Do Members of LLCs Owe A Fiduciary Duty To Each Other in CT?

A limited liability company is essentially a combination or mix of a corporation and a partnership.  The LLC as an entity provides the flexibility of a partnership with the ability to govern and create ownership interests similar to a corporation.  The legislature codified the framework for LLCs in Connecticut in Title 34, Chapter 613 of the General Statutes.  The statutory frameworks permits the owners or members of LLCs to include specific governance provisions in a document called an “operating agreement.” Many times members use an attorney to draft the operating agreement. The operating agreement may cover a variety of topics including:

  • duties and rights of members and managers
  • finance
  • distributions
  • ownership and transfer of property
  • admission and withdrawal of members
  • lawsuits by and against the company
  • merger, consolidation and conversion
  • dissolution

If the members of an LLC fail to address any of these issues, the provisions for the Connecticut general statutes apply as a default.  With some exceptions, the statutory framework basically provides for simple majority control. The failure to address these issues typically results in significant control in the majority member.  So, if a minority member wants some aspect of control on these topics, the member would be well advised to take care of it by using an attorney to negotiate or draft provisions in the operating agreement with protections as part of the admission process.

Notwithstanding the above, members holding a minority ownership interest in an LLC continue to have rights that may provide some protection depending on the circumstances and the operating agreement.  In particular, a minority owner might be permitted to assert claims in a lawsuit for  breach of fiduciary duty or breach of statutory duty to address various inequities and unfair management of an LLC.  A minority interest holder might seek to apply these rights in various situations such as:

  • freezing out of the minority owner from affairs of the business
  • unfairly devaluing the member’s ownership interest
  • operating the company in bad faith
  • depriving the member of books and records of the LLC
  • use of deception and fraud in a buy-out of a member
  • unfair expulsion of a member
  • inequitable assignment of membership interest or sale of business
  • improper dissolution or valuing of membership interests
  • self dealing with excessive guaranteed payments or distributions

The outcome of these claims might depend on whether the court acknowledges a fiduciary duty exists between members of an LLC or between a member-manager of an LLC and the other owners.  The existence of a fiduciary duty is significant because it requires the utmost good faith and loyalty.  It also might help the attorney because it shifts the burden of proof in a civil case requiring the member owing such a duty to prove good faith and fair dealing.  As a result, the question in many disputes involving minority ownership of LLCs is whether a fiduciary duty exists.

In Connecticut, by case law, a court may deem a fiduciary duty to exist when there is “justifiable trust confided on one side and a resulting superiority and influence on the other.”  The relationship is broadly defined to permit courts to consider new situations.  It is generally a relationship “characterized by a unique degree of trust and confidence.”  The superior position of one party typically will permit a great opportunity for abuse of confidence.

At the outset, a fiduciary duty is likely to be found to exist if the operating agreement includes such duties for members or managers.  As such, an individual that is offered a minority stake in an LLC might want to insist that the operating agreement impose a fiduciary duty on the manager or controlling members.  In addition to an operating agreement, a claim for breach of duty may be found in General Statutes Section 34-141.  The statute states in relevant part:

 A member or manager shall discharge his duties under section 34-140 and the operating agreement, in good faith, with the care an ordinary prudent person in a like position would exercise under similar circumstances, and in the manner he reasonably believes to be in the best interests of the limited liability company, and shall not be liable for any action taken as a member or manager, or any failure to take such action, if he performs such duties in compliance with the provisions of this section.

Further, there are a series of trial court cases in Connecticut where lawyers have argued this point and judges have recognized a fiduciary duty between managers and/or controlling members of an LLC and the other members.  The reasoning is based, in part, on the law dealing with partnerships and the fiduciary duty owed to each partner.  There is some dispute as to the existence and extent of this duty, but the Connecticut Supreme Court has chosen to keep an open definition of a fiduciary relationship.  Nevertheless, until such duties are further codified or deemed to exist as a matter of law, a controlling member or manager might opt to have such duties disclaimed in an operating agreement.

