LLCs, Direct vs. Derivative Claims, and Special Litigation Committees: A Lively Debate
June 20, 2022
The current issue of The Business Lawyer, a quarterly publication of the ABA’s Business Law Section that rightly bills itself as “the premier business law journal in the country,” features a pair of dueling articles of great interest to scholars, practitioners, and other students of the limited liability company. The articles’ authors, whom I’ve had the good fortune getting to know at annual meetings of the LLC Institute and who have guest posted on this blog (here and here) and spoke on my podcast (here), are among the leading authorities in the country on closely held business entities and, in particular, unincorporated entities including partnerships and LLCs.
I’m speaking of Donald J. Weidner (pictured left), Dean Emeritus and Alumni Centennial Professor at Florida State University College of Law, and Daniel S. Kleinberger (pictured right), Emeritus Professor of Law at Mitchell Hamline School of Law.
Among his many accomplishments outside academia, Dean Weidner is co-author of The Revised Uniform Partnership Act published by Thomson Reuters, was the Reporter for the Revised Uniform Partnership Act (1994), and has written numerous articles on partnerships, limited liability companies, and financial accounting (SSRN author page here).
Professor Kleinberger’s extra-curricular contributions are no less impressive, including co-author of a leading treatise on LLCs published by Warren Gorham & Lamont, Co-Reporter and Principal drafter of statutory text and Official Comments to the Revised Uniform Limited Liability Company Act (2006), and author of a host of articles in law reviews and journals (SSRN author page here).
As any long-time reader of this blog knows, and as I wrote not long ago, one of the more common issues litigated at the outset of business divorce litigation involving LLCs as well as close corporations are motions to dismiss a minority member’s direct claims against managers that should have been brought derivatively under the prevailing Tooley test for direct versus derivative claims. The two articles by Dean Weidner and Professor Kleinberger offer a spirited point and counter-point debate between two schools of thought concerning the ability of LLC members to pursue and obtain effective remedies for misconduct claims against LLC managers, either as direct or derivative claims, and the ability (or not) of conflicted LLC managers to gain control of those claims through appointment of a surrogate Special Litigation Committee (SLC) once the claims are characterized either as direct (no SLC) or derivative (yes SLC).
Dean Weidner’s Article
Dean Weidner’s article, entitled, The Unfortunate Role of Special Litigation Committees in LLCs (available here), offers sharp criticism of what he labels “the imposition of the complexities of derivative litigation” derived from public corporation derivative law “upon closely held LLCs [that] imposes significant transaction costs that cannot be spread and that typically serve no purpose.”
Among other critiques, recognizing that the most common claims for manager misconduct lend themselves to characterization as derivative rather than direct, Dean Weidner targets what he characterizes as the 2006 Revised Uniform LLC Act’s ill-advised departure from the partnership precepts of its 1996 progenitor by its importation of the direct-derivative dichotomy and provision for LLC managers to appoint Special Litigation Committees (SLCs) “to decide how to dispose of derivative claims.” This “dramatic reversal” from the original 1996 Act — which, he argues, created a set of default rules appropriately geared to “small entrepreneurs” giving “easy access” to member remedies” — in favor of RULLCA’s adoption of the “large corporation model of derivative litigation,” has “severely restricted the rights of members to bring a direct action, while locking in their economic interests.”
His solution? Legislatures should amend their LLC statutes to permit LLCs “to ‘opt in’ to the machinery of derivative litigation, rather than force them to ‘opt out’ of it,” or even to exempt closely held LLCs from the strictures of derivative litigation. If legislatures balk at those solutions, he writes, courts should move away from the “more lenient standard of review” of SLC determinations, of which the New York Court of Appeals’ ruling in Auerbach v Bennett (1979) is paradigmatic, “essentially treating the SLC as exercising the business judgment of the full board and defer[ring] to it.” Instead, he suggests, courts should follow Delaware’s lead in Zapata Corp. v Maldonado (Del. Sup. Ct. 1981) and In re Oracle Corp. Derivative Litigation (Del Ch. 2003) by imposing a stricter, less deferential standard of review for SLC determinations and a “more demanding requirement for SLC independence that requires neutrality with respect to a wide variety of personal and social factors in addition to economic factors.”
