IL Supreme Court Expands on Shareholder Derivative Suits and Standing Doctrine in Att”y Malpractice Suit

Some minority shareholders in an LLC sued their former counsel for legal malpractice alleging the firm failed to file “obvious” breach of fiduciary claims against the LLC’s corporate counsel.

Affirming summary judgment for the defendant law firm in Stevens v. McGuirreWoods, LLP, 2015 IL 118652, the Illinois Supreme Court gives content to the quantum of proof needed to sustain a legal malpractice claim and discusses the type of legal interest that will confer legal standing for a corporate shareholder to sue in his individual capacity.

The plaintiffs’ central claim was that McGuirreWoods (MW) botched the underlying case by not timely suing Sidley Austin, LLP (Sidley) after the LLC’s majority shareholders allegedly looted the company.  Sidley got the underlying case tossed on statute of limitations grounds and because the plaintiffs lacked standing. minority shareholder plaintiffs lacked standing to individually sue Sidley since Sidley’s obligations ran squarely

The trial court in the legal malpractice suit granted summary judgment for MW due to plaintiffs’ lack of standing.  The court held that even if MW had timely sued Sidley, the claim still would have failed because they could not bring claims in their individual capacity when those claims belonged exclusively to the LLC. After the First District appeals court partially reversed on a procedural issue, MW appealed to the Illinois Supreme Court.

Result: Plaintiffs’ lacked standing to assert individual claims against Sidley.  Judgment for MW.

Rules/Reasons:

Some cases describe the legal malpractice suit as a “case-within-a-case.”  This is because the thrust of a legal malpractice claim is that if it wasn’t for an attorney’s negligence in an underlying case, the plaintiff would have won that case and awarded damages.

The legal malpractice plaintiff must prove (1) defendant attorney owed the plaintiff a duty of care arising from the attorney-client relationship, (2) the defendant’s breached that duty, and (3) as a direct and proximate result of the breach, the plaintiff suffered injury.

Injury in the legal malpractice setting means the plaintiff suffered a loss which entitles him to money damages.  Without proof the plaintiff sustained a monetary loss as a result of the lawyer defendant’s negligence, the legal malpractice suit can’t succeed.

The plaintiff must establish that he would have prevailed in the underlying lawsuit had it not been for the lawyer’s negligence.  The plaintiff’s recoverable damages in the legal malpractice case are the damages plaintiff would have recovered in the underlying case. [¶ 12]

Here, the plaintiffs sued Sidley in their individual capacities.  Since Sidley’s obligations flowed strictly to the LLC, the plaintiff’s lacked standing to sue Sidley in their individual capacity.

Under the law, derivative claims belong solely to a corporation on whose behalf the derivative suit is brought.  A plaintiff must have been a shareholder at the time of the transaction of which he complains and must maintain his shareholder status throughout the entire lawsuit.  [¶ 23]

Illinois’ LLC Act codifies this common law derivative suit recovery rule by making clear that any derivative action recovery goes to the LLC.  By contrast, the nominal plaintiff can only recover his attorneys’ fees and expenses.  805 ILCS 180/40-15.

A nominal plaintiff in a derivative suit only benefits indirectly from a successful suit through an increase in share value. The Court held that the plaintiffs’ missing out on increased share value was not something they could sue for individually in a legal malpractice suit.  Had MW timely sued Sidley, any recovery would have gone to the LLC, not to the plaintiffs – even though they were the named plaintiffs.  Since the plaintiffs could not have recovered money damages against Sidley in the earlier lawsuit, they cannot now recover those same damages under the guise of a legal malpractice action.

An added basis for the Court’s decision was that plaintiffs lacked standing to sue by divesting themselves of their LLC interests.  Standing means one has a real interest in the outcome of a controversy and may suffer injury to a legally recognized interest.

Since plaintiffs relinquished their LLC membership interests before suing MW, they lacked standing to pursue derivative claims for the LLC.

Afterwords:

This case illustrates in vivid relief the harsh results flowing from statute of limitations and the standing doctrine as it applies to aggrieved shareholder suits.

The case turned on the nature of the plaintiff’s claims.  Clearly, they were suing derivatively (as opposed to individually) to “champion” the LLC’s rights.  As a result, any recovery in the case against Sidley would flow to the LLC – the entity of which plaintiffs were no longer members.

And while the plaintiffs did maintain their shareholder status for the duration of the underlying Sidley case, their decision to terminate their LLC membership interests before suing MW proved fatal to their legal malpractice claims.

 

LLC Stopped From Selling Member’s Residence In Violation of Prior Charging Order – Utah Federal Court

Q: Can A Court Stop An LLC That Pays the Monthly Mortgage of One of Its Members From Selling that Member’s Home Where A Charging Order Has Issued Against the LLC to Enforce a Money Judgment Against the LLC Member?

A: Yes.

Q2: How So?

A2: By selling the member’s property and paying off the member’s mortgage with the sale proceeds, the LLC is effectively “paying the member” to the exclusion of the plaintiff judgment creditor.

