The Nutmeg State Out Front on Member Inspection Rights Under RULLCA

Farrell Fritz, P.C.
Contact

For the second time in two years, the Connecticut Supreme Court has ventured into uncharted waters of LLC governance under the Revised Uniform LLC Act which, to date, has been adopted by 22 states and awaits legislative approval in two more.

Last year, the Court in Manere v Collins reversed an order dismissing a minority member’s oppression-based claim for judicial dissolution on the ground that the lower court applied the incorrect legal standard. Observing that “[n]o court has had the occasion to directly address the issue of which test applies to claims of oppression pursuant to the RULLCA,” the Connecticut court held that oppression as that undefined term is used in RULLCA should be evaluated under the “reasonable expectations” test applied by most states, including New York, under their close corporation dissolution statutes. The court rejected the more demanding “fair dealings” standard which prominently considers whether the majority’s conduct was in furtherance of a legitimate business purpose. For more on Manere, read here Professor Dan Kleinberger’s analysis of the case and here my post on the Iowa Supreme Court’s Barkalow decision last May in which it agreed with and adopted the reasonable expectation factors prescribed in Manere.

Earlier this month, in Benjamin v Island Management LLC, the Connecticut Supreme Court again broke new ground under RULLCA, interpreting its provisions governing the rights of members in manager-managed LLCs to inspect books and records. The court’s key ruling held that a member of a manager-managed LLC who demands inspection of books and records for the stated purpose of investigating mismanagement need not come forward with “credible proof” of mismanagement in order to satisfy RULLCA’s requirement that the member “seeks the information for a purpose reasonably related to the member’s interest as a member.”

In so ruling, the court in Benjamin explicitly rejected Delaware’s more restrictive standard under that state’s statutes governing inspection rights both of shareholders and LLC members — see, for example, former Chancellor Bouchard’s decision in Riker v Teucrium Trading, LLCrequiring the investor to “show, by a preponderance of the evidence, a credible basis from which the [court] can infer there is possible mismanagement that would warrant further investigation.” The court also dispensed with Delaware’s strict necessity test requiring a plaintiff to prove that each category of books and records is essential to the inspection’s stated purpose.

Background

The plaintiff in Benjamin, Helen Ziegler Benjamin, is the trustee of one of six trusts created for the six children of the late William Ziegler III. The trusts own, directly or indirectly, several major family businesses (including the country’s largest distributor of cigars) with an aggregate value Forbes Magazine in 2015 estimated at $2.8 billion. The subject company in the lawsuit is Island Management, LLC, a manager-managed Connecticut LLC co-owned equally by the six trusts and created to oversee and build the family’s assets held by a separate family-owned holding company. The LLC is managed by two of the six siblings who receive income as co-managers and also as executives of companies they oversee.

After William’s death in 2008, a disagreement arose among the siblings regarding the amount of annual distributions. Helen, who has no children, pressed for larger distributions to benefit present trust beneficiaries while some of her siblings with children, including the LLC’s co-managers, took the position that present distribution levels were satisfactory and that more earnings should be retained to preserve wealth for future generations.

In 2016, in an effort to end the ongoing disagreement, the other Ziegler trustees offered to buy out Helen’s interest, which Helen rejected as undervalued. After making an informal request for financial and related information about the LLC and other family enterprises, which was denied, Helen made a series of written demands for inspection of the LLC’s books and records, each of which cited Connecticut’s RULLCA statute governing member inspection rights. The co-managers provided many responsive records but refused to produce others, claiming the information was unnecessary or the request was improper.

The stated purposes of the final demand, which requested 27 categories of documents including information relating to management arrangements and fees, were to determine the value of Helen’s trust’s membership interest in the LLC and to ‘‘ascertain the condition and affairs of such entities so that the [Trust] may exercise its rights as a member of the [LLC] in an informed manner.’’ The demand went on to express Helen’s concerns about potential conflicts of interest of the co-managers, excessive fees supposedly taken by them, and her need to investigate the appropriateness of fees paid to the LLC from other family owned entities. The demand concluded: “The refusal to provide information to the members of the [LLC] concerning such payments raises questions about the propriety of the management arrangements and fees. I therefore have a reasonable basis to suspect possible irregularities. The requested information and documents are necessary to investigate whether the payments were, in fact, improper.’’

