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June 2012

June 2012
From the Colorado Bar Association Business Law Section
Ed Naylor, Editor
For the printable PDF version of this newsletter, click here.
In this issue...
Will Your LLC’s Anti-Assignment Clause Withstand Scrutiny?
By Trevor A. Crow, Dufford & Brown, P.C.

In Condo v. Conners, 266 P.3d 1110 (Colo. 2011) the Colorado Supreme Court addressed the issue of whether the assignment of voting rights and rights to receive distributions of an LLC interest was ineffective because it violated the anti-assignment clause of the LLC’s operating agreement. Although in this case the Court ruled the assignor’s prohibited assignment was void, drafters are on notice they must make very clear the intentions of the parties for assignment restrictions and the consequences of violating the restrictions.

Background

Thomas Banner attempted to assign a portion of his membership interest in the Hut Group LLC to his former wife Elizabeth Condo. Banner was a 1/3 member of the Hut Group. As part of their divorce, Banner drafted an assignment of his right to receive monetary distributions and his voting interest in the Hut Group to Condo. This assignment referenced Article 10.1 of the Hut Group’s operating agreement that stated “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest in [the Hut Group] without the prior written approval of all the Members.” Accordingly, Banner sought the approval of the assignment from the other members of the Hut Group, Thomas Conners and George Roberts. Conners and Roberts refused to consent to the assignment.

In response, Banner drafted a different assignment that similarly assigned Banner’s right to receive distributions and transferred Banner’s voting interest to Condo. This second assignment agreement, however, did not reference the anti-assignment clause in the operating agreement. Banner and Condo executed this agreement without notice or approval from Conners or Roberts. When Conners and Roberts learned of the unapproved assignment, they contacted Banner and expressed their concern that it violated the operating agreement. Ultimately, after some negotiation, Banner sold his entire interest in the Hut Group to Conners and Roberts for $125,000.

Subsequently, Condo sued Conners and Roberts for tortious interference with contract and civil conspiracy. Her claims alleged that (1) she was validly assigned the right to receive distributions from the Hut Group and (2) the defendants had conspired with Banner in bad faith to buy his interest below market value, which destroyed the value of her right to receive Banner’s monetary distributions.

Issue for the Supreme Court

The Colorado Supreme Court decided, among other issues, whether Colorado courts should construe contractual anti-assignment clauses under the “classical approach” or the “modern approach.”

Classical Approach

Under the classical approach, courts interpret anti-assignment clauses as a restriction on the power of any member to assign an interest, and thus any nonconforming assignment has no legal effect.

Modern Approach

In contrast, the modern approach provides that, absent “magic words” stating that any nonconforming assignment is “void” or “invalid,” an anti-assignment clause merely imposes a contractual duty upon each member to refrain from assigning any contractual interest. Thus, members retain the power to willfully breach the duty, allowing the transfer to be legally effective, and leaving the non-assigning parties with the remedy of bringing a breach of contract action against the party that wrongfully assigned the interest.

Court’s Holding

The Court applied the classical approach and held that the Operating Agreement in this case rendered Banner powerless to assign any portion of his membership interest without the consent of all other members. Although the Court applied the classical approach, the Court also noted that the opinion does not stand for a blanket rejection of the modern approach to assignments. Rather, the Court’s opinion narrowly held that the modern approach did not apply under the specific facts in this particular case. As support, the Court cited the Restatement (Second) of Contracts § 322(2)(a), which generally provides that the modern approach is necessarily dependent on the circumstances and the express terms of the operating agreement. In other words, the Court held that whether the classical approach or the modern approach should be applied depends upon the express or presumed intentions of the parties, which must be ascertained from the entire contract and the surrounding circumstances.

Recommendation

The Court’s willingness to apply the modern approach or the classical approach depending on the circumstances is yet another example of the importance of careful drafting. If the intention is to make any non-conforming assignment void, the drafter should include the magic words “any nonconforming assignment is void and invalid” in the operating agreement.

The Business Judgment Rule
The First Line of Defense

By Jennifer Lynn Peters, Esq., Otis, Coan & Peters, LLC

As the economy plunged and debtors looked for ways to avoid paying their obligations to lenders across the country, the courts saw an explosion of cases alleging breach of fiduciary duty, breach of the duty of good faith and fair dealing, and other “mismanagement” by directors, officers, and/or managers of financial institutions and other entities. A growing number of such claims by shareholders and others affected by the closure of a financial institution are also being filed. So what is a director, officer, or manager to do when faced with such claims? Often, the legal doctrine known as the Business Judgment Rule can provide the best, most effective, and first line of defense.

