The Supreme Court of Connecticut recently decided two matters of first impression regarding direct and derivative standing for members of an LLC. Saunders v. Briner, 334 Conn. 135 (2019). First, it held that Connecticut’s prior limited liability company act (“CLLCA”), barred members and managers of LLCs from bringing derivative actions absent a provision in the operating agreement allowing such claims. Id. at 181. Second, the court held that in limited circumstances, the sole member of an LLC may pursue derivative claims as direct actions. Id.
In Saunders, the defendant, Clark Briner, formed an LLC, Revere Investments LLC, with another member. After launching Revere, the members asked plaintiff -- Roger Saunders -- to help them find investors and secure temporary financing. Id. at 140-41. Saunders was not initially a member of Revere (he later acquired an interest), but for his assistance, he received preferential fees and profits generated from investors Saunders sourced.
As the business grew, Briner began performing a disproportionate amount of Revere’s work. Briner sought a change in Revere’s business model, which resulted in the creation of Revere High Yield Debt Fund, L.P. (“Fund”), an investment fund, and Revere High Yield, GP, LLC (the “Fund GP”). The Fund GP was an LLC that was co-owned and managed by Briner and Saunders. As Briner began bringing more investors to the Fund, he asked to receive the same preferential payments that Saunders had been receiving for investors he brought in. Id. at 144. Briner’s request was denied. Undeterred, Briner set up a new entity through which he made loans to Revere while also earning profits similar to Saunders’s – negatively affecting the profits of Revere and/or the Fund. Id. at 145-46.
Saunders sued Briner and his related entities for fraud, breach of contract, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty and other claims. Id. at 146-47. His complaint included 14 direct counts by Saunders individually and 13 counts brought derivatively on behalf of Revere, the Fund GP or both. Saunders was awarded in excess of $530,000 in compensatory damages and nearly $640,000 in attorney’s fees based on one of the derivative claims. Id.
On appeal, Briner argued, for the first time, that Saunders lacked standing to bring both the derivative and the direct actions. Id. at 149. The Connecticut Supreme Court first considered derivative standing under the CLLCA. The CLLCA was modeled on the Prototype Limited Liability Company Act (the “Prototype Act”). Id. at 158. The drafters of the Prototype Act emphasized that it “does not permit derivative suits unless they are provided for in the operating agreement.” Id. at 159-60 (internal citations omitted). The Saunders court found the CLLCA to be functionally identical to the Prototype Act and held that the Connecticut legislature chose to omit the derivative action under the CLLCA. Thus, absent a provision in the LLC’s operating agreement, Plaintiff could not bring claims derivatively under the CLLCA. Id. at 161-62.
To further support its conclusion, the court compared the CLLCA to the act that replaced it in July 2017, the Connecticut Uniform LLC Act (“New LLC Act”). Unlike its predecessor, the New LLC Act does permit derivative actions. Id. at 162. The legislature knew how to allow for derivative claims, and did so through the adoption of the New LLC Act; however, the new act came too late for Saunders, who filed suit in 2012.
Saunders argued that even if barred by the CLLCA, his derivative claim should be allowed pursuant to common law. But the court rejected this argument too. LLCs were not recognized at common law, but are instead entities created by statute. Id. at 164. The common-law remedy Saunders argued for would “frustrate the purpose” of the CLLCA, which the court would not do. Id. Concluding that Saunders could not bring his claims derivatively, the court next considered whether Saunders could bring direct actions against Briner.
Saunders’s LLC -- whose sole member was Saunders -- entered into the transactions at issue with Briner. But, it was Saunders, in his individual capacity, who brought the action. Based on this, Briner argued that Saunders lacked standing because the claims belonged to Saunders’s LLC. Id. at 165. Thus, the question before the court was “whether to exempt single-member limited liability companies from the direct and separate injury requirements necessary to bring a direct action.” Id. at 167.