A fiduciary duty may or may not be desirable depending on your ownership interest or your role in the LLC.  The take away here is that an operating agreement is the best method to clearly define the duties of members and managers.  The operating agreement can include specific provisions on the extent and nature of the duties of a manager or member of an LLC.  In the absence of a specific provision in the operating agreement stating otherwise, members or managers may be deemed a fiduciary with respect to other members.  Although not required, a lawyer familiar with LLCs can assist in ensuring valuable rights are in an agreement or bringing a lawsuit when rights are violated.

Lost Profits Must Be Reasonably Certain for Breach of Contract Claims

The burden to prove damages is always on the Plaintiff, or the party that brings the lawsuit.  Many times I receive calls from prospective clients who believe they have significant amount of damages.  However, under Connecticut law damages are only recoverable to the extent that the evidence affords a sufficient basis for estimating their amount in money with “reasonable certainty.”  Proving damages in a business lawsuit does not require exactitude but a litigant cannot base a claim solely on subjective opinion.

Although there is no precise formula to prove the amount of damages, a court will not permit an award of damages based on speculation or conjecture.  In certain cases, assumptions are permitted, but the assumptions must be reasonable and relate to the facts of the case.  As a result, before proceeding with a breach of contract case, an attorney will want to explore if the prospective client can prove damages.  Without provable damages, there is likely no case worthy to pursue if money damages are at issue.

The damages also must relate to the specific cause of action in the case.  There are different elements of recoverable damages for different types of cases.  Some cases carry with it statutory damages, and other cases are governed by Connecticut’s common law or history of court decisions.

One category of frequently claimed damage for breach of contract is loss of future profits or loss of anticipated profits.  Generally, in a breach of contract case, you seek to put the injured party in the same financial position they would have been but for the breach.  In a lost profit case, a party in litigation will claim that “but for” the breach of contract, the party would have earned a projected amount of money.

Connecticut case law clearly provides for the availability of an award of lost profits in general breach of contract cases.  Courts construe lost profits as an element of available compensatory damages.  The mere fact, however, that lost profit damages are available generally, does not mean lost profit damages are recoverable in all cases. To determine whether lost profits are available, the parties will need to look to the terms of the contract and whether lost profits were reasonably contemplated by the parties.  Contracts also frequently contain disclaimers or exclusions of lost profit damages even if the parties contemplated that such damages might occur.

Additionally, although lost profit damages are potentially available, it does not necessarily follow that sufficient evidence exists to reliably prove anticipated profits from a business deal gone bad.  Courts will sometimes permit owners of a business to testify as to anticipated profits, but usually only when the owner has knowledge and familiarity with an established history of profits sufficient to project anticipated future profits.  In most cases, the parties need to retain experts to review relevant financial data and to provide an opinion on lost profits.

Litigants and their attorneys typically use economists or accountants as experts to prove lost profits in business cases.  Expert fees can add considerable expense to a case as the expert will likely have to review significant amounts of financial data and the factual details concerning the business deal.  The expert expense may be necessary to incur in many cases to successfully prove damages.  An expert’s opinion on lost profits must also pass a reliability test.  If challenged by an opponent, the expert will have to establish that the method of establishing a damages figure was reliable.  Courts will use a series of factors to consider the reliability of methods and the arguments raised by lawyers to exclude such opinions from trial.

In conclusion, readers should understand that lost profits are available as a potential element of damages in most breach of contract cases in Connecticut.  However, the fact that such damages are potentially available does not establish a right to recover.  The burden to prove lost profit damages remains with the Plaintiff, and must be shown with reasonable certainty and not subjective opinion, conjecture or surmise.

Are Breach of Contract Disputes Governed by Terms of Contract Alone?

You might think so, but generally whether the terms alone govern a dispute depends on the language in the contract.  When a contractual relationship breaks down, parties that previously agreed to terms of a contract suddenly no longer agree on the meaning of key terms. Many times parties to a contract have evidence that supports one meaning versus another.  The question becomes whether any of the evidence is relevant or if the court will simply interpret the terms as written.

