Friday, July 16, 2010

Business to business fraud (Part IV): The obligation of good faith

In prior posts I considered some recurrent causes of business to business fraud and potential remedies (breach of fiduciary duty and fraudulent inducement) common in business litigation. In this post I discuss the obligation of good faith.

The obligation of good faith.
This is a tricky obligation. It is a duty engrafted onto every contract, including operating agreements of LLCs. But it won’t stand alone as a separate obligation to permit suit for breach of contract. For example, if one party has discretion pursuant to the agreement to do something, he or she must exercise that discretion in good faith; the party cannot act to deny the other party the anticipated benefits of the agreement. The obligation won’t be applied to overrule an explicit contract provision, however, which makes the obligation confusing and difficult for the courts to apply in contract breach cases.

Loan agreements as an example.

Banks have the right to declare defaults under most loan agreements, but do they have to exercise good faith in declaring a default? Consider a condominium development in which the development has a value of $100 and the loan outstanding is $80 or less. The bank loan officials declared that as long as the loan to value ratio was maintained at 80% or less, no default would be declared. But when payments were missed, the loan was transferred to a workout group, which decided to declare a default and foreclose. They had discretion to declare a default, but was it exercised in good faith if the loan to value ratio were still 80% or less?

In Chemical Bank v. Paul, 244 Ill.App. 2d 772, 614 N.E.2d 436 (1st Dist. 1993), I helped prove that the bank violated its obligation of good faith when it failed to promptly approve legitimate commercial leases and condominium sales, and declared a default despite a favorable loan to value ratio, crippling the real estate developer’s ability to repay its loan. Since that time, courts have limited the obligation of good faith, reasoning that, if the contract allows the bank to declare a default under certain conditions, if those conditions occur, the bank should not be prevented from doing what the contract allows. This would not change the result in Chemical Bank because the bank was also guilty of bad faith in failing to approve leases and condominium sales: the loan documents gave it discretion to approve these transactions, but that discretion had to be exercised in good faith.

LLC Acts and other statutes.
As noted in my prior post, Delaware permits LLC agreements to eliminate fiduciary duties. Nevertheless, the parties cannot overrule the duty of good faith. The proponents of the Delaware approach like the idea of implementing only contract-based duties, leaving it to the parties to define them, and limiting the role of the courts. The model LLC Act forbids disclaimer of certain fiduciary duties. Proponents of this approach note the value of forbidding chicanery and the difficulty of differentiating between breach of a fiduciary duty and breach of the obligation of good faith.

Fiduciary duties and good faith duties overlap.
If an LLC manager has the discretion under an operating agreement to purchase goods for the LLC and if fiduciary duties have been disclaimed in the operating agreement, how does one examine a transaction in which the manager buys the goods from an affiliate? In my view, there should not be a presumption of fraud as there would be if fiduciary duties existed (that is, if they had not been disclaimed in the operating agreement), but if the price were too high or the goods were of the wrong type for the LLC, the manager should be guilty of bad faith. The question is whether the elimination of the presumption is a good idea.

A cynical real estate investor once told me that limited liability partnerships were simply vehicles for transferring wealth from the limited partners to the general partner. I wonder whether Delaware’s LLC Act that permits the complete disclaimer of fiduciary duties simply operates to facilitate the transfer of wealth from LLC non-managers to cynical LLC managers. In Delaware, I hope that the obligation of good faith will prevent this.

Fighting business to business fraud (Part III): Fraudulent inducement

In prior posts I considered some causes of business to business fraud common in business litigation and one remedy: breach of fiduciary duty. In this post, I consider another remedy: fraudulent inducement or sue for money damages.

Fraudulent Inducement

If one person made a representation to another to induce them to sign an agreement and if that representation were false, the victim might be able to get out of (rescind) the agreement.

Germane factors

First, was the representation an opinion or a fact? “This is the greatest gas station in the world” is an opinion and sales puffing, whereas “this gas station had revenues of $xxx,xxx per month” is a fact. So, if you buy a gas station and then discover that the representation of past or existing revenues was false, you might be able to return the gas station to the seller and get your money back or sue for the difference between the revenues as represented versus the actual.

Second, what do the actual documents say about the representation, if anything? Standard language in a securities offering or private placement memorandum precludes any investor from relying on any statement in the document, and makes it much more difficult to sue for securities fraud based on the fraudulent inducement theory.

Third, when the victim discovered the fraud, what did he or she do? If after discovery the victim proceeded as if nothing were wrong, the fraud lawsuit might be waived. I recommend aggressive pursuit of your rights if you are a victim of business fraud.

Punitive Damages

If you meet the elements of fraudulent inducement, substantial damages can be recovered, and punitive damages are possible.

Fighting business to business fraud (Part II): What to do if you are a victim of business fraud

My prior post considered some of the recurring causes of business fraud. In business litigation, there are several common remedies for such fraud. In this post we consider only one.

