Monday, January 11, 2010

Indiana Case law: LLC Fiduciary Duty to Former Member

The Indiana Court of Appeals decided that Indiana Liability companies have a continuing fiduciary duty to a former shareholder or member to accurately report the company's fiscal results to the IRS for a year in which the former member held stock or was still a member of the limited liability company. That is Mike A. Abdalla, et al. v. Raed I. and Hani I. Qadorh-Zadin. This is how the Court of Appeals got to that conclusion.

The Court of Appeals started with this legal basis:

Limited liability companies, such as the ones at issue here, were not available in Indiana until the enactment of Indiana‟s Business Flexibility Act in 1993. Ind. Code § 23-18-1-1 et seq. The popularity of LLCs has forced courts nationwide to address traditional business issues in terms of this statutory creation. In Indiana, there is little case law regarding LLCs and hardly any case law concerning fiduciary duties in the LLC context. In light of this limitation, we decided in Purcell v. Southern Hills Investments, LLC, 847 N.E.2d 991, 997 (Ind. Ct. App. 2006), that “common law fiduciary duties, similar to the ones imposed on partnerships and closely-held corporations, are applicable to Indiana LLCs.”

Shareholders in a closely-held corporation, such as Q Realty, owe each other fiduciary duties. G&N Aircraft, Inc. v. Boehm, 743 N.E.2d 227, 240 (Ind. 2001). In such a corporation, “[t]he fiduciary must deal fairly, honestly, and openly with his corporation and fellow stockholders. He must not be distracted from the performance of his official duties by personal interests.” Id.
Against which there was this law:
With regard to the assignment of membership in an LLC, Indiana Code section 23-18-6-4.1(e) provides that “[u]nless otherwise provided in a written operating agreement, a member who assigns the member‟s entire interest in the limited liability company ceases to be a member or to have the power to exercise any rights of a member when an assignee of the member‟s interest becomes a member with respect to the assigned interest.” Despite the option included in the statute to deviate from the provision on assignment of interest, the companies‟ operating agreements clearly state that a member who assigns all
of his interest in the LLCs “shall no longer have any rights or privileges of a Member . . ..” (Appellants‟ App. p. 82). As such, it would appear that the Zidans relinquished their fiduciary duties on August 4, 2006 and thus no longer have a course of action concerning the K-1 Schedules which were drawn up in the Fall of 2007.
The former members argued this:
On the other hand, the Zidans focus our attention on Thompson v. Central Ohio Cellular, Inc., f.k.a., Cellwave Inc., et al., 639 N.E.2d 462 (Ohio Ct. App. 1994). In Thompson, after the plaintiff sold his shares to Cellwave in late 1991, the corporation had tax returns prepared for the 1991 tax year. Id. at 464. On April 1, 1992, Cellwave provided Thompson with a K-1 Schedule that reflected an allocation to him of more than $6 million in long-term capital gains for 1991. Id. Although Thompson claimed that the K-1 Schedule improperly shifted a significant tax burden to him, Cellwave refused to provide a corrected K-1 Schedule. Id. Thompson filed a complaint, alleging breach of fiduciary duty and fraud. Id.
Analyzing the character of the „shareholder termination rule,‟ the Cellwave court emphasized that the rule is not absolute. Id. at 470. The court specified that “[t]ermination of the fiduciary relationship does not shield the fiduciary from its duties or obligations concerning transactions which have their inception before the termination of the relationship.” Id. Because the reporting to the IRS of Cellwave‟s financial results for the year 1991 was based on transactions which had their inception before the termination of the fiduciary relationship, the court concluded that Cellwave owed a fiduciary duty to Thompson. Id.
Notice that this differs in several ways from the Illinois case reported by Chicago Business Litigation Lawyer Blog in LLC Members Owe Company, Manager No Fiduciary Duty, Appeals Court Rules.