I have posted before on the implications of the parol evidence rule in Connecticut.  A recent Appellate Court case serves to highlight some important aspects of the rule.  The case is Sullo Investments LLC v Marci Moreau and will be released for official publication on July 1, 2014.  In Sullo, the defendant signed a guaranty agreement for a commercial note.  The defendant lost at trial.  On appeal, the defendant claimed that the trial court erred because the court went beyond the four corners of the guaranty agreement and considered extrinsic evidence in violation of the parole evidence rule.

The Appellate Court disagreed and pointed out that the parole evidence rule is only implicated where the evidence serves to contradict or vary terms that are actually in the contract.  The rule:

“does not of itself, therefore, forbid the presentation of parol evidence, that is, evidence outside the four corners of the contract concerning matters governed by an integrated contract, but forbids on the use of such evidence to vary or contradict the terms of such a contract.”

The rule of evidence that applies to bar the evidence is relevance.   If the court cannot use the evidence to alter the terms of a complete and clear contract, then the evidence becomes irrelevant.  However, the evidence may be relevant for another purpose or the rule may not apply to the terms of the contract.  For example, extrinsic evidence may be admissible:

  • To explain an ambiguity in the contract
  • To prove a collateral agreement that does not vary the terms of the written
  • To add missing terms to a contract that does not state it is complete
  • To show mistake or fraud

These are all examples where the evidence would not alter the terms of a complete, written contract in clear terms.  As such, to determine whether evidence outside the contract is relevant, you have to consider the nature of the evidence, its purpose, and whether it contradicts the clear terms of a complete contract.  The parol evidence rule also highlights the need to draft clear contracts with clauses that make it clear the contract alone will govern the dispute.  Otherwise, the court will permit each party to introduce evidence outside the four corners of the contract.  This could include conversations, emails, and other documents.

Prevention of Performance and Breach of Contract

 A recent Connecticut Supreme Court case (Blumberg Associates Worldwide, Inc. v Brown & Brown of CT)  addressed the prevention doctrine in breach of contract cases.  Under the prevention doctrine if a party to a contract

prevents, hinders, or renders impossible the occurrence of a condition precedent to his or her promise to perform, or to the performance of a return promise, that party is not relieved of the obligation to perform, and may not legally terminate the contract for nonperformance.

In addition, if one party hinders, the other party’s performance will be excused.  The other party will not be permitted to recover damages for breach of contract.  In sum, when one party causes the failure of performance under a contract, the party cannot take advantage of it legally in court. 

The prevention doctrine is part of the application of the implied covenant of good faith and fair dealing that is part of every contract.  Essentially, it is part of an obligation to proceed under a contract in good faith.  The issue in the Blumberg case was whether the prevention doctrine could apply to conduct that occurred before the contract was executed by the parties.  

The court held that it could not.  So, the prevention doctrine only applies if a contract already exists.  The reason is because the duty not to prevent or hinder arises only from implied contractual duties.  Therefore, if there is no contract, there is no duty.

Whether particular conduct constitutes wrongful prevention is decided by a jury or judge.  In Connecticut, prevention can be raised by the attorney in the breach of contract case in defense or prosecution of a claim.

What To Do If You Suspect Your Business Partner Is Stealing – Some Basics

In any case involving theft by a business partner or business dispute, it is very important to have an understanding of the basic issues and legal framework. Although these cases often involve complex problems, you cannot determine a good course of action without starting with the basics.

 

Here are 5 of the basic issues and what to do if you anticipate a business dispute with a partner or small business in Connecticut.

1. Figure out the type of entity you formed for your business

Principals of small or closely held companies or partnerships typically start off their businesses by choosing an entity such as a Limited Liability Company (LLC), Limited Liability Partnership (LLP), or Corporation (C Corp. or S Corp.). This may seem like a "no brainer" but you might be surprised that many partial business owners (typically minority owners) do not know the exact type of business entity they own.  

