Wisconsin Lawyer
Vol. 78, No. 9, September 2005

Planning for Conflict of Interest Transactions

• The First LLC Case

by Richard A. Latta

The Wisconsin Supreme Court's decision in Gottsacker v. Monnier sets a clear rule of law that material conflicts of interest do not preclude a member of a Wisconsin limited liability company (LLC) from voting his or her interest in the LLC.¹ The question is how to apply this rule to conflict of interest transactions for corporations and LLCs. The answer may lie in the questions from the bench during the Jan. 14, 2005, supreme court oral argument.

No Communication with Minority

The Gottsacker case is clearly one in which bad facts could have resulted in bad law. At oral argument, several of the justices focused on the fact that the transfer of New Jersey LLC's sole asset (a warehouse) to 2005 New Jersey LLC was made without the knowledge or consent of Gregory Gottsacker, a member of New Jersey LLC. The reason why Gregory may not have been consulted is that communication between Gregory and his brother Paul (the second LLC member) was virtually nonexistent, and Julie Monnier (the third LLC member) had not spoken with Gregory since 1998 (facts highlighted by both the supreme court and the circuit court in their respective decisions).

Questions from the Bench

The questions from the bench showed the justices' concern about the procedural aspects of the case, including the following:

How to Define "Deal Fairly." When an LLC member has a material conflict of interest under Wis. Stat. section 183.0402(1)(a), what standard should the court apply to determine if parties "dealt fairly" with the LLC? This question of what standard to apply included whether "deal fairly" means: 1) not a fair result, or 2) not giving notice of the transaction. The court answered this question in its decision by stating it interprets the "deal fairly" requirement to mean "that members with a material conflict of interest may not willfully act or fail to act in a manner that will have the effect of injuring the LLC or its other members."² To the court, the inquiry of whether a member has willfully acted or failed to act in a manner that causes injury contemplates both the conduct and the end result, which the court views as intertwined.³ The court also stated the inquiry contemplates a determination of the LLC's purpose and the justified expectations of the parties.⁴ The court then held that no express determination had been made of whether the majority had willfully failed to deal fairly, and the supreme court remanded the case to the circuit court for further findings.⁵

Conduct of Parties. If the parties use a process that is procedurally fair, does the process create a presumption of dealing fairly? In other words, does "deal fairly" mean only that the process has to be fair? By its reference to conduct (in the two-part test using conduct and the end result to determine what constitutes dealing fairly), the court answered this question by stating the conduct of the parties is a mutual component with the end result when determining whether a member with a material conflict of interest has dealt fairly with the LLC and with the LLC's other members.⁶

Court's Concern about De Facto Vetoes. At oral argument the justices recognized if the court were to adopt (as requested by Gregory Gottsacker) a rule excluding the vote of a member whenever there was a risk of a conflict of interest, then the minority could prevent the LLC from taking actions by asserting that a conflict of interest exists regarding the majority. One of the justices noted that such a rule could create a tyranny of the minority because it would give the minority a de facto veto power over the majority. The supreme court rejected this position in the statement "construing the [operating] agreement to allow one minority member to effectively deadlock the LLC is unreasonable absent express language."⁷

Planning for Conflict Transactions

Based on the court's decision, one can derive the following principles for how to deal with conflict of interest matters:

Conduct of Parties. The procedural process used by those involved in a conflict of interest transaction is significant because the conduct of the parties is essential to meeting the two-part test of "conduct and end result" set forth by the court. Compliance with an entity's governing documents (for example, an LLC's operating agreement or a corporation's articles and bylaws) will likely be significant to a court that is deciding whether the owners of an entity have "dealt fairly" when there is a conflict of interest. The conduct prong of the two-part test may be met by providing notice to the minority of meetings at which the minority holders will have an opportunity to be heard with regard to the matter at issue. Such conduct increases the likelihood that a court will uphold the majority's ability to direct an LLC's actions, because it will demonstrate the minority was given an opportunity to be heard and, if applicable, the right to vote on the matter at issue.

End Result Test. When a material conflict of interest exists for one or more of the parties, the managers or members of an LLC should obtain third-party indicia as to the value of the matter at issue (for example, third-party appraisals of land or businesses or, for assets of lesser value, evidence of comparable value in the market) or the reasonableness of the terms of a contract or other obligation (for example, market comparables for related party leases, loans, or other contracts). This use of third party advisors is also consistent with the corporate law provision under Wis. Stat. section 180.0826 (for which there is not a comparable provision in the LLC statutes, chapter 183) allowing a board of directors to rely on the advice of third-party advisors, such as attorneys and accountants, regarding matters within the advisors' sphere of expertise when the board is making decisions about fairness of the terms of transactions.

