California limited liability company disputes | Courtroom war stories and lessons learned

Courts Split Over Application of Penal Code to Claims of LLC Misappropriation

Almost one year ago, in Switzer v. Wood, California’s Fifth Appellate District held that an LLC manager or member participating in the theft of the LLC’s property could face liability under Penal Code section 496 — a statute designed to address receipt of stolen property — including an award of treble damages and attorney fees.  The LLC Jungle covered that opinion in an earlier post: Can the Criminal Law Concept of “Receiving Stolen Property” Apply to LLC Disputes?

But in a recently published opinion — Siry Investment, L.P. v. Farkhondehpour — California’s Second Appellate District has taken the opposite side of the debate, holding that Penal Code penalties do not apply to claims of entity misappropriation.

Now we have a classic “split of authority” that will likely be resolved by the California Supreme Court.  Here is a breakdown:

Penal Code Section 496 and LLC Disputes

Penal Code section 496(a) provides for criminal punishment for “Every person who buys or receives any property that has been stolen or that has been obtained in any manner constituting theft or extortion, knowing the property to be so stolen or obtained, or who conceals, sells, withholds, or aids in concealing, selling, or withholding any property from the owner, knowing the the property to be so stolen or obtained[.]”

Penal Code section 496(c) then provides: “Any person who has been injured by a violation of subdivision (a) … may bring an action for three times the amount of actual damages, if any, sustained by the plaintiff, costs of suit, and reasonable attorney’s fees.”

LLC and partnership cases regularly feature claims of misappropriation of entity assets.  But Penal Code section 496 hadn’t really been applied in that context — that is, until Switzer v. Wood came along.

Switzer v. Wood: Penal Code Applies

In Switzer v. Wood, the Fifth Appellate District held that Penal Code section 496 applied to claims of misappropriation of LLC assets.

The court held that a “criminal conviction is not a prerequisite” and that “[a]ll that is required for civil liability to attach under section 496(c), including entitlement to treble damages, is that a ‘violation’ of subdivision (a) or (b) of section 496 is found to have occurred. … A violation may be found to have occurred if the person engaged in the conduct described in the statute.”

The court found no reason to deviate from the plain meaning of the statutory language, stating: “The wording of the statute makes no exception for cases involving preexisting business relationships.”  As such, under Switzer, Penal Code section 496 applies to any type of theft — including misappropriation of entity assets in breach of fiduciary duties.

Siry Investment, L.P. v. Farkhondehpour: Penal Code Doesn’t Apply

In the recently-published opinion Siry Investment, L.P. v. Farkhondehpour, the Second Appellate District took the opposite view, stating “we respectfully part ways with Switzer v. Wood….”

Addressing typical claims featuring allegations that entity income was fraudulently diverted into one of the stakeholder’s separate entities, the Court of Appeal held that Penal Code section 496 did not apply.

The court acknowledged that the Switzer opinion was based on “a literal reading of the Penal Code” under which section 496 would apply to any situation involving the receipt of property “that has been obtained in any manner constituting “theft,” which in turn is broadly defined to include fraudulent misappropriation of property.  However, the court ruled that it would chart “a different path” here.

The court drew a distinction between “receiving stolen property” (which it held Penal Code section 496 was intended to remedy) and “other types of theft” involving fraud, misrepresentation, or breach of fiduciary duty.  The court held:

we conclude that Penal Code section 496’s language sweeps more broadly than its intent and hold that it does not provide the remedy of treble damages for torts not involving stolen property.

The court gave several reasons for its decision.

First, the law of torts already provides adequate remedies for other forms of theft involving fraud, misrepresentation, and breach of fiduciary duty — i.e., damages under Civil Code sections 3333 (damages for all harm proximately caused by obligations not arising from contract) and 3336 (damages for wrongful conversion).  Applying Penal Code remedies to those claims “would all but eclipse these traditional damages remedies.”

Second, “reading Penal Code section 496 to apply in theft-related tort cases would effectively repeal the punitive damages statutes.”  Normally, to obtain more than compensatory damages in a business tort case, a plaintiff would need to satisfy the strict standards applicable to punitive damage awards: proving, by “clear and convincing evidence” that the defendant was guilty of “oppression, fraud, or malice.”  In enacting Penal Code section 496, the Legislature “has not shouted, stated, or even whispered anything about Penal Code section 496 effecting such a ‘significant change’ to the universe of tort remedies.”  Instead, the Legislature had a far narrower goal: “to dry up the market for stolen goods.”

Last, the court observed that because Penal Code section 496 authorizes an award of attorney fees along with treble damages, it would authorize fee shifting “in nearly every tort case involving fraud, misrepresentation, or breach of fiduciary duty, thereby creating a gaping exception to the general rule against such fee shifting.”

What’s Next?

Until additional authority is published, trial courts within the Fifth District will likely follow Switzer, trial courts within the Second District will likely follow Siry Investment, and trial courts elsewhere will choose which approach to follow.

Splits in authority like this are usually resolved by the California Supreme Court in time.  We will keep you posted.

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