Legal Presumption

The Business Judgment Rule is a legal presumption providing that so long as a director or officer of a company is disinterested, has acted on an informed basis and in good faith, and with an honest belief that the action taken was in the best interest of the company, the decisions made are not subject to challenge. See Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163 (Del. 1995). The burden is initially on the plaintiff challenging the decision or action to rebut the presumption. If they fail to do so, courts will not second-guess the decision made by corporate officers and directors. Id.

The Colorado Supreme Court described the Business Judgment Rule as the “business judgment doctrine bars judicial inquiry into the actions of [a manager] taken in good faith and in the exercise of honest judgment in furtherance of a lawful and legitimate corporate purpose.” In re Hirsch, 984 P.2d 629 (Colo. 1999). Even as far back as 1908, Colorado followed the general principle that a court should not interfere with the internal affairs and management of a corporation. See Horst v. Traudt, 43 Colo. 445, 448, 96 P. 259, 260 (1908). Consequently, when the Business Judgment Rule applies, decisions and actions of disinterested directors and officers will not be disturbed or questioned by a court if they can be attributed to “any rational business purpose.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled on other grounds Brehm v. Eisner, 746 A.2d 244 (Del. 2000). The rule is meant to preclude a court from imposing its own judgment on the business and affairs of a company. As stated in Hirsch, “courts are ‘ill equipped and infrequently called on to evaluate what are and must be essentially business judgments.’” 984 P.2d at 151, citing Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 1001 (1979).

Rebutting the Presumption

Colorado, like most states, looks to Delaware for guidance on issues of corporate law. Under Delaware law, and in most states, the Business Judgment Rule means that a court will presume that management acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company so long as the officer, director, or manager being sued can show she was disinterested in the transaction and was reasonably informed. See McMullin v. Beran, 765 A.2d 910, 917 (Del. 2000). Thus, under Delaware law and generally, to rebut the presumption under the Business Judgment Rule, the claimant must show a breach of one of the duties often referred to as the “fiduciary triad”—care, good faith, or loyalty. As discussed in the subsequent paragraph, the Business Judgment Rule may also not apply if a showing is made that the officer, director, or manager was not independent or disinterested in the questioned transaction. See Aronson, 473 A.2d at 812. This typically involves a review of the financial interests of the officer, director, or manager whose actions are being challenged to show she had a financial interest in the underlying transaction. Another, but far more difficult, option to overcome the Business Judgment Rule is to show that the decision being challenged was not made in good faith. Id.

The third means of challenging the presumption created by the Business Judgment Rule is to show that the decision or action was not “informed” or made with “due care.” Id. This typically requires evidence that there was not a reasonable effort to ascertain and consider relevant information prior to the decision being made or action being taken. The question is not whether every fact was known and considered; but rather, whether all material facts that were reasonably available were considered. See Brehm v. Eisner, 746 A.2d 244, 259 (Del. 2000). Whether this informational component is satisfied is measured by concepts of gross negligence. Id. If the presumption is rebutted by one of these showings, the burden shifts to the officer, director, or manager to prove that the challenged action or transaction was entirely fair to the corporation and its shareholders. See Nixon v. Blackwell, 626 A.2d 1366, 1376 (Del. 1993). Rebutting the presumption does not create per se liability. Rather, it simply shifts the burden to the officer, director, or manager to prove that the challenged action was fair in all respects. See Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983). Proving an action was entirely fair usually involves a showing of full and fair disclosure.

Personal Interest

It is important to keep in mind that the Business Judgment Rule does not apply where a director, officer, or manager being sued is shown to have an interest, usually a financial stake of some sort, in the transaction in dispute. See Kim v. Grover C. Coors Trust, 179 P.3d 86, 95 (Colo.App. 2007). A director, officer, or manager is not “disinterested” if they either stand on both sides of a transaction or expect to derive a personal financial benefit from it. See Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971). In other words, if the director, officer, or manager is engaged in self-dealing, she cannot claim the benefit of the Business Judgment Rule. However, self-interest alone is not sufficient to disqualify an officer, director, or manager from using the Business Judgment Rule as a defense. There must be some personal benefit derived from the officer, director or manager’s interest in the transaction or a lack of disclosure. See Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 363 (Del. 1993).

