Unincorporated Business Entities Law

Bernards v. Summit Real Estate Management, Inc., 229 Or. App. 357, 213 P.3d 1 ( Ct. App. 2009) involves a demand-refusal derivative suit by a member of two member-managed Oregon LLCs.  Each LLC owns an apartment complex that is managed by Summit Real Estate Management, Inc. (apparently unrelated to any of the members).  After Summit and one of its officers embezzled substantial sums from each LLC, Bernards demanded that each LLC sue them.  When other members refused “without explanation,” Bernards filed a derivative suit against Summit and its officer.  Later, Bernards joining the other members, alleging that breach of both contract and fiduciary duties.  213 P.2d at 360-362.

Section 63.801(b) of the Oregon LLC Act allows derivative suits on a showing of demand futility, but allows the operating agreement to change that rule.  Section 5.4(d) of the operating agreement of each LLC required unanimous member consent for a derivative suit.  213 P.2d at 360-61 & 366.  The Court rejected the argument that Section 5.4:

Section 5.4(d) cannot carry the freight with which defendants would load it.  There is no logical connection between the premise that the consent of every member is a contractual prerequisite for legal action, and the conclusion that every member has the unfettered authority to withhold consent.  That is particularly true in light of the well-settled rule that the parties to a contract are bound by a requirement of good faith and fair dealing.  Even more to the point, another provision of the operating agreement, Section 5.10 (as noted above), provides that a member can be held liable for action or inaction taken in bad faith, “gross negligence, fraud, or willful or wanton misconduct.”  The operating agreements, then, confirm rather than contradict the proposition that, although every member’s consent is required before another member may take legal action, that consent cannot be withheld except for a valid business reason.

Id. at 366-67 (emphasis added)(citations omitted).

As indicated by the court, Section 5.10 of the operating agreement provided that members were not liable

… for honest mistakes of judgment or for action or inaction taken in good faith for a purpose reasonably believed to be in the best interest of the Company; provided that such mistake, action, or inaction does not constitute gross negligence, fraud, or willful or wanton misconduct.

Id.at 364 ( emphasis added) (internal quotations omitted).  The Court clearly saw good faith as that required of a fiduciary, rather than the contractual obligation of good faith and fair dealing. 

Although the Court did not discuss this, Section 63.160 of the Oregon LLC Act limits the use of operating agreements to eliminate member (and manager) liability of damages, and uses language similar to that of Section 102(b)(7) of the Delaware General Corporation Law to do so: 

However, no such provision shall eliminate or limit the liability … for … 

1. Any breach of the member’s or manager’s duty of loyalty to the limited liability company or its members;
2. Acts or omissions not in good faith which involve intentional misconduct or a knowing violation of law;
3.  Any unlawful distribution …; or
4.   Any transaction from which the member or manager derives an improper personal benefit.

Section 63.160.  Section 63.160(2) differs from DGCL Section 102(b)(7)(ii)

acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law

(emphasis added).  Arguably, the omission in the Oregon statute of the word “or” limits the scope of “good faith.”  That said, the Oregon statute also prohibits elimination of liability for breaches of the duty of loyalty.  If it was not already clear that acts not in good faith breach the duty of loyalty, the Delaware Supreme Court has now settled that question as a matter of Delaware law (In re Walt Disney Litigation and Stone v. Ritter).

In any event, Section 5.10 of the operating agreement in Bernards arguably conditions the waiver of liability to acts taken in “good faith.”  Thus, the exclusion of “gross negligence, fraud, or willful or wanton misconduct”  applies only to acts taken in good faith.

The problem with complaint was that it did not plead any specific facts indicating misconduct by the members in rejecting the demand.  The court rejected that argument that the misconduct by Summit and its officer was clear that a failure to sue them could only be explained by misconduct.  213 P.3d at 267-70.

Gary Rosin