IRS's presence as a creditor and the LLC's lack of funds precluded the availability of bringing the action as a direct § 7.01(d) claim.⁴¹

D. Accounting Actions

Section 33-44-410 specifically authorizes members to sue the LLC and other members. It does not authorize suits by members against managers. (Is this an oversight or an intentional...