The LLC produced only some of the materials requested by the final demand. Its written reply asserted that the request was improper as to the stated mismanagement purpose because the statutory inspection right “requires credible proof of mismanagement, of which there was none.”

The Lower Court Proceedings

Helen commenced an action to compel the LLC to comply with her inspection demands. The first count of her two-count complaint alleged violation of her statutory inspection rights under § 34-255i(b) of  Connecticut’s Uniform LLC Act, which derives from RULLCA § 410(b) and provides in relevant part:

A member may inspect and copy full information regarding the activities, affairs, financial condition and other circumstances of the company as is just and reasonable if:

(A) The member seeks the information for a purpose reasonably related to the member’s interest as a member;

(B) 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; and

(C) the information sought is directly connected to the member’s purpose.

The second count of Helen’s complaint alleged breach of § 5.7 of the LLC’s operating agreement giving members, “upon request, . . . the right, during ordinary business hours, to inspect and copy any and all of the books and records of the Company” at the member’s expense.

By the time of trial, following further production of some but not all of the information Helen demanded, the dispute focused on four categories of documents: (1) the general ledger; (2) information pertaining to the LLC’s management services agreements with the holding company and its operating subsidiary; (3) information pertaining to the compensation of the LLC’s managers, officers, and employees; and (4) records showing payments made to third parties on behalf of Helen’s trust.

In its post-trial decision, the lower court ruled in Helen’s favor as to each of the four document categories. It found that her desire to value shares and to determine whether improper transactions occurred are proper inspection purposes. It rejected the LLC’s argument that Connecticut courts should interpret § 34.255i consistently with Delaware law to require credible proof of mismanagement when inspection is sought for the purpose of investigating mismanagement. The court also treated § 5.7 of the operating agreement not only as “confirmatory” of the statutory remedy but “expansive” insofar as it did not require a written request.

The Supreme Court’s Decision

In its appeal to the Supreme Court, the LLC argued for reversal and remand on the grounds, first, that the lower court failed to apply the proper legal standard under § 34.255i and, second, that the claimed breach of the operating agreement was purely derivative of the statutory violation and thus could not provide an alternative basis on which to affirm the judgment. The Supreme Court disagreed with both contentions and affirmed the lower court’s judgment.

The court’s opinion written by Justice Raheem L. Mullins acknowledges at the outset that RULLCA’s inspection provision “has not been subjected to judicial scrutiny by any of [the other RULLCA] jurisdictions” and that “[t]here is also no illuminating Connecticut legislative history.” But the court is not “without guidance on this subject,” he continues, referring to the “well-developed body of law” surrounding corporate records inspection” which, he cautions, is subject to “any reasons to distinguish treatment of this subject as applied to LLCs.”

What follows are the highlights of Justice Mullins’s detailed and scholarly analysis in support of the court’s first-impression construction of RULLCA’s inspection rights for members of manager-managed LLCs, which, for those not familiar with RULLCA, the statute treats separately from the more liberal inspection rights granted members of member-managed LLCs. You can also watch here the virtually conducted oral argument of the case in the Supreme Court.

