Sham LLC Election Leads to Standing Defect and Vacation of $20 Million Judgment
The LLC Jungle has frequently posted on a common battleground issue in LLC litigation: authority to act for the LLC. (See here for a few posts on this issue.)
In a recent opinion published by California’s Fourth Appellate District — NNN Capital Fund I, LLC v. Mikles (order for publication here) — the “purported representatives” of an LLC filed a lawsuit in the name of the LLC against its former manager and eventually obtained a $20 million arbitration award confirmed as a judgment. But on appeal, the court held that the “purported representatives” apparently lacked authority, and vacated the judgment.
Facts: disgruntled LLC members conduct sham election appointing “liquidating trustees” for the LLC
NNN Capital Fund I, LLC (“Cap Fund”) was formed in 2008 to provide short-term financing to affiliated borrowers for real estate syndications. Cap Fund’s manager was NNN Realty Investors, LLC (“NNNRI”). By 2011, in the wake of the Great Recession, several of Cap Fund’s loans (which were unsecured) were in distress and nonperforming.
Also in 2011, Todd Mikles was appointed president of NNNRI. Several of Cap Fund’s members told Mikles they wanted to wind up Cap Fund. Mikles proposed that his separate LLC (Sovereign Strategic Mortgage Fund, LLC — “SSMF”) would purchase the distressed loans at a discount and issue new notes to Cap Fund. Disclosures regarding the transaction were made, and Cap Fund’s members approved the transaction by a 77% vote. As part of the approved transaction, NNNRI resigned as Cap Fund’s manager, and a new manager (SCMG Liquidation, LLC — “SCMG”) was appointed.
In December 2015, Cap Fund’s manager SCMG dissolved Cap Fund pursuant to the dissolution provisions of the company’s operating agreement and distributed all remaining assets to the members.
Cap Fund members Tyrone Wynfield and John Weiss “were apparently unhappy with the company’s management” and dissolution, and they purported to conduct a vote of Cap Fund’s members to appoint themselves as “liquidating trustees.”
Under Cap Fund’s operating agreement, not all members were qualified to vote. Specifically, transferees were not allowed to vote unless they were admitted as members. The record showed that several of those who voted on Wynfield’s and Weiss’ proposal had not been admitted as members and were not qualified to vote. Nonetheless, Wynfield and Weiss counted those votes in the totals and declared the vote successful.
Wynfield, purporting to be Cap Fund’s “liquidating trustee” filed a lawsuit in Cap Fund’s name against Defendants Mikles, SSMF, and SCMG.
Trial court and arbitration proceedings: $20 million arbitration award confirmed as a judgment
The trial court ordered the case to arbitration pursuant to provisions in the operating agreement. Defendants filed a motion to dismiss the arbitration proceedings based in part on lack of standing. The arbitrator did not hold a hearing on the motion to dismiss and allowed the arbitration to proceed.
After the arbitration, the arbitrator issued a final award for over $20 million. As part of the award, the arbitrator ruled that Wynfield and Mary Jo Saul (the purported new liquidating trustee after Wynfield’s death) had standing to bring the action in Cap Fund’s name.
The trial court confirmed the award as a judgment. Defendants appealed.
Court of Appeal: judgment vacated; standing doubtful due to invalid election
The Court of Appeal held that Wynfield and Saul “may lack standing to sue on behalf of Cap Fund.”
The court first observed that standing defects can be raised at any time — even on appeal. “A plaintiff’s lack of standing is treated as a ‘jurisdictional’ defect and is not waived by a defendant’s failure to raise it by demurrer or answer.”
Addressing the election purportedly designating Wynfield as the LLC’s “liquidating trustee,” the court noted that Wynfield and Saul failed to counter the Defendants’ argument that the election was invalid because the decisive votes were cast by members who were not qualified to vote under the terms of the operating agreement. The court also pointed out that the operating agreement “does not authorize any individual member to file an action on the company’s behalf, but instead specifically vests this authority in the company’s manager” — and the manager was SCMG, not Wynfield.
The court cited well-known “derivative action” case law, reciting that claims based on injury or damage to a business entity belong to the entity, not its owners. (It is unclear from the opinion why Wynfield apparently did not pursue a derivative claim from the beginning instead of filing the action in the LLC’s name.)
The court acknowledged the very limited circumstances under which an arbitration award can be challenged, but held that the potential defect in standing created a jurisdictional problem that warranted relief.
The Court of Appeal vacated the judgment and the trial court’s interim orders compelling arbitration and confirming the arbitration award, and directed the trial court to make factual findings regarding whether Wynfield and/or Saul had standing to bring the action on the LLC’s behalf. If standing cannot be established on remand, the Court of Appeal held, the trial court “shall dismiss the action.”
Lesson
Under the NNN Capital opinion, if an action is filed on behalf of an LLC by someone lacking authority to act for the LLC under the terms of its operating agreement, the case might have a jurisdictionally fatal standing defect.