Source: Earthgrains Baking Companies, Inc. v. Sycamore Family Bakery, Inc., et al, USDC Utah 2015 (https://casetext.com/case/earthgrains-baking-cos-v-sycamore-family-bakery-inc-3)

In this case, the plaintiff won a multi-million dollar money judgment against a corporate and individual defendant in a trademark dispute.  The plaintiff then secured a charging order against a LLC of which the individual defendant was a 48% member.  When the LLC failed to respond to the charging order, the plaintiff moved for an order of contempt against the LLC and sought to stop the LLC from selling the defendant’s home.

The court granted the contempt motion.  First, the court found that it had jurisdiction over the LLC.  The LLC argued that Utah lacked jurisdiction over it since the LLC was formed in Nevada.  The LLC claimed that under the “internal affairs” doctrine, the state of the LLC’s formation – Nevada – governs legal matters concerning the LLC.

Disagreeing, the court noted that a LLC’s internal affairs are limited only to “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.”  The internal affairs doctrine does not apply to claims of third party creditors.  Here, since the plaintiff was a creditor of the LLC’s member, this was not a dispute between LLC and member.  As a result, the internal affairs rule didn’t apply and the Utah court had jurisdiction over the LLC since a LLC member lived in Utah.  (See Cosgrove v. Bartolotta, 150 F.3d 729, 731 (7th Cir. 1998)).

The Charging Order required the LLC to pay any distribution that would normally go to the member directly to the plaintiff until the money judgment was satisfied.  The Charging Order specifically mentions transfers characterized or designated as payment for defendant’s “loans,” among other things.

The LLC was making monthly mortgage payments on the member’s home and listed the home for sale in the amount of $4M.  Plaintiff wanted to prevent the sale since there was a prior $2M mortgage on the home.

In blocking the sale, the court found that if the LLC sold the member’s home and paid off the member’s mortgage lender with the proceeds, this would violate the Charging Order since it would constitute an indirect payment to the member.  The court deemed any payoff of the member’s mortgage a “distribution” (a direct or indirect transfer of money or property from LLC to member) under the Utah’s LLC Act. (Utah Code Ann. § 48-2c-102(5)(a)).

Since the Charging Order provided that any loan payments involving the member were to be paid to the plaintiff until the judgment is satisfied, the court found that to allow the LLC to sell the property and disburse the proceeds to a third party (the lender) would harm the plaintiff in its ability to satisfy the judgment.

Afterwords:

An interesting case that discusses the intricacies of charging orders and the thorny questions that arise when trying to figure out where to sue an LLC that has contacts in several states.  The case portrays a court willing to give an expansive interpretation of what constitutes an indirect distribution from an LLC to its member. 

Earthgrains also reflects a court endeavoring to protect a creditor’s judgment rights where an LLC and its member appear to be engaging in misdirection (if not outright deception) in order to elude the creditor.

[A special thanks to attorney and Forbes contributor Jay Adkisson for alerting me to this case (http://www.forbes.com/sites/jayadkisson/)]

 

Florida Series: Charging Order that Gives Receiver Management Control over LLC Finances Too Broad – Fla Appeals Court

A creditor’s exclusive remedy against a debtor who is a member or manager of a limited liability company (LLC) is a charging order on the debtor’s distributional interest.

McClandon v. Dakem & Associates, LLC, (see here), a recent Florida appellate case, illustrates that while the charging order remedy is flexible enough to allow for some creative lawyering, it still has limits.

McClandon’s facts are straightforward: the plaintiff obtained a money judgment against an individual who had an interest in several limited liability companies.   In post-judgment proceedings, the plaintiff sought a charging order against the debtor’s LLC interests.  The court granted the charging order and appointed a receiver to take control of the LLCs’ finances.

The debtor appealed.

Partially reversing the charging order’s terms, the appeals court found the trial court exceeded its authority and encroached on the legislature by giving the receiver managerial control over the LLCs.

Section 605.0503 of the Florida LLC statute permits a court to enter a charging order as a creditor’s exclusive remedy to attach a debtor’s interest in a multi-member LLC.  The statute further provides that a court can apply broad equitable principles (i.e., alter ego, equitable lien, constructive trust, etc.) when it fashions a charging order.  Florida’s LLC act is based on the Revised Uniform Limited Liability Company Act of 2006 which specifically provides that a court can appoint a receiver to assist in collection of a debtor’s LLC distributions.  See RULLCA Section 503(b)(1).

The court had discretion to appoint a receiver to help the creditor foreclose on the charging order against the debtor’s LLC interests.  But the court exceeded its boundaries by giving the Receiver expansive management authority over the LLC’s finances.

Since there was no statutory predicate for the court to allow the Receiver to exert managerial control over the LLCs, the trial court’s charging order was overly broad.

Afterwords:

The charging order remedy lends itself to flexibility and creative lawyering.  While a creditor can have a receiver appointed to assist in collecting LLC distributions, the receiver cannot – at least in Florida and other states following the Uniform LLC Act – exert control over the LLC’s financial inner workings.  When petitioning for a receiver, creditor’s counsel should make sure the receiver does not engage in the management of the LLC’s business operations.