  • The text of § 34.255i “neither contains a credible proof requirement nor assigns any particular burden of proof depending on the inspection purpose that is alleged. That said, the terms in the statute are sufficiently elastic that we cannot say that the [LLC’s] proposed standard is untenable as a matter of law.”
  • Investigating mismanagement in general “is a proper purpose for seeking inspection of corporate records.”
  • “No jurisdiction holds that allegations or proof of actual mismanagement is required. But some jurisdictions, including Delaware, have held that a shareholder seeking to inspect corporate records to investigate whether the corporation is being properly managed must come forward with facts that demonstrate a reasonable basis to suspect mismanagement” (italics in original). Justifications for the requirement include guarding against “idle curiosity,” “fishing expeditions,” and to balance the plaintiff’s need for information against the burden imposed on the entity and other stakeholders.
  • Other jurisdictions reject the credible proof requirement, citing the shareholders’ “right to know”; that as a practical matter it denies the right to inspect in most cases because often misconduct is discoverable only by first examining the books; and in the absence of a “clear statutory directive placing the burden on the shareholder to prove his or her purpose,” it should be sufficient for the shareholder to allege a proper purpose in general terms and, if the corporation disputes the allegation, it can come forward with evidence that the primary purpose of inspection is improper.
  • An important distinction exists “between the statutory schemes for inspection of corporate records and for inspection of LLC records” which renders “more persuasive” the arguments against the Delaware standard. Whereas the Connecticut statute governing corporation permits inspection if the shareholder’s demand “is made in good faith and for a proper purpose,” the counterpart LLC statute “does not impose such a condition for LLC member inspection except when inspection is sought by a dissociated member . . .. The absence of this good faith requirement for current LLC members cuts strongly against imposing a credible proof requirement on such members.”
  • Judicial backstops exist that can protect company concerns over “unfettered and burdensome inspection” such as requiring the member “to provide greater specificity when justified by the facts and circumstances of the case, including the nature of the entity and the extent of the member’s knowledge of the company’s business.”
  • “An LLC resisting inspection also can provide evidence to demonstrate that the statutory conditions have not been met.”
  • The LLC may, “through its operating agreement, impose reasonable restrictions on the availability and use of information provided for under § 34.255i.”
  • The absence of a credible proof requirement does not prevent a trial court from considering “the absence of facts demonstrating a basis to suspect mismanagement, in combination with other factors, in determining whether an improper purpose is the true reason for the demand and the extent to which disclosure is just and reasonable under the circumstances.”
  • The “strict necessity test” applied under Delaware law, requiring the plaintiff to prove that each category of books and records is essential to the inspection’s stated purpose,” has no support in the “plain meaning” of the “direct connection” requirement in § 34-255i(b)(2)(C), “which is more suggestive of relevance than indispensable need.”
  • While Helen’s inspection demands did not cite § 5.7 of the operating agreement, the omission does not render her claim for breach of § 5.7 derivative of her statutory claim. The provision “does not require that the request expressly invoke the operating agreement” and Helen’s complaint “provided the requisite notice.”
  • Under the common-law “implied improper purpose” rule, when a proper purpose is not expressly required, as with § 5.7, “the entity can avoid inspection if it proves that disclosure would, in fact, be adverse to the entity.”

Closing Comments

Time will tell whether courts in other RULLCA states will follow the Connecticut Supreme Court’s lead in Benjamin. Putting aside any differences in the text of RULLCA’s inspection statute and its Delaware counterpart, the contest between Benjamin‘s member-friendly approach and Delaware’s management-friendly approach to inspection demands for the purpose of investigating mismanagement boils down to assigning the initial burden of production to the LLC member to put forth credible evidence of mismanagement before shifting the burden to the LLC to show improper purpose (Delaware) versus shifting the burden to the LLC to show improper purpose based only on the member’s allegation in general terms of a proper purpose to investigate mismanagement (Benjamin).

I was disappointed but not surprised that the Benjamin opinion, in its extensive survey of out-of-state authorities citing cases from 17 other states, on a relatively minor point cited a single New York case involving shareholder inspection rights under the Business Corporation Law. The last time I checked, I found not one single New York appellate decision construing the standards for member inspection of books and records under § 1102 of New York’s LLC Law.

Finally, a tip of the hat to Lou Conti, Lisa Jacobs, and Steve Leitness for their very fine presentation last week at the annual LLC Institute conference on LLC Information Rights — Understanding, Drafting & Litigating, which is how I learned about the Benjamin case.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Farrell Fritz, P.C. | Attorney Advertising

Written by:

Farrell Fritz, P.C.
Contact
more
less

Farrell Fritz, P.C. on:

Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide
- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.