United States: Kentucky Legislature Adds Clarity To Derivative Litigation Against Limited Liability Companies

Last Updated: February 22 2016
Article by Michael T. Leigh

Changes last year to Kentucky's Limited Liability Company ("LLC") statute provide new clarity to the availability of and procedure for derivative litigation against LLCs in Kentucky.1 Clarification of derivative litigation against LLCs was much-needed, as previously the statute contained no provisions expressly authorizing the maintenance of such actions in the LLC (as opposed to business corporation) context.2

In order for an LLC to be sued derivatively, an LLC member who wishes to bring a derivative complaint must first either make a demand for action on the LLC, or convince a court that any such demand would be "futile." The clear preference in the law is that demand be made. If demand is made, it is to be supplied to the other LLC members, and, if the LLC is manager-managed, on the manager.3 The demand must request that the LLC cause the company to bring an action to redress the injury or enforce the right the member seeks to enforce.4 If demand is made, a derivative suit can be filed only if the members (and manager, if applicable) do not bring the action within a reasonable amount of time.5 If a derivative action is filed following demand, the complaint must state "with particularity" the date and content of the plaintiff member's demand and the response to that demand.6

One notable difference from the corporate derivative statute is lack of any express mention of what happens if the members and manager undertake an investigation into the allegations made in the pre-suit demand. In the business corporation context, the statute expressly states the commencement of an investigation permits a court to stay any derivative proceeding until the investigation is completed.7 The new LLC derivative statute lacks that language, though members and managers supplied with pre-suit derivative demand would be well-advised to attempt agreement with the purportedly aggrieved member to withhold filing of any action to permit the LLC to conduct an investigation in hopes that any allegations can be addressed without the need for expensive litigation. In the event agreement cannot be reached and the member files suit, the defendant LLC members should move for a stay of the litigation on similar grounds. Because any recovery by a derivative plaintiff goes back into the LLC—meaning the plaintiff does not enjoy any personal monetary recovery—common sense and comparison to the business corporation statute strongly suggests that a good-faith investigation should be grounds to stay litigation in order to preserve LLC resources.

The new LLC derivative provision also allows suit to be brought if demand would be futile.8 Like the particulars of any pre-suit demand made, futility of making demand must be alleged in a derivative complaint with "particularity."9 Drawing from the "demand futility" law in the business corporation context, as well as case law from jurisdictions that permit derivative actions against LLCs, makes clear that futility must be asserted with particularized factual allegations.10 Allegations by a derivative plaintiff that futility of demand should be evident from the face of the allegations is typically not sufficient to satisfy the demand futility requirement.11

The new statute also states the proper venue for any derivative litigation against an LLC is in the Circuit Court for the county in which the LLC maintains its registered office and agent.12 The ability of an LLC to set a registered agent in any county provides flexibility in controlling where the LLC can be sued in derivative litigation. For example, establishing a Louisville-based registered agent (such as a Louisville-based registered-agent service or law firm) would require that any derivative litigation be filed in Jefferson County Circuit Court. Because Jefferson Circuit Court routinely handles derivative claims, that choice affords the company an added level of consistency and experience in how such cases might be treated by the court, as well as reducing litigation costs by not having to pay counsel to educate a potentially unfamiliar court with the procedure and law involved in these suits.

Lastly, the LLC derivative statute contains a fee-shifting provision that permits, but does not require, the court to assign payment of plaintiff's or defendants' fees depending on whether the suit results in monetary recovery by the plaintiff for the LLC's benefit, or, instead, was an unfounded complaint. If at the end of the litigation the court determines that the litigation as whole, or any portion of it, was commenced without reasonable cause or for an improper purpose, the court may order the plaintiff to pay the defendants' reasonable legal fees and court costs.13 The availability of fees from a plaintiff who files an unfounded complaint is further reason an LLC should upon receipt of a pre-suit demand letter undertake a good-faith investigation into the purportedly aggrieved member's allegations: If that investigation discloses that the allegations are without merit and the member files a derivative suit anyway, the defendant LLC members have begun a record on which they can rely in support of a motion for fees and costs at the end of the litigation in the event they prevail against the derivative plaintiff.

