The “Business Judgment Rule” Applies in LLCs Too
Corporate directors have long relied on the “business judgment rule,” under which their decisions are presumed to have been made “on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. Courts defer to board judgments that can be attributed to any rational business purpose.”
In an opinion recently published by California’s Second Appellate District — Tuli v. Specialty Surgical Center of Thousand Oaks, LLC — the Court confirmed that the business judgment rule (as described above) applies in LLCs too. Tuli is a wild case about a rogue LLC member’s unsuccessful efforts to sabotage the business to extract a higher buyout, followed by the LLC’s exercise of a “Terminating Event” provision in the Operating Agreement resulting in the ouster of the rogue LLC member for $0.
Facts: inactive LLC member goes rogue, threatens the LLC and its staff with sham claims in an attempt to leverage a higher buyout; LLC invokes Operating Agreement’s nuclear “Terminating Event” provision
The LLC’s surgery center business and Tuli’s role
As described in the beginning of the Court’s opinion: “From 1997 to 2005, Tuli and defendant Dr. Andrew Brooks worked together to create a group of surgery centers. Tuli was an experienced and sophisticated entrepreneur whose ventures had won him millions of dollars. … Brooks was a surgeon, a veteran of some 15,000 operations.” The centers charged fees that they returned proportionally to their owners, who were mainly surgeons, but also included Tuli. By 2005, the surgery centers numbered five in the Los Angeles area and one under development in Thousand Oaks.
The case involved the surgery center in Thousand Oaks owned by Specialty Surgical Center of Thousand Oaks, LLC (“Specialty”), in which Tuli and Brooks were the original equal owners. In 2005, a Tennessee company called Symbion paid Tuli and Brooks over $16 million each to buy their interests in all of the surgery centers except Specialty, and to buy a small interest in Specialty that could grow over time with the exercise of options.
Specialty did not own physical assets and did not accumulate retained earnings. Every month, it distributed to members all of the revenue it had collected from surgeries, exhausting its cash on hand. Specialty’s “only real asset” was its members’ prospective entitlement to a share of the revenues from future surgeries.
After some surgeons joined and Symbion exercised its first option, by 2009 Tuli and Brooks each owned an 11.3% membership interest in Specialty.
The Operating Agreement’s nuclear “Terminating Event” provision
Specialty’s Operating Agreement featured a “Terminating Event” provision, which was “designed to ensure ‘bad actors’ within the company did not damage it.” Tuli and Brooks negotiated the Terminating Event provision extensively, and it arose after some prior experiences with “bad actors” and member surgeons who had proven to be “very difficult” and “challenging.” Symbion also agreed that the Terminating Event provision should be included.
Under the Operating Agreement, a “Terminating Event” would occur when a “Member has disrupted the affairs of the Company or has acted adversely to the best interests of the Company, as determined in the reasonable discretion of the Governing Board, and fails to cure such conduct within thirty (30) days after receipt of a written notice[.]” If uncured, the member would be ousted from the LLC and the member’s interest would be fully redeemed at a formula “that normally would set the price at zero.” Anyone who had received a net return in excess of their original investment would have a “negative” capital account and therefore a redemption price of zero. The Governing Board consisted of six surgeons, including Brooks. Tuli was not on the Board.
(Note the Terminating Event provision is different, and more drastic, than the statutory remedy of “dissociation,” in which the dissociated member loses their voting interest but retains their economic interest.)
As stated by the court: “This provision had real teeth.”
Tuli goes rogue; LLC ousts him
Specialty opened successfully. Tuli ultimately received a net benefit from Specialty of $3,034,512 on his initial investment of $100,000 — more than a 30x return.
Friction arose after “Tuli wandered off the job — permanently.” After working at the office almost daily from 2005 to 2007, Tuli “completely abandoned Specialty” and, based on witness testimony, he was apparently focusing his attention on starting a software company. While the surgeons continued performing operations and bringing in revenue, “Tuli’s productive effort was zero, but he continued to get 11.3% of the take.”