The leading case applying a single-member exception is Watson v. Button, 235 F.2d 235, 237 (9th Cir. 1956). There, the Ninth Circuit determined that courts may relax the requirement that direct actions be brought in the name of a company when the action would not prejudice the corporation, its shareholders or creditors and would not result in a multiplicity of actions. Saunders, 334 Conn. at 173. Building on Watson, the American Law Institute (“ALI”) promulgated a rule under which shareholders may bring derivative claims as direct actions when doing so would not impinge upon the policy justifications underlying the separate injury requirement. Under the ALI’s rule, a direct action is permitted when it will not: “(i) unfairly expose the corporation or defendants to a multiplicity of actions; (ii) materially prejudice the interests of creditors of the corporation; or (iii) interfere with a fair distribution of the recovery among all interested persons.” Id. at 171.
Persuaded by Watson and the ALI rule, the Saunders court held that a trial court may allow a single-member LLC to pursue direct actions when doing so would not implicate the foregoing policy issues undergirding the direct injury principle. Id. at 176. To deny Saunders standing for a harm suffered by his entity would exalt form over substance. Id. at 177. In this case, the court determined that Saunders’s case may proceed because it did not impinge on the policy justifications for direct actions.
Although the Saunders decision was largely unanimous, three of the court’s seven justices dissented from the majority’s decision to adopt the single-member exception to direct standing. In the dissent’s view, this court-created exception to direct standing invaded upon the legislature’s role. Affecting the rights and remedies of an LLC is a uniquely legislative function. Because the legislature is active in this area -- indeed, it had recently passed the New LLC Act -- it was, in the dissent’s view “best to stay our hand rather than make a public policy judgment expanding standing in civil cases involving LLCs.” Id. at 198.
In explaining its position, the dissent noted that the exception to close corporation standing adopted by the majority usually arises in “purely intracorporate disputes.” Id. at 192. In this case, the dispute was not within one LLC, but rather was a single-member LLC suing another LLC. In the dissent’s view, this case was “nothing more than a simple ‘wrong plaintiff’ case” and did not require the adoption of the single-member standing exception. Indeed, the dissent noted that Saunders never advocated for the approach adopted by the majority. Id. at 193.
Further, the dissent deemed cases rejecting the single-member exception more persuasive than the Watson/ALI model. Id. at 193. The leading case rejecting this exception is Bagdon v. Bridgestone/Firestone, Inc., 916 F.2d 379 (7th Cir. 1990). There, the Seventh Circuit found that the single-member exception renders the application of commercial rules less predictable. Saunders, 334 Conn. at 193. If members of an LLC wanted to vary standing rules, they are free to do so by contract, but that decision should be left to investors and other participants -- not the courts. Id.
The dissent in Saunders also regarded the exception as allowing single-member LLCs to unfairly take the best of both corporations and partnerships -- limited liability through the corporate structure and direct compensation for corporate losses. Id. at 194. As the dissent put it, “an LLC is not a legal coat that one slips on to protect the owner from liability but then discards or ignores altogether when it is time to pursue a damage claim.” Id. at 196 (quoting Turner v. Andrew, 413 S.W. 3d 272, 276 (Ky. 2013)).
The Saunders decision provides a few points to keep in mind regarding LLCs. First, operating agreements are critical. Had the parties included a standing provision in their operating agreement, they could have saved themselves significant costs and uncertainty.
Second, although individuals frequently see no distinction between themselves and their single-member entities, there is one. Despite the holding in Saunders, the general rule remains that the party suffering an injury is typically the party that must seek redress -- the view espoused by the Saunders dissent.
Third, although Connecticut has abandoned the CLLCA in favor of the New LLC Act, Saunders may be persuasive authority in those jurisdictions that follow LLC Acts modeled on the Prototype Act.
At Novack and Macey, we have extensive experience advising shareholders involved in closely held company disputes, as well as advising companies on how to avoid disputes in the first place. For more information about our services, please contact Andy Campbell at 312.419.6900 or firstname.lastname@example.org.