To determine what type of entity you formed look for documents such as Articles of Organization, Articles of Amendment, Certificate of Incorporation, Organization and First Report, Certificate of Amendment, Certificate of Limited Liability Partnership, or Statement of Partnership Authority. These are the so called "incorporating" documents or "originating" documents filed with the Secretary of State. These documents clarify the type of entity chosen and the original incorporators or members of the entity. These documents are available to the public and are available for searching at the Secretary of State website www.concord-sots.ct.gov . If you cannot find your documents, try searching the Connecticut Commercial Recording Division website.

2. Figure out the structure and control of your entity.

The structure and operations of an entity often are governed by formal documents in most cases, or by default rules in others. Formal documents may include bylaws, resolutions, shareholder agreements, stockholder agreements, voting agreements, or operating agreements. These documents likely detail your ownership and management rights.

Of course, we see many cases where these agreements do not exist or were never finalized. It remains important to find what you have to show any agreement, even if informal. Maybe you exchanged some emails or you drafted a memorandum of understanding or informal partnership agreement. However, if you do not have a formal or informal agreement, Connecticut General Statutes can operate as a fall back or default to govern the operation and management of corporate entities. You can review the basic statutory laws of Corporations on the Connecticut General Assembly Website www.cga.ct.gov/current/pub/titles.htm . For example, Connecticut statutory laws for Corporations are found in Title 33.

3. Get access to the books and records of the business.

Many times, clients come to us after the business partnership has fallen apart, become insolvent, or dissolved. In many of these instances, one of the partners has access to all the records, and the other partner does not. Your rights to obtain company records may be spelled out in the agreements or documents mentioned in # 2 above. Alternatively, inspection rights for books and records are provided by statutory law. For example, Connecticut General Statutes § 33-946 – 950 permits inspections of books and records by shareholders and directors. However, many times feuding business owners end up having to file a so called "books and records" lawsuit in Connecticut state court to get access to the corporate books and records.

Getting access to the company financials is important. At minimum, you should seek to obtain summary financials, such as income statements, profit and loss statements, or trial balances. However, the ideal is to have access to the actual raw data. This means getting access to bank account(s) (including web access), loan accounts, credit accounts, and the company accounting journals. Getting access to this data may depend on whether the accounting software is server based, such as Peachtree, or cloud based such as QuickBooks online.

4. Identify all sources where records might be stored

>Businesses generate all kinds of data and records. Increasingly, this data is completely digital and electronically stored on a computer, server, or at third party sites such as Rackspace or Boxnet. Additionally, emails seemingly become critical in every case that ends up in litigation. You need to identify where emails and other electronic means of communication (text or instant message) might exist such as the company email servers or third party sites (i.e. Google, Microsoft, Comcast, or Verizon).

Once you identify the locations of the records, you may need to try to preserve this information so you have it in usable form in the event of a dispute. Correctly copying digital records may require an expert in computer forensics. You also may want to involve an attorney so that you understand the full extent of your obligations to preserve evidence and gain protections from discovery.

If your dispute requires a lawsuit to resolve, you many need to act quickly to subpoena records from third party providers before records become lost, destroyed or deleted. If you suspect key evidence exists in emails, you may need to subpoena Internet service providers or third parties that provide applications over the Internet such as Google. Generally, to get the authority to issue a subpoena, an attorney will need to bring a lawsuit concerning the dispute or a lawsuit seeking permission to seek "discovery" of these documents to help build a case.  This is known as a bill of discovery. 

5. Seek help from professionals.

Various professionals, such as forensic accountants, computer forensic experts, fraud investigators, and attorneys can assist in most business disputes. It is a good idea to consider a conference with a professional to review your concerns. Also, you should always consider having your attorney lead the investigation as the involvement of an attorney can add a layer of protection when your opponent later seeks to obtain the results of your investigation.

No Contract, No Problem – Charter Oak Gets A Chance To Prove Its Case

 In a decision that will be officially release tomorrow (download)the Connecticut appellate court ordered a new trial in favor of Charter Oak Lending for the claims it brought against employees who defected to a competitor.   Unless there is a successful appeal to the Connecticut Supreme Court, this means Charter Oak will get a second chance to prove its claims against the key employees despite the lack of a written contract in place covering non-competition.   I originally posted about this case in November of 1999 when Charter Oak lost at the trial level.  The case result had generated media interest surrounding the claims because the damages and the lack of a contract governing the employment relationship. 