Breach of Fiduciary Duty

Lawyers and accountants owe fiduciary duties to their clients. Officers, directors, agents, employees, shareholders of small corporations, managers of LLCs, partners, and others owe fiduciary duties to others with whom they are in business. This means that they have duties of disclosure, honest dealing, and loyalty to their company and partners.

LLC Acts and Fiduciary Duties

One of the biggest issues in LLC law today is whether state statutes allowing LLC’s should permit their organizers to write the fiduciary duty obligation out of the agreement. Delaware permits LLC’s to draft operating agreements to eliminate fiduciary duties, whereas Illinois only permits LLC’s to define the scope (limit) of fiduciary duties if not manifestly unreasonable and denies the parties the right to eliminate fiduciary duties, including the duty of loyalty. Separate statutes govern corporations.

So, if you have a partner who secretly arranged to compete against you, examine your agreements and the relevant statutes to see if you can sue for breach of the fiduciary duties of loyalty, candor, and care. Damages for breach include forfeiture of the perpetrator’s compensation and money damages for the victim’s lost revenue. In some cases you will need a temporary remedy (a temporary restraining order or preliminary injunction) to enforce your rights.

Business Corporation Acts and Breaches of Fiduciary Duty

The Illinois Business Corporation Act permits injunctions to preserve the right to relief for any of the actions allowed by the Act. The inherent judicial power allows courts to grant injunctions to preserve your ability to sue in situations not covered by any state statute governing corporations. Injunctions for breaches of fiduciary duty based on a partnership agreement or LLC operating agreement can be granted where the elements necessary for such relief can be shown.

Delay in seeking protection of your rights when you are victimized by a breach of fiduciary can be fatal. Getting a money judgment after the entity or the individual defendant is insolvent is a useless exercise.

Fighting business to business fraud (Part I)

Businesses, professionals, and entrepreneurs often shun lawyers until a business partner lies to them or flees the jurisdiction with all of their money. When something like this happens, the victim has only two choices: surrender or file a business lawsuit. The Patterson Law Firm files a lot of business lawsuits designed to fight business to business fraud, and today’s post considers some causes of business fraud.

Business fraud erupts in these recurring circumstances:

Unequal Bargaining Power, Real or Perceived

Usually you think this only occurs between banks or insurance companies and consumers, but it happens in business too. Venture capitalists drip feed money to an entrepreneur and when he or she needs more money, more control is grabbed, and sometimes the entrepreneur is squeezed out of the business once he or she has completed all the hard work of making the product and preparing to market it. Partnerships between those with money and those who contribute only sweat equity are common and can work, but those with the money often cite the golden rule: “them with the gold rule.”

In one case, the financial partner locked out and purported to fire the President of the company, who had invented the hi-tech product being sold. In another case, one brother locked out the other and vowed not to let him profit from the company of which he was a 50% shareholder. In both these cases, those with the gold thought they had more power than they did. Neither got away with it, although in both cases it took the legal system over a year to fix.

Unequal Experience

A first-time entrepreneur is no match for an experienced investor when it comes to negotiating an agreement, but there are many other less obvious scenarios. Consider a business person with 50 years’ experience in a family business but who has to contemplate turning the business around, liquidating, or going bankrupt. Such a person is ripe for scams from self-proclaimed turnaround specialists and others promising the money to help. This could be the first time the business person faces these decisions, but the specialists make their living at this and know all the tricks.

Communication Ambiguities, Unintentional or Otherwise

Consider this LLC agreement section: “any Member or Manager may engage in or possess an interest in any other business venture, independently or with others, of any nature or description; and neither any other Member or Manager nor the LLC shall have any rights by virtue hereof in and to such other business ventures, or to the income or profits derived there from.” In another section the same agreement stated: “no Manager shall be liable to the LLC or its Members for monetary damages for breach of fiduciary duty as a Manager, except for liability for (i) any breach of the Manager’s duty of loyalty to the LLC or to its Members or (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.”

Can one manager of the LLC secretly invest in a competing business under this agreement? This example comes from an actual case in which one manager secretly competed with the LLC and, when caught, argued that the LLC agreement allowed his competition. (In Illinois, the provision purporting to allow competition should not be enforceable because the LLC Act forbids eliminating the duty of loyalty, which includes the duty to refrain from competition.)

You might argue that this arose from careless and slovenly document preparation, and it is also possible that the parties were not contemplating how to police themselves at the time and were not thinking about potential treachery. They were all friends and business partners at the time the agreement was signed. Perhaps the traitorous party noticed the ambiguity and decided to exploit it. Perhaps he deliberately seeded the agreement with a provision he planned to exploit. Or maybe, in these days of canned form agreements, the issues were never discussed.

My next post will consider some possible remedies for a victim of business to business fraud.

Shareholder Class Action Proceeds

In a prior post, I discussed the Supreme Court case Merck v. Reynolds, in which the application of the discovery rule in securities fraud cases was at issue. To recap, the Supreme Court granted cert to decide if the two-year statute of limitations ran from the first possible evidence of fraud as argued by Merck or the discovery of scienter as argued by the plaintiffs.