Monetary Damages are Remedy. In the supreme court's order remanding the case to the circuit court for further findings, the supreme court directed the circuit court to require the majority to account to the LLC and Gregory for any improper personal profit derived without Gregory's consent.⁸ The inference is the supreme court decided that monetary damages are the appropriate remedy, as compared to a nullification of the transfer (which was the remedy ordered by the circuit court and the court of appeals). Justice Roggensack made this explicit in her concurrence (in which Justice Wilcox joined), in which she stated the remedy available on remand is an accounting to accurately determine the fair market value of the property and if Gregory was not paid his fair share of any profit achieved through the sale, the majority members must compensate him for any lost profit he sustained.⁹ Given the court's views regarding the appropriate remedy in Gottsacker, in the context of planning a transaction, the use of third-party valuations at the time of the transaction would provide useful guidance in the event of future judicial review so a court can make a finding regarding whether the parties have dealt fairly with one another (and, if they have not, then such a valuation would be useful for determining the existence of monetary damages).

Drafting Counts

In addition to how parties conduct themselves in conflict of interest transactions, attorneys need to take care in how they document what occurs in conflict of interest transactions and also how they prepare the operating agreement for the LLC. This is shown by a recent court of appeals decision, Lenticular Europe LLC, in which the court construed Wis. Stat. section 183.1101 to permit a minority member of an LLC to sue on behalf of the LLC.¹⁰ Due to drafting conventions used for chapter 183 (and the routine use of the phrase "unless otherwise provided in an operating agreement" as a method to designate the ability of parties to depart from the statutory default provisions), the Lenticular decision demonstrates why attorneys need to strive for clarity when they prepare operating agreements and documents memorializing conflict of interest transactions.

Holding Applicable to Corporations

While the Gottsacker decision concerned LLCs, the court's analysis is equally applicable to Wisconsin corporations (as are the above planning ideas for how to deal with these situations). The key statutory language construed in Gottsacker under Wis. Stat. section 183.0402(1)(a) is parallel to the director conflict of interest provisions for corporations under Wis. Stat. section 180.0828(1)(a) (a parallel that was made clear by the supreme court in footnote 10 in Gottsacker). Accordingly, there is every reason to believe a corporate conflict of interest transaction presented to the court will come out similar to Gottsacker - that is, allowing to stand a transaction in which there is a material conflict of interest if the majority has met the criteria for having "dealt fairly" with the corporation and the minority shareholder.

Conclusion

The supreme court's decision in Gottsacker provides Wisconsin attorneys with a useful two-part test against which to gauge conflict of interest transactions and by doing so significantly advances the ability of attorneys to guide Wisconsin corporations and LLCs in matters of corporate governance. The two-prong test of conduct of the parties and the end result of the conduct advances the law of corporate governance by providing workable thresholds to be met in planning for conflict of interest transactions.

Attorneys attempting to fulfill the conduct prong of the two-part test may do so by complying with the LLC's operating agreement (or other governing document) or, if none (or if the governing document is silent), then by complying with the relevant provisions of chapter 183. For example, compliance with chapter 183 can be achieved: 1) by providing an opportunity for the minority to be heard on the matter (such as by providing a timely notice of a meeting on the matter) and 2) if applicable, by providing the minority the right to vote on the matter at issue. When the transaction is not otherwise an arm's-length transaction, the end-result test can be met by obtaining third-party indicia as to the value of the matter at issue (for example, third-party appraisals or valuations) or the reasonableness of a contract's terms.

Given the similarity of the conflict of interest statutes for corporations and LLCs, the holding in Gottsacker

is equally applicable to Wisconsin corporations and thus would allow to stand a transaction in which there is a material conflict of interest when the majority has met the court's two-prong test for having "dealt fairly" with the corporation and the minority shareholders.

The two-part test developed by the supreme court raises Wisconsin law to a more sophisticated level and is a welcome addition to the analysis of how to plan for conflict of interest transactions.

Endnotes

¹Gottsacker v. Monnier, 2005 WI 69, __ Wis. 2d __, 697 N.W.2d 436.

²Id. ¶ 31.

³Id.

⁴Id.

⁵Id. ¶¶ 31, 32, 36, 37.

⁶Id. ¶ 31.

⁷Id. ¶ 25.

⁸Id. ¶ 36.

⁹Id. ¶ 39.

¹⁰Lenticular Europe LLC v. Cunnally, 2005 WI App 33, ¶¶ 15, 18, 27, 279 Wis. 2d 385, 693 N.W.2d 302 (voting provisions of LLC operating agreement did not plainly set forth intent to override statutory default terms of Wis. Stat. section 183.1101 regarding member right to sue and so statutory default terms that allow member to sue on behalf of LLC apply; the Lenticular court distinguished the Gottsacker court of appeals' decision).

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