As I noted at the time, it is always better to have a written contract in place with employees to govern post termination conduct involving competition, solicitation, confidential information, and trade secrets. However, the lack of contract does not by itself leave a business without a remedy especially if the situation involves use of trade secrets or confidential information or the employees actively competing before departure.  

In Charter Oak, the trial court dismissed the claims finding that Charter Oak failed to make out a threshold case during the trial.  In other words, the case never reached the level of a final decision on the merits because the judge found that the basic elements of the claims were not met.  The basic claims were breach of fiduciary duty, misappropriation of trade secrets and unfair trade practices. 

The appellate court reversed the decision and found that facts existed to make out threshold claims for these causes of action.  Therefore, the trial court judge should have permitted the case to proceed to a final decision on the merits.  Significantly,  the appellate court deemed as sufficient Charter Oak’s claim that its client list was a trade secret entitled to protection under General Statutes 35-51 known as the Connecticut Uniform Trade Secrets Act (CUTSA).  The court stated:

to make out a prima facie case for a violation of CUTSA, the plaintiff was required to present sufficient evidence that, if believed, would prove that the information in its customer list had independent economic value and that the plaintiff made reasonable efforts to maintain its secrecy.

Here were some of the facts that the court found sufficient to afford trade secret protection to the client list:

  • access was limited
  • the computers were encrypted
  • the building was secured where the computers were stored
  • employees were not permitted to share the list
  • employees understood the list was private
  • the lists were not sold or disclosed to third parties
  • the list could not be obtained from any other single source
  • the list gave Charter a competitive advantage

In addition to the ruling on CUTSA, the appellate court reaffirmed some aspects of the law with respect to fiduciary obligations of agents or employees.  The court affirmed the duty of loyalty owed by an agent to his or her principal.  This duty applies regardless of a whether a contract exists.  In the business context, this duty forbids an employee from actively competing against an employer concerning the subject matter of the agency or from using confidential information against the employer in competition.

Whether Charter Oak prevails in the new trial remains unclear.  However, the lack of a contract or written agreement should not prevent Charter Oak from getting a final decision on the merits.

Do You Need A Contract To Stop A Former Employee From Competing?

The short answer is yes, a business does need a contract, also known as a "non-compete agreement," to prevent a former employee from fairly competing in business once the employee resigns.  Even with a written agreement, there are limitations on non-compete agreements because they are viewed as a restraint of trade.  To be enforceable, the restrictions in the agreement must be reasonable in time, scope, and geography. The restrictions also must be reasonable in relation to legitimate business interests you are seeking to protect.   

A poorly drafted agreement, or no agreement at all, can leave a business with little legal recourse to stop a former employee from fair competition once the employee resigns.  Simply put, the law in Connecticut permits fair competition upon resignation.  However, the lack of a written agreement does not give free license to employees to unfairly compete in all circumstances. 

For example, what about an employee that starts competing against your business without your knowledge while continuing to work for you?  Is this fair competition that should be freely permitted?  Depending on the circumstances, this type of conduct can be actionable in a civil case for damages.  The actionable conduct is breach of the employee’s common law duty of loyalty, which exists without a written agreement in certain circumstances.  There are also statutes in Connecticut that can protect businesses in certain situations that do not require contracts such as unauthorized computer access or misappropriation of trade secrets.   

I just read a story about a recent case that demonstrated some of the legal issues involved when there are no contracts in place with former employees.  According to the small business report by Carlye Adler of CNN, Charter Oak Lending, located in in Danbury Connecticut, lost a trial against several former employees who allegedly left to work for a larger company, CTX Mortgage.  Charter Oak alleged it lost more than a third of its business and a million dollars in fees after a sudden departure of 10 employees to CTX. The litigation lasted four years and ended with a defense verdict for the former employees. Charter Oak is appealing the decision. 

