Managers of a limited liability company owe to the company fiduciary duties of loyalty and care, must act in good faith, and refrain from reckless or unlawful conduct.
A member who seeks information about a manager-managed limited liability company must state the purpose for the request under the Uniform Limited Liability Act.
In a dispute involving a family farm, the trial court exercises equity to look through the details of disputed loan payments and find that they were to benefit of the limited liability company and its members.
Some cases make you wince when you think about the underlying relationship. This case in which a son sued his father over the repayment of a mortgage is one of them. It comes from the Iowa Court of Appeals and is interesting from my perspective because the underlying statute is the same as applies here in New Jersey and because it demonstrates the scope of equity to reframe disputed issues into a more manageable solution.
The dispute in Erwin v. Erwin (opinion here) addressed the dispute between Michael Irwin and his son, Richard, that grew out of the father’s attempt to pass the family farm without incurring tax liability. The father and Richard’s mother, who owned the farm individually, formed a limited liability company, Erwin Farms II, LLC, in 2012 and passed the land to the company. At the time of the transfer, the land was subject to a mortgage. Richard received a block of non-voting membership units. The remaining membership units, including all of the voting units, were owned by the parents.
The operating agreement of the company named Michael Erwin as manager. In addition to the existing mortgage, after the land was transferred to the LLC, the Erwin parents took two loans for improvements. By the time of the trial, those loans had all been paid.
Missing Corporate Formalities
Michael did an admittedly poor job in keeping the books. The debts of the farm business remained in his name and were paid by him individually. He initially commingled the LLC’s money with his personal money and another LLC, Erwin I Farms, LLC, that had been used to pass assets to one of Richard’s siblings. Initially, father and son made a number of oral agreements concerning the lease to Richard of the ErwinII’s land in return division of profits and expenses. After an accountant discovered tax issues related to the commingling of funds, Richard requested information about Erwin II’s operations, but received nothing.
Those agreements came to an end when the lawsuit was filed. Michael terminated the oral leases and also entered into conservation easements with the federal Farm Service Agency on land that Richard had been using. Richard’s claims against his father focused on the loan payments and refusal to provide documents. The case went to a bench trial in 2018. The judge found that the father had failed in a number of respects to perform his duties as manager, but that the company had not been damaged by the actions of the father Michael. Significantly, the trial court held, and the appeals court affirmed, that the father was not liable for paying operating debts accumulated in his individual name with company funds.
Breach of Duty Under the RULLCA
Iowa is one of the 20 states plus the District of Columbia — a group that includes New Jersey — that has enacted the model Revised Uniform Limited Liability Company Act (RULLCA). One of the RULLCA provisions at the center of this dispute was the father’s fiduciary duties as manager and whether they had been breached when he paid loans in his individual name with company funds. These statutory duties, the court noted, included the duty of loyalty, defined as:
“a. To account to the company and hold as trustee for it any property, profit, or benefit derived by the members …,” “b. to refrain from dealing the with company in the conduct or winding up of the company’s activities as or on behalf of a person having an interest adverse to the company,” and “c. To refrain from competing with the company in the conduct of the company’s activities before dissolution of the company.”
And also the duty of care, defined in Iowa’s LLC statute as:
in the conduct and winding up of the company’s activities [ ] to act with the care that a person in a like position would reasonably exercise under similar circumstances and in a manner the member reasonably believes to be in the best interests of the company. In discharging this duty, a member may rely in good faith upon opinions, reports, statements, or other information provided by another person that the member reasonably believes is a competent and reliable source for the information.
(Although Iowa’s statute requires reasonable care and good faith, the model act and New Jersey law only require a manager refrain from “grossly negligent or reckless conduct, willful or intentional misconduct, or knowing violation of law.”)
Good Faith and Fairness Defenses
Richard argued that his father’s debts were his own, and that Michael breached his fiduciary duties of loyalty and care by using company funds to pay personal debt. The court rejected this argument, noting first that the land was transferred with the mortgage and that the parties at the time intended to service that debt with the revenue generated by the farm. The court found no damages from the loan payments and that the father had demonstrated that he acted in good faith in a manner beneficial to the company — even he had been negligent and in a technical breach of his fiduciary duties in the process.
Each alleged statutory and contractual breach is based on the assumption that Mike G. harmed Erwin II. Yet, the record reveals that the reinvestment of Erwin II financial assets back into the company was a benefit to the company, and even directly to R.J. personally. In fact, the statutory defenses and applicable contractual provisions contain exceptions to the rules allowing a manager to take otherwise barred actions that benefit the company. Mike G. paid the mortgage on the Turner Farm to maintain ownership of the property and, eventually, leave it to R.J. with a minimal tax liability. The facts of this case establish that Mike G.’s conduct reinvesting Erwin II financial assets by paying the Turner Farm mortgage was done in good faith and for the benefit of Erwin II and R.J. In effect, R.J.’s complaint is that if Erwin II was paying the mortgage and other debt associated with the Turner Farm, he did not receive as much value from the Turner Farm as he thought he was gifted or should have been gifted. Given the undisputed facts of the history of the Turner Farm and the creation of Erwin II, we find no inequity in the Turner Farm income being used to pay the debts arising out of the Turner Farm purchase and operating loans.
Thus, even if the father had used the funds of the company to pay personal loans, the net result was that the property was now free of debt and the son, Richard, had failed to show any damages.
Failed Attempt to Secure Company Information
Richard also pursued a claim that his father had wrongfully withheld information about the business from him in not complying with his requests for financial documents. The court rejected the claim because the request was deficient under the relevant statutory provision. That provision, substantially identical in Iowa and New Jersey to the model RULLCA, provides that:
b. During regular business hours and at a reasonable location specified by the company, a member may obtain from the company and inspect and copy full information regarding the activities, financial condition, and other circumstances of the company as is just and reasonable if all of the following apply:
(1) The member seeks the information for a purpose material to the member’s interest as a member.(2) The member makes a demand in a record received by the company, describing with reasonable particularity the information sought and the purpose for seeking the information.(3) The information sought is directly connected to the member’s purpose.
c. Within ten days after receiving a demand pursuant to paragraph “b”, subparagraph (2), the company shall in a record inform the member that made the demand all of the following:
(1) Of the information that the company will provide in response to the demand and when and where the company will provide the information.(2) If the company declines to provide any demanded information, the company’s reasons for declining.
Equity in Business Divorce Disputes
These decisions are a good illustration of the manner in which “equity” — a body of law based on fairness — looks beyond the technicalities of a matter to find a remedy or, in some cases, to deny a remedy. Equity applies when the remedies thought are non-monetary, for example, expulsion of a member as opposed to a claim for money damages for the member’s conduct. The court’s analysis emphasizes the practicality and fairness of the loan repayments at issue. A strict and narrow reading the statute likely would have compelled a different result.
Please feel free to contact me if you have any questions or a similar problem that you would like to discuss.