In contrast, if the court determines that the litigation resulted in "a substantial benefit to the company," the court may order the LLC to pay the plaintiff's attorneys fees and court costs.14 While in many jurisdictions a "substantial benefit" sufficient to justify an award of fees and costs to a plaintiff can be either pecuniary recovery or simple vindication of corporate or fiduciary conduct with no pecuniary recovery by the company, Kentucky has long held in the business corporation context that "a pecuniary benefit [to the corporation] is a prerequisite to recovery of" fees and costs.15 Courts will likely import the same prerequisite of pecuniary recovery to an LLC in a derivative action in order for a derivative plaintiff to be entitled to fees and costs for bringing the case.

Derivative litigation often involves complex issues of fiduciary duty and complicated questions concerning the procedural correctness with which a derivative plaintiff brings suit. The recent addition of express provisions concerning when and how an LLC member can sue derivatively on behalf of the LLC will help LLC members and managers faced with a pre-suit demand letter or a derivative complaint navigate these issues and present the best defenses to the litigation. As the new statutory provisions and derivative law in the corporation context suggest, engaging competent counsel and carefully laying the groundwork for a defense of derivative claims can make an enormous difference in how successful LLC members are in defending against these suits.

Footnotes

1. 2015 Ky. Acts 34 §§ 50 (amending KRS § 275 to add new section 337).

2. Despite the lack of any express statutory provision authorizing derivative suits in the LLC context, Kentucky state and federal courts have looked to the statutory derivative procedures for corporations for guidance on the propriety and procedures for derivative actions against LLCs. See, e.g., Pixler v. Huff, 2012 U.S. Dist. LEXIS 106492, at *3 (W.D. Ky. 2012). Importation of corporate derivative principals proved to be prescient, or, alternatively, the Kentucky legislature followed the courts' lead, as the language of the new LLC derivative litigation statute closely tracks the language of the business corporation derivative litigation statute and the leading Kentucky federal court case to have addressed the issue (Pixler).

3. KRS § 275.337(2)(a).

4. KRS § 275.337(2)(a).

5. Id.

6. KRS § 275.337(4)(a).

7. KRS § 271B.7-400.

8. KRS § 275.337(2)(b).

9. KRS § 275.337(4)(b).

10. See, e.g., KRS § 271B.7-400 (requiring a derivative complaint in business corporation context to state "with particularity...why [plaintiff] did not make the demand"); Beckworth v. Bizier, 2015 U.S. Dist. LEXIS 130605, at *31–33 n.6 (D. Conn. Sept. 29, 2015) (stating Connecticut law recognizes demand futility in LLC context); Franklin v. Jackson, 2015 U.S. Dist. LEXIS 30899, at *35–44 (D. Md. Mar. 13, 2015) (applying Maryland law in the non-stock incorporated entity context); Lukas v. McPeak, 730 F.3d 635, 638 6th Cir. 2013) (applying Tennessee law in the corporation context); Firehouse Gallery LLC v. Phillips, No. 09-cv-698, 2009 U.S. Dist. LEXIS 113476, at *13–14 (M.D. Fla. Nov. 19, 2009) (applying Delaware law in the LLC context); Ishimaru v. Fung, 2005 Del. Ch. LEXIS 167, at *37–38 (Del. Ch. Oct. 26, 2005) (applying Delaware law in LLC context).

11. See cases cited in note 10, supra. But see Auletta v. Ortino (In re Ferro Corp. Derivative Litig.), 511 F.3d 611, 618–619 (6th Cir. 2008) (applying Ohio law in the corporation context and finding that Ohio courts have found a demand presumptively futile where the directors are antagonistic, adversely interested, or involved in the transactions attacked or all directors are named as wrongdoers).

12. KRS § 275.337(7).

13. KRS § 275.337(8)(a).

14. KRS § 275.337(8)(b).

15. Toler v. Clark Rural Electric Cooperative Corp., 512 S.W.2d 25, 26–27 (Ky. 1974) (affirming denial of attorney's fees in shareholder litigation that successfully obtained judgment setting aside election of board of directors, but no pecuniary recovery to the company); see also Orbit Gas Co. v. Arnett, 620 F.2d 304, 304 (6th Cir. Ky. 1980) (relying on Toler to hold that in Kentucky a pecuniary benefit is a prerequisite to recovery of fees and costs in shareholder derivative litigation).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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