Additionally, the self-interest of one board member will not disqualify the entire board from taking advantage of the Business Judgment Rule. Id. Further, merely alleging complete dominion or control over business decisions is also not enough to defeat the Business Judgment Rule. See Cinerama, supra, at 1168. There must also be evidence that there was disloyalty to the organization, that there was a failure to disclose the interest in the transaction which a disinterested board member would have found significant in evaluating the transaction, or that the benefit received was material or significant, rather than minimal, and that the interested director’s involvement tainted the overall process. Id. The relevant determination for purposes of deciding whether the Business Judgment Rule will apply to defeat claims of mismanagement even where a director has an interest in the transaction is whether the interest was sufficient to create a reasonable likelihood that it actually affected the director’s actions to the corporation’s detriment. Id. As the Delaware Supreme Court has recognized, in some circumstances the mere existence of a personal benefit may “when viewed in context, be found to be immaterial in fact to the exercise of a judgment motivated entirely to achieve the best result for the corporation.” Id.

If a director has a personal interest in a corporate transaction, then the statutory procedure for conflicts of interest will usually apply. Under this procedure, a conflict of interest transaction will be void unless there is full disclosure, with approval by disinterested directors or the shareholders, or the transaction is fair to the corporation.

No Action, No Presumption

The Business Judgment Rule is also not available as a defense where there is no action whatsoever taken by management. Where there is not a conscious decision not to act, the failure of a board or manager to act will render the Business Judgment Rule inapplicable. See Hill v. State Farm Mut. Auto. Ins. Co., 166 Cal.App. 4th 1438, 1476 (2008). This is because the prerequisite of acting with sufficient information is not present where the board or manager simply failed to act and did not specifically decide on a course of conduct that involved taking no action. Only where a specific decision not to act is made will the Business Judgment Rule apply to bar failure to act allegations.

Mere Bad Decision Does Not Create Liability

Under the Business Judgment Rule, the mere fact that, in hindsight, an officer, director, manager, or management group made a bad decision or a mistake is not sufficient to challenge that decision or allege breach of fiduciary duty or other mismanagement claims. Courts acknowledge that, while shareholders might disagree with a management decision and while it may be apparent in hindsight that the decision was wrong, the decision is not subject to attack when it was made in good faith by disinterested persons. As one court recognized, a plaintiff has a stringent, heavy task in defeating the Business Judgment Rule. Panter v. Marshall Field & Co., 646 F.2d 271, 297 (7th Cir. 1981). In the absence of fraud, bad faith, or interested-party transactions, the Business Judgment Rule can thus provide officers, directors, and managers a solid defense to claims of mismanagement.

May 2012 Meeting of the Working Group on Legal Opinions (ABA)
By Colleen R. Belak, CBA-Business Law Section alternate representative

The most recent meeting of the Working Group on Legal Opinions was held in New York on May 21–22. It was a gathering of some of the best legal opinion minds in the country.

The theme of this conference was having a good defense. The conference included sessions on legal opinions from a litigator’s perspective, risk management for opinion committees, qualifications and exceptions to remedies opinions in loan transactions, real estate opinions, and traps for the unwary in the legal opinion practice. Here are some good strategies for your legal opinion defensive playbook.

Best Defense for Opinion Litigation

The number of lawsuits and the amount of damages sought in legal opinion litigation have increased substantially. The risk of being sued over an opinion letter has little to do with the quality of the opinion or the lawyering and much to do with the quality of the client. The largest single factor for the increased severity of claims is the increased number of companies that are failing. A client that is a going concern is not very likely to sue; a failed company is much more likely to sue. One of the most popular claims being brought against lawyers is for aiding and abetting the company’s management, with allegations that such actions contributed to the failure of the company. Joint and several liability is typically imposed on claims of aiding and abetting. These lawsuits are often taken on contingency or partial contingency by lawyers who are not necessarily skilled in business law or legal opinion practice.