Specialty made a buyout offer to Tuli, but Tuli rejected it as “lowball.”
On February 13, 2014, Tuli directed his attorney to send a threatening letter. The letter was over the top in chest-thumping aggression. It was sent to 23 people connected in various ways to Specialty, including not just the surgeon LLC members, but also other surgeons that Specialty was trying to recruit, and even employees of Specialty. The letter threatened that its recipients would be exposed to individual, and potential criminal, liability if they did not “cease and desist” from “statutory violations” and “bad faith” dilution efforts. The letter understandably sparked fear among Specialty’s membership and staff.
Specialty’s Governing Board exercised the “Terminating Event” provision and sent a letter notifying Tuli of the same. Tuli refused to attempt any cure. Specialty then ousted Tuli from the LLC without compensation. Tuli sued.
Trial court: most claims dismissed on summary judgment based on the business judgment rule; last claim for restitution/unjust enrichment rejected at trial
The trial court disposed of most of Tuli’s case (breach of fiduciary duty and related claims) on summary judgment based primarily on the business judgment rule. Tuli’s remaining claim for restitution / unjust enrichment went to a 10-day court trial and was rejected.
Tuli appealed.
Court of Appeal: affirmed; business judgment rule applies with full force, and the member’s ouster was not a “forfeiture”
The Court of Appeal affirmed the trial court’s rulings.
The court confirmed that the business judgment rule applied to the LLC’s Governing Board’s decision to invoke the Terminating Event provision in the Operating Agreement.
The court rejected Tuli’s argument that the business judgment rule did not apply due to a conflict of interest. Tuli argued that the Board was conflicted because they would gain a proportional ownership advantage with Tuli’s ejection. But the court ruled that the conflict of interest exception to the business judgment rule “arises when the interests of the individual decisionmakers diverge from the interest of the enterprise as a whole.” Here, the court found, “Specialty’s decisionmakers worked in the best interests of the company as a whole.” There was a clear “benefit” to the company from terminating Tuli after his threatening and harmful behavior.
The court also rejected Tuli’s argument that the business judgment rule did not apply because the Governing Board acted in bad faith by expressing frustration that he was earning high profits without bringing in business or providing services and by offering to buy out his interest. The court held that none of that displayed bad faith. The court found: “Nor is it corporate bad faith for company decisionmakers to be frustrated with a corporate team member who is earning ‘high profits,’ as Tuli phrased it, for doing nothing.”
Last, the court affirmed the trial court’s rejection at trial of Tuli’s claim for restitution / unjust enrichment. Tuli argued that his loss of shares was an unlawful “forfeiture,” which turned on whether Tuli’s loss bore a reasonable relationship to the harm the parties anticipated when they originally signed the Operating Agreement with its Terminating Event provision.
The court found the relationship was reasonable, noting that the “anticipated range of harm” at the time of contracting was $60 million — the sum Symbion invested in the series of surgery centers. Specialty members testified that the medical profession runs on trust, “and public accusations that doctors in a particular practice are felons committing crimes could doom the whole business, especially if the charge is being made by a presumably knowledgeable insider.”
Tuli, in contrast,
put nothing into Specialty that he did not recover. To the contrary, he gained an eye-popping 30-to-1 return on his $100,000 investment. He lost only the opportunity to make even more: a prospective right to share in future revenues generated entirely by others. Tuli did nothing to entitle himself equitably to a share of their labors. In fact, for years Tuli had done nothing. And then he effectively tried to tank the company.
The court also noted that Tuli was “an experienced and sophisticated business executive” who was represented by counsel and negotiated specifically over the Terminating Event provision. The court also pointed to the actual harm to Specialty’s business that Tuli’s letter had caused.
Lesson
Under the Tuli opinion, the business judgment rule applies to LLC managers and decision-makers. The business judgment rule might constitute a complete defense to claims alleging wrongdoing, even in the context of the exercise of extreme remedies in the Operating Agreement, depending on the specifics of the conduct at hand.