Business Law Section Blog: Off the Marx: Questions from the Wisconsin Supreme Court’s New Precedent for Limited Liability Companies, Part 1:

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  • Business Law Section Blog
    February
    26
    2020

    Off the Marx: Questions from the Wisconsin Supreme Court’s New Precedent for Limited Liability Companies, Part 1

    Andrew J. Parrish, Robb E. Leach

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    In Marx v. Morris, the Wisconsin Supreme Court handed down one of the more notable Wisconsin business decisions in recent years. In this first of two articles, Drew Parrish and Robb Leach explore their top questions in the wake of the Marx decision.

    In Marx v. Morris,1 the Wisconsin Supreme Court handed down one of the more notable Wisconsin business decisions in recent years. The court held for the first time that limited liability company members have common law fiduciary duties, which alone would have made Marx a decision to be closely followed by business lawyers.

    But, the court also made a more curious finding: limited liability company members (and apparently also nonmembers) have standing to bring claims against other members (and, possibly against even nonmembers too) for damages sustained by the LLC.

    Background

    Marx revolved around North Star Sand LLC, a Wisconsin limited liability company whose only members were themselves LLCs.

    The suit involved only three of those members: plaintiffs Fracsand LLC and Management Funds LLC, and defendant R.L. Co., LLC. But in an interesting wrinkle, the members of those member-LLCs were also parties to the action: Daniel Marx brought claims on behalf of himself and his single member LLC (Fracsand), and was joined as a plaintiff by Michael Murray, also on behalf of both himself and his LLC (Management Funds). They sued another member of North Star Sand LLC, R.L. Co. LLC, as well as its sole member, Richard Morris (also North Star’s attorney).

    Drew Parrish Drew Parrish, DePaul 2002, is an attorney with Wheeler, Van Sickle & Anderson, S.C. in Madison, where he practices in commercial transactions, energy law, and general business law.

    Robb Leach com rleach wheelerlaw Robb Leach, North Dakota 2015, is an associate with Wheeler, Van Sickle & Anderson, S.C. in Madison, where he practices in real estate and energy law.

    Although North Star was a limited liability company, its management was apparently controlled by a board of directors, much like a corporation. And it appears that each of the individuals who controlled North Star’s members served on the board.

    In a 4-2 vote, the board authorized the sale of a North Star subsidiary to another company in which Morris held an interest. The losers of that vote, Marx and Murray, then filed suit on behalf of themselves personally and on behalf of their single member LLCs. The plaintiffs alleged that the sale of the subsidiary was for less than fair value, resulting in harm to them as members who held interests in the LLC.

    If North Star had been a corporation, then the result of the case would have been fairly predictable: the sale of a corporate asset or subsidiary is a harm primarily sustained by the company, and shareholders have no standing to bring a claim on their own behalf.2

    But in Marx, the majority held that an LLC, as a “creature of statute,”3 is fundamentally different.4 The majority decision, authorized by Chief Justice Patience Roggensack, placed dispositive reliance on the fact that LLCs may elect to be taxed as partnerships, so that the LLC’s gains and losses pass through to the individual members.5

    Thus, the majority found that an injury to the LLC also essentially “passes through” to members who have elected partnership taxation in an operating agreement. Claiming that nothing in the LLC statutes required different treatment, the court advanced the novel theory that tax elections determine standing for an LLC and its members.6 Justice Dan Kelly wrote a stern dissent, pointing out a host of practical and doctrinal problems with the majority decision.7

    But What Does It Really Mean?

    Numerous commentators have previously addressed Marx, including in this blog. Conclusions range from the court having provided “clarity” about individual member rights and duties, to the court “opening the door” to more lawsuits by LLC members.8

    Given Marx’s breezy treatment of myriad issues, we have found it impossible to reach any firm conclusions about what Marx really means or what impact it will have on Wisconsin businesses. Does Marx represent a sea change in LLC jurisprudence? Or, is it little more than sound and fury, signifying nothing?

    The only conclusion we can reach is that it will likely take future litigation to settle the mire that Marx roiled up.9 In fact, we were fascinated by the sheer number of uncertainties that Marx has triggered about the rights and liabilities of LLCs and their members.

    Many Questions Seeking Answers

    In this two-part article, we explore our top 10 questions in the wake of this peculiar decision.

    We begin with questions on rules of standing, tax elections, and damages, while part two addresses questions on common law fiduciary duties, a non-LLC member’s ability to sue, the possible impact of operating agreements to prevent the application of Marx, and Marx’s apparent departure from Chief Justice Roggensack’s previous opinion in Gottsacker v. Monnier.

    The Questions, Part 1

    What are the rules of standing for limited liability companies that choose to be taxed as corporations?

    The majority decision relied almost exclusively on the LLC’s election to be taxed as a partnership rather than as a corporation: for the majority, the pass-through nature of the company’s earnings justified conflating damages incurred by the LLC with damages suffered by an individual member.

    But, as called out by the dissent, the Marx majority did not address the broader question of standing for LLCs that elect different tax treatment. Logically, if the tax election controls the issue of standing, then members of LLCs who are taxed as corporations should be subject to the same rules of standing applicable to corporations. But it is unknown whether the court would follow that logical thread in addressing standing for LLCs that do not elect partnership taxation.

    What are the rules of standing for limited liability companies that change their tax election?