The best defense against these lawsuits is to be in a position to get out of the action early, before discovery or trial. The best way to accomplish that is to build certain defenses into the legal opinion, including specifically describing the scope of the opinion and the law firm’s representation of the client (for example, the law firm has not represented the client before and was retained only to issue the legal opinion on a particular transaction). A best practice is to approach legal opinions more like contracts and have everything you need within the four corners of the opinion so you have the best chance at getting the action dismissed on a motion to dismiss. To maximize the chances of getting out early, put the most important issues in the opinion itself (such as certain definitions, assumptions or exceptions, what law applies, etc.) and then incorporate by reference everything else you want to apply (such as customary practice, which is best done by referencing a particular document or standard). Support for this approach stems from the recent case of Fortress Credit Corp. v. Dechert, LLP, 89 A.D.3d 615, 934 N.Y.S.2d 119 (2011). In Dechert, the court reversed the trial court and limited the court’s review to the four corners of the opinion.

Should You Incorporate the Kitchen Sink?

This approach raises the question whether we are going back to the “kitchen sink” method of legal opinions. The conference attendees were not in favor of this all-inclusive approach. Rather, the general consensus was that there must be a balance, and lawyers must be deliberate in choosing what to include and what to incorporate by reference. Including the information in the opinion carries more certainty than incorporating it because a court may not consider documents that are incorporated by reference. Similarly, incorporation of a specific document may result in a higher likelihood of the court considering it than incorporation of principles that are scattered in numerous (or voluminous) materials.

May 2012 Meeting of the Joint Committee
on Statement of Commonly Accepted Opinion Practices

By Herrick K. Lidstone, Jr., CBA-Business Law Section Representative to the WGLO

While I was unable to attend the WGLO meeting in person, I did attend by telephone the meeting of the joint committee of the WGLO and the ABA’s Business Law Section Legal Opinions Committee which has been working since mid-2010 to draft a “statement of commonly identified opinion practices.” A third draft of the statement has been circulated to committee members, and is an effort to describe selected third-party legal opinion practices in use throughout the United States for closing opinions. The statement is being drawn from, and is intended to supplant (at least in part), the Guidelines for the Preparation of Legal Opinions (57 The Bus. L. (ABA) 875 (2002)) and Legal Opinion Principles (53 The Bus. L. (ABA) 831 (1998)), both prepared by the ABA Business Law Section Committee on Legal Opinions. This is a continuing effort for the WGLO and the ABA Business Law Section to provide national structure to customary practice for third party closing opinions issued in business transactions. [Read Article]

This initial statement is intended to address the least controversial issues, including matters such as:

(i)  Legal opinions are expressions of professional judgment and not guarantees;
(ii) The so-called “golden rule” of opinion giving;
(iii)  The laws covered by and excluded from coverage (unless expressly included) in legal opinions; and
(iv) What is a “market opinion” if such a concept exists and an acknowledgement that the benefit of the opinion to the recipient should warrant the time and expense to prepare the opinion.

In preparing the statement, the national attorneys involved are taking care to address each word carefully, changing language from the Guidelines and Principles where considered necessary to more clearly or accurately state the desired conclusions. Among other questions being addressed is whether to include Committee comments or footnotes to provide further explanation, or to allow the statement to stand on its own.

There is no timing for the completion of the initial statement or for the commencement of work on a statement involving more controversial issues. There may be a draft available for comment by interested parties within the next several months. When finalized, the initial statement will be presented to various sections of the Colorado Bar Association for consideration. As you may recall, both the CBA Business Law Section (November 2008) and the Real Estate Section (February 2009) have adopted the ABA’s Statement on the Role of Custom and Practice in the Preparation and Understanding of Third-Party Legal Opinions (63 The Bus. L. (ABA) 1277 (Aug. 2008)).

Business Law Section Activities
Securities Subsection Luncheons

Part 2: The JOBS Act: Private Placements and Related Issues—Thursday, July 19

Please join us for Part 2 of an overview of the recently enacted JOBS Act, which will primarily focus on the provisions relating to Regulation A+, Regulation D and Crowdfunding.

RSVP: Register online, call 303-860-1115 x727 or email lunches@cobar.org. Please note: You must be logged into the website in order to register for the program.