On April 27, 2010, the Supreme Court handed down its decision and it is a victory for shareholder class actions! The Supreme Court held that the statute of limitations does not run until a plaintiff discovers all of the elements of a claim. The six-judge majority decision, written by Justice Breyer, and a concurrence, written by Justice Scalia, disagree on whether the statute provides for constructive discovery – oddly putting Justice Scalia on the side of allowing more time to file a suit as he reads the statute as requiring actual discovery of scienter.

A factor in the Court’s reasoning requiring evidence of scienter and not possible evidence of scienter is the heightened pleading standard in securities fraud claims. Under federal securities law, a plaintiff needs to plead specific facts regarding intent to defraud. The limitations statute states that the period begins on the discovery of a violation. As a violation does not occur without the requisite intent to defraud, discovery (or constructive discovery) of scienter, not possible scienter, is necessary for the limitations period to start. The five-year statute of repose countered Merck’s argument that the discovery requirement will subject defendants to defend litigation after the facts were stale.

Alas, the opinion likely does not extend beyond the statute in which it arose. It is, however, an opinion that goes against the pro-business leanings of the Court as of late and is especially noteworthy for its unanimity in allowing the suit to proceed.

Greater Protection for Shareholders in the New Year?

The Supreme Court’s begins hearing January arguments today. Of interest to shareholders, however, is not a case argued today but rather a case heard in November 2009. Before the end of the current term, the Court will issue an opinion in Merck v. Richard Reynolds. Merck focuses on whether the statute of limitations on a federal securities fraud action begins to run when an investor obtains evidence of scienter of fraud or when any evidence of fraud is uncovered.

The distinction is real and would impact many securities fraud cases. Federal law requires securities fraud cases to be brought within the earlier of two years of knowledge or five years of the violation. Generally speaking, the two year period relating to knowledge does not run until all elements of a violation are discovered. The issue is important in security fraud cases because there is often evidence of fraud before there is evidence of the requisite intent. The evidence of fraud, however, is only recognizable in hindsight based on newer evidence demonstrating the intent to defraud. For example, in Merck, an internal study reached a suspicious but supportable conclusion. It was not until an independent study was published two years later that Merck’s original position demonstrated its intent to defraud.

If the statute of limitations is applied to the first instance of possible fraud, shareholders are put in a position whereby they need to take aggressive action to protect their rights. Such action is expensive, such as instituting preliminary injunction and temporary restraining order actions to preserve possible evidence of intent, and may not uncover any fraud on the part of the corporation. Corporations would also incur an added expense as they are forced to defend preliminary litigation. Waiting until all of the evidence necessary to bring a case is available will not harm corporations that are engaged in ethical practices.

Merck will be an important case to watch not only for its impact on the discovery rule in securities fraud cases. As the Wall Street Journal Law Blog points out today, it may also demonstrate whether the Obama Administration can affect a change in the Court’s pro-business stance under President Bush.

When Do You Need A Preliminary Injunction In An Illinois Corporate Shareholder Dispute?

Illinois is supposed to be more shareholder friendly than Delaware. Its Business Corporation Act provides minority shareholders protections if the majority shareholders are

  1. committing waste;
  2. practicing fraud;
  3. acting illegally; or
  4. oppressing minority shareholders.

There was an article in Business Law Today a while ago that contended that minority shares of stock are worthless apart from whatever rights were provided in a shareholders’ agreement, but I disagree: minority shareholders in Illinois--without any shareholders’ agreement-- have the rights given them by the Illinois Business Corporation Act (and this Act influenced the drafting of the Model Business Corporation Act). If they sue to vindicate these rights, the majority shareholders can elect to buy them out, and their buy out price is the fair value (not the fair market value) of their shares.

Listing the rights given by statute begins to answer the question posed. If you are a minority shareholder, you need a preliminary injunction if the majority shareholders are doing one or more of the above acts and you or the corporation is going to be immediately irreparably harmed as a result. Waste of corporate assets might not be recoverable absent immediate action; an illegal act may cause the corporation to be sanctioned by law enforcement officials. Oppression is an elastic concept, but the standard is the reasonable expectation of the shareholders. Most of these defalcations will diminish the goodwill of the corporation, a harm that is difficult to quantify, justifying a preliminary injunction.

In the midst of the ill-will that accompanies actions that necessitate shareholder actions, actual or threatened improper withdrawals from the corporation may require a preliminary injunction or temporary restraining order. Minority shareholders need to be vigilant in guarding the corporate purse. A preliminary injunction can be justified on a constructive trust theory (corporate money is a res that is the subject of dispute over whether the payment is proper). The Illinois Business Corporation Act codifies the court’s power to issue injunctions as well. And the Act provides panoply of remedies available to the court: appointment of a receiver or director, for example, and, more broadly, any order necessary.