Professor Kleinberger’s Response
Professor Kleinberger’s counter-point article, entitled The Direct-Derivative Distinction, the Special Litigation Committee, and the Uniform Act: A Response to Professor Weidner (available here), mounts a vigorous rebuttal to what he labels the “two key premises” underlying Dean Weidner’s arguments. The first is that RULLCA “deserted its appropriate target group,” a criticism that Professor Kleinberger writes, “misapprehends the evolution of the Uniform Limited Liability Company Acts.” The second is that RULLCA “destroyed a member’s easy access to judicial remedies,” which Professor Kleinberger contends both undervalues the remedial measures instituted by RULCCA concerning minority members, including the addition of a judicial dissolution remedy for oppressive majority conduct, and wrongly posits that courts should put a heavier thumb on the aggrieved minority member’s side of the scale. As Professor Kleinberger puts it, “some plaintiffs should win, and others definitely should not.”
After challenging the two assigned premises, Professor Kleinberger’s article goes on to challenge what he classifies as Dean Weidner’s four principal arguments:
- First, Professor Kleinberger contends a number of “flaws” in Dean Weidner’s “attack of the direct-derivative distinction,” including his disagreement with Dean Weidner’s arguments that the distinction improperly “channels claims for breach of the operating agreement” into the derivative category and that the LLC’s status “as an entity separate from its owners is irrelevant to the existence vel non of the direct-derivative distinction.”
- Second, Professor Kleinberger disputes what he describes as Dean Weidner’s “attack on the SLCs by tying the SLC to [the Uniform Law Commission’s] calamitous recognition of the direct-derivative distinction” in RULLCA (2006). Writes Professor Kleinberger, “the SLC reflects and results from basic governance principles applicable to any business entity that is delineated as a legal person separate from its owners.”
- Third, Professor Kleinberger defends RULLCA’s endorsement of the standard of review of SLC determinations articulated in Auerbach over the “minority view” articulated in Zapata, describing Delaware jurisprudence on the issue as “notoriously unstable and requir[ing] continual study,” and doubting the persuasiveness of empirical data cited by Dean Weidner suggesting that SLCs are tilted in favor of management.
- Fourth, Professor Kleinberger argues that RULLCA § 805 and its comments do not deserve criticism as setting a lax standard for the independence and disinterestedness of members of the SLC, and disagreeing that “conflicted decisionmakers should be irrefutably presumed to be incapable of appointing independent and disinterested surrogates, especially when the conflicted decisionmakers know that a court will closely scrutinize the appointees for independence and disinterestedness.”
Let me be the first to admit that my above summaries barely scratch the surface of the learned professors’ carefully sculpted arguments and the supporting materials cited for each. In this relatively short post I cannot possibly do justice to their scholarship and for that I apologize to Dean Weidner and Professor Kleinberger. To my readers, all I can say is, read the articles, you will learn a great deal.
The View From the Trenches
I suppose my own views on the subject of LLCs, the direct-derivative distinction and SLCs are heavily influenced by decades of litigation experience handling business divorce cases mostly involving member-managed, owner-operated, and family-owned firms, as opposed to large, capital-intensive, manager-managed LLCs with both active owners and passive investors (the latter type more likely to be a Delaware LLC litigating in Delaware Chancery Court). It’s what I sometimes refer to as the “Two Worlds of LLCs” which, for better or worse, co-exist under the same set of statutory default rules.
The large, highly capitalized LLCs, more closely resembling the corporate model with different classes of ownership and centralized management, also tend to have better access to sophisticated legal advice conducive to the making of well-tailored, fully negotiated operating agreements that can vary the default rules to suit the needs and desires of the business and its equity holders, including carefully crafted provisions for dispute resolution. Not so much in the world of small LLCs more closely resembling the partnership model in their management and less likely to benefit from a well-crafted operating agreement and therefore likely more dependent on statutory default rules. Moreover, I hardly ever see the appointment of an SLC in such cases.
In other words, as I see it, Dean Weidner’s views speak more pragmatically to the world of the smaller LLC whereas Professor Kleinberger’s views speak more pragmatically to the world of the larger LLC. Is there some overlap in these two worlds? Of course.
In any event, to the extent we have judges who understand the differences between these two worlds and the ramifications of those differences, I, for one, am not terribly concerned with the ability of our courts to reach just outcomes in cases involving disputes between members of LLCs of every stripe and size.