    One flaw in the majority’s reasoning was its failure to acknowledge the ephemeral nature of tax elections.

    Of course, an LLC can choose to be taxed as either a partnership or a corporation, which the majority relied upon as largely dispositive of LLC member standing. But, the majority did not attempt to address what would occur if that tax election changed.10

    Claims involving mismanagement of an LLC can comprise conduct that spans over a number of years. If the LLC changes its tax election over those years, would that have an impact on the standing of members to bring claims for harm to the company? When must the partnership tax election be in effect for a member to have individual standing for harm incurred by the LLC? At the time that suit is brought? At the time the damages are incurred? Could an LLC manager or controlling member effectively shield him/herself from claims by other members by changing the company’s tax election?

    The majority’s reasoning raises these questions but offers no hints on how they might be resolved.

    Does tax election affect standing for other types of business entities?

    Despite purporting to apply its new standing rule solely to limited liability companies, the majority acknowledged that LLCs are not the only business entities eligible for pass-through taxation. The majority explicitly acknowledged that S-corporations may have pass-through treatment, but was silent as to how that might affect standing for the shareholders of those companies.11

    Prior to Marx, there appeared to be no question that S-corporations were subject to the same rules of derivative standing as applied to all other corporations. Is that now in question? Although unlikely, partnerships can also elect to be taxed as corporations. How would such an election affect the standing of partners to bring claims?

    Given the majority’s heavy reliance on tax elections to resolve the question of standing in Marx, is there a cogent reason why such elections should only affect standing for LLCs and not other types of business entities?

    How are damages determined when a member brings an individual claim for damage done to the LLC?

    Justice Kelly’s dissent called out a number of problems in apportioning damages when allowing an individual member to bring claims for losses sustained by the LLC.

    The claim in Marx was premised on the sale of the LLC’s subsidiary for allegedly less than its fair value, which raises the obvious question as to what damages can properly be awarded to an individual member who brings such a claim. Is that member entitled to receive the full measure of losses sustained by the LLC? Can such a windfall be equitably justified? Is the proper measure of damages only the share of loss based on the member’s proportionate interest in the LLC?

    The majority offered no direction on this fundamental question. It would be interesting to see how the trial court attempts to conjure jury instructions if the case is tried on remand.

    What are the rights of members who do not bring individual claims for harm to the LLC?

    This goes hand-in-hand with the previous question. If a single member can bring a claim for damages sustained by the LLC, then what about the rights of the other members who were also allegedly harmed by the LLC’s losses?

    The purported “pass through” nature of the company’s losses was the reason for permitting a single member to bring a claim for loss to the LLC. Yet, under that same reasoning, all other LLC members would be equally harmed. Equitably and logically, those other members should be entitled to share in any recovery of the LLC’s losses.

    The Marx majority did not address this issue, presumably because the plaintiffs in Marx were the only directors who did not vote in favor of selling the LLC’s subsidiary (which still wouldn’t explain why all of the LLC’s losses should be claimable by members who only secondarily incurred a proportionate share of those losses).

    But, imagine another scenario where there are additional members who do not assent to the firm’s mismanagement. In that instance, who is entitled to claim the damages incurred by the LLC? Is it a race to the courthouse? What if there are separate lawsuits by separate members, each claiming the LLC’s losses? Must all members be joined to a single action for a proper apportionment of damages and liability? Would members who are not parties to the action, but incurred the same “pass through” losses, have equitable claims against a member who recovered the LLC’s losses?

    Continued in Part II.

    Endnotes

    1 Marx v. Morris, 2019 WI 34.

    2 See, e.g.,Notz v. Everett Smith Grp., Ltd. (2009 WI 30, ¶ 23, 316 Wis. 2d 640, 764 N.W.2d 904), a case pertaining to “‘the majority's power to sell a part of a company to an entity that it has a hundred percent interest in … [a]t a fair price.’ … “[s]uch a transaction may give rise to a derivative claim for injury that is primarily to the corporation … that is the only claim available.”)

    3 Since corporations are also controlled by statute (with common law fiduciary duties, just as the Marx majority applied to LLCs), it is not clear why the majority felt that this was a meaningful distinction.

    4 2019 WI 34, ¶ 38.

    5 2019 WI 34, ¶¶ 22-34.

    6 Notably, the majority identified no precedent that supported this reasoning, seemingly rendering Marx sui generis on the issue of standing and tax elections.

    7 See 2019 WI 34, ¶¶ 69-96.

    8 See: Tiffany E. Woelfel & Sherry D Coley, Clarified Individual Member Rights and Duties in Limited Liability Companies (May 14, 2019); Olivia M. Pietrantoni, Kurt M. Simatic, Jeffrey A. Mandell, Supreme Court Finds Unexpected Difference between Corporations and Limited Liability Companies (May 31, 2019); Athena Skaleris, Wisconsin Supreme Court Opens the Door to More Lawsuits by LLC Members (April 18, 2019); J. William Boucher, LLCs and Standing to Sue: Wisconsin Supreme Court Weighs In (December 02, 2019).

    9 As noted recently in this blog, there is also proposed legislation intended to overturn the Marx holding, which remains pending at this time.

    10 See Treas. Reg. § 301.7701-3(a).

    11 See Marx, 2019 WI 34, ¶ 44 n.24.

    ​​




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