Wisconsin Lawyer
Vol. 78, No. 9, September
2005
Planning for Conflict of Interest Transactions
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
Richard A.
Latta, U.W. 1986, LL.M. (taxation) New York Univ. 1989, is a
partner with Michael Best & Friedrich LLP and a member of the
firm's Management Committee. He practices in the areas of
corporate law, corporate governance, bank law, and tax planning. He is
cochair of the ABA Taxation Section's Subcommittee on Partnership
Workouts and a member of the board of the State Bar of Wisconsin
Business Law Section. he did not represent any party in the Gottsacker
case.
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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