Financial Institutions Subsection
Monthly Luncheon Series

Regulation of Banking – Quantity, Nature, Impact—Wednesday, July 18

Banking, as the most regulated industry, is experiencing an explosion of new regulation. Populist influences push for more lending, but no risk, borrowers’ non-repayment without penalty, and better service despite new price controls are clashing with constrictive regulations. Don Childears, President and CEO of the Colorado Bankers Association, will explore the current and future impact of the new regulations on banking, competition and customers. Submitted for one general CLE credit. Click here for more information.

About the Monthly Luncheon Series: The Financial Institutions Subsection CLE Luncheon Series takes place in the CBA-CLE classroom on the third Wednesday of each month with a different topic for each program. Topics are announced approximately one month prior to the date of the program and registration is handled through the CBA-CLE office.

2012 Business Law Institute—October 18–19

To be held at the Four Seasons Hotel in Denver. Call 303-860-0608 or 800-860-2531 for more information.

CBA-CLE Information

2012 Legislative Update with Michael Valdez: Tales from Under the Golden Dome—Tuesday, July 10

CBA Director of Legislative Relations Michael Valdez will recap the 2012 regular and special legislative sessions. Michael’s presentation will cover CBA-sponsored legislation, uniform acts, and an overview of the state and judicial budget picture, as well as stories that will not be printed in any publication. In addition, learn about notable legislation that may impact your practice. Submitted for one general CLE credit. Click here for more information.

Abuse of Power in Arizona—Wednesday, July 18
Hear from the Colorado Attorneys Who Successfully Prosecuted the Largest Attorney Ethics Case in History

In March, 2010 the Chief Justice of Arizona asked the Chief Justice of Colorado for help. The Chief Justice’s request led to a two-year investigation and trial of the former Maricopa County Attorney and two of his senior prosecutors by attorneys in the Colorado Supreme Court’s Office of Attorney Regulation Counsel.

This is a story of years of intimidation and retaliation by the former Maricopa County Attorney. His targets were sitting judges, County Supervisors, County administrators, and private lawyers. After years of prosecutorial misconduct, the Rule of Law in Maricopa County was fast disappearing. As the elected head of the fourth-largest county in the United States, his misuse of power led to the largest lawyer discipline prosecution in history.

The presentation will detail the investigation and prosecution as well as the harassment and intimidation directed at the disciplinary prosecutors from Colorado, John Gleason and Jamie Sudler. Hear first-hand about their experience in Arizona and their attempt to return justice to Maricopa County. Submitted for two general and two ethics CLE credits. Click here for more information.

 

Bank Regulations: What Every Lawyer Should Know: Regulatory Agency Interplay, Loan Considerations, and FDIC Loss Sharing Agreements—Thursday, August 2

Join us for these three insightful sessions, co-sponsored by CLE and the Financial Institutions Subsection:

The first topic will be an overview of the bank regulatory structure, including federal and state regulatory agencies. This will cover the FDIC, the Federal Reserve, the OCC and the state banking regulators. Vital to understanding this area is knowing the interaction of these regulatory agencies.

The second discussion will deal with banking laws that all lawyers should be aware of. Lawyers representing banks should have a basic understanding of certain laws that apply to banks and how those laws can impact their practices.

The final session will teach you about FDIC loss sharing agreements. The focus in this segment will be on those lawyers representing borrowers that have loans at banks with loss sharing agreements, and how loss sharing agreements can affect their borrowers. Submitted for three general CLE credits. Click here for more information.

 

CBA-CLE Featured Publication

Guide for Colorado Nonprofit Organizations: Avoid the Pitfalls of Maintaining a Nonprofit Corporation’s Tax Exempt Status

This guide covers the legal aspects of forming nonprofit entities in Colorado, with specific chapters on federal and state taxes. The guide includes:

  • How to Organize and Operate Nonprofit Organizations
  • Tax Treatment of Nonprofit Organizations
  • Fundraising by Nonprofit Organizations
  • Nonprofit Organizations With Employees
  • Major Corporate Events and Transactions
  • Other Legal Considerations for Nonprofit Organizations

The guide includes sample forms, tables, and references to online resources to augment the text as well as a comprehensive subject index. This publication was written by more than 20 of Colorado’s top corporate attorneys, many of whom specialize in advising and representing nonprofit, tax-exempt organizations. Find out more here.

Contributions for future newsletters are welcome –
Contact Ed Naylor at ed.naylor@moyewhite.com or 303-292-2900

This newsletter is for information only and does not provide legal advice.

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