It appears that the decision against Charter Oak was based in part on the lack of contracts and the categorization of the defendants as independent contractors rather than employees.   The Trade Secrets Blog by Womble Carlyle picked up the story and had an interesting take focused on pure versus unfair competition.  The blog post supports the legal concept that a line can be crossed turning pure competition into unfair business. 

Charter Oak’s appeal of this case will be interesting to follow.  The outcome will likely depend on what evidence existed at trial to demonstrate unfair competition prior to the employees’ departure along with consideration of the duty of loyalty.  The takeaway is that it is always better to have written agreements to protect your business’ customers, client lists, and confidential information.  However, the lack of such an agreement will not always give free license to former employees to unfairly compete in all circumstances.   A close examination of the facts of each case must be undertaken to consider common law and statutory remedies that do not necessarily require agreements. 

Connecticut Business Litigation And Improper Interference With A Business Contract

Unfortunately, all too often business competitors resort to unfair and improper tactics to gain an advantage in business.  A common example occurs when a competitor maliciously or intentionally interferes with a company’s contracts or business relationships.   When this occurs, businesses have to consider whether a legal remedy is available.

In Connecticut, courts have long recognized the business litigation claim of tortious interference with contractual relations as an available remedy for this type of conduct.  To be successful against a competitor in a lawsuit for this claim, a business must prove three essential elements:

  • Existence of a contract or beneficial business relationship
  • Knowledge of the relationship
  • Intentional interference with the contract or business relationship
  • Actual loss or damage 

Upon first consideration, tortious interference with a contract might seem to apply to many business competitors.  However, Connecticut courts require more than mere interference for a successful lawsuit.  In particular, not every act of interference is actionable in court. 

In Connecticut, a business must also prove that the interference was "improper" or with an "improper motive."   A business can prove that interference with a contract was improper by demonstrating any of the following:

  • Fraud or misrepresentation
  • Intimidation
  • Malice
  • Other improper motive or means

Although the improper motive element is harder to prove, a successful claim could also result in an award of punitive damages.  Additionally, a business does not have to prove that the interference actually resulted in a breach of the contract or business relationship.

As such, if your business is dealing with a competitor that has crossed the line and resorted to fraud or unfair practices to harm your business, a lawsuit for tortious interference with contractual relationship is one of the available remedies in Connecticut.   

Getting A Contract In Writing Does Not Always Satisfy The Statute Of Frauds

One of the first things lawyers check for when contesting an oral contract is the statute of frauds.  The statute of frauds comes from an English rule dating back to the 1600’s.  At its most basic level, the statute of frauds requires certain types of contracts to be in writing or else they are not enforceable in court actions.  However, sometimes, even when a contract is in writing, it still will not satisfy the statute of frauds.

That is what happened in SS-II, LLC v. Bridge Street Associates, an advanced opinion released today by the Connecticut Supreme Court.  The dispute involved an option to purchase property pursuant to a commercial lease that was in writing.  The tenant wanted to exercise the option and the seller did not want to close on the sale. 

When the tenant brought a lawsuit for specific performance trying to force the sale, the owner raised the Connecticut Statute of Frauds as a defense and won in court.  In Connecticut, the agreements that must be in writing under the statute of frauds include the following:

  • any agreement by any executor promising to answer damages out of his own property
  • any promise to answer for the debt, default or miscarriage of another
  • any agreement made upon consideration of marriage
  • any agreement for the sale of real property or any interest in or concerning real property
  • any agreement that is not to be performed within one year 
  • any agreement for a loan in an amount which exceeds fifty thousand dollars.

Not only do these agreements have to be in writing, but they also have to contain the contract’s essential terms.  In a contract to sell land, the terms must describe a certain price, the parties to the contract, and the land.  In the SS-II case, the contract did not comply with the statute of frauds because the purchase price was not certain and was subject to some conditions.  Although there are counter defenses to the statute of frauds, such as partial performance, the court deemed that they did not apply. 

The takeaway from this case is to be cautious with oral contacts and do not assume a writing alone will make the agreement enforceable.  A contract has to be in writing, signed, and have the proper terms in it or else you may not have an enforceable agreement if the statute of frauds applies.