Massachusetts Appeals Court Permits Claim for Breach of Fiduciary Duties Against Company Counsel by Minority LLC MembersPosted: February 2, 2018
by Michael Cohen and William Cushing
In Baker v. Wilmer Cutler Pickering Hale and Dorr LLP, 91 Mass. App. Ct. 835 (2017), decided this past July, the Massachusetts Appeals Court allowed the minority members of a Massachusetts limited liability company to sue the LLC’s outside counsel for breach of fiduciary duty relating to counsel’s involvement in an alleged “freeze-out” scheme that benefited the majority members. Although the Supreme Judicial Court had previously held that counsel to closely-held corporations may owe fiduciary duties to individual stockholders, Baker is the first case in which a Massachusetts appellate court has permitted a claim for breach of fiduciary duty to proceed against outside company counsel by minority owners. Corporate lawyers should be acutely aware of the Baker decision and its implications.
The factual allegations relating to the underlying dispute that are set out below come from the plaintiffs’ complaint, as related by the Appeals Court’s opinion.
Elof Eriksson and W. Robert Allison formed Applied Tissue Technologies LLC (“ATT”) as a Massachusetts LLC in early 2000, at which time they were issued seventy-five and twenty-five percent membership interests in the company, respectively. (Both Eriksson and Allison later assigned portions of their interests to family trusts, and a former key employee was granted a small interest in ATT.)
In 2003, ATT adopted an amended operating agreement which provided, among other things, that (a) the members have exclusive management control over ATT, which they exercise by votes in proportion to their percentage interest in the company, (b) the agreement cannot be amended unless both Eriksson and Allison agree in writing, (c) the proportion of net profits to which each member is entitled cannot be reduced or diluted without that member’s consent, (d) if any member chooses to provide additional funds to the company, those advances are treated as loans for which ATT will pay interest at the prime rate, and (e) all members owe each other a duty of utmost loyalty and good faith in the conduct of ATT’s affairs.
By early 2012, ATT was facing financial difficulties, and Eriksson and Allison could not agree on how to address ATT’s challenges. Eriksson was willing to contribute capital in exchange for additional equity in the company, while Allison wanted outside investment and a new management team.
Around this time, company management urged Eriksson to gain “control” of the company. Eriksson reached out to his daughter, an associate at a Boston law firm, who in turn connected her father with a partner at the firm who had experience working with emerging companies. In February 2012, ATT’s chief executive officer signed an agreement to engage the law firm as company counsel. The agreement expressly provided that the law firm would represent ATT, and would not represent any individual members of ATT. Shortly thereafter, the law partner relocated his practice to another law firm, which provided ATT with a substantially similar engagement letter to represent only the company.
At the request of Eriksson and management, ATT’s outside lawyers initially drafted a plan to buy out Allison’s minority membership interests, along with an email that Eriksson would send making the buyout offer to Allison. Allison rejected the offer and responded that he wished to work to maximize ATT’s value for a more favorable exit down the road. He also reminded Eriksson of the minority protections in the ATT operating agreement and suggested that all members meet to address the issues facing the company. Soon after receiving Allison’s response, Eriksson and ATT’s outside lawyers prepared an alternative plan to forcibly remove the minority member protections by using General Laws chapter 156C, section 60, which authorizes a Massachusetts LLC to merge with another business entity (in this case, a Delaware LLC specifically created to facilitate the “freeze-out”) upon the vote of a simple majority of the members unless the company’s operating agreement provides otherwise. Because ATT’s operating agreement was silent about a member’s rights in connection with a merger, ATT could be merged into the new entity by a simple majority vote, thereby depriving the minority members of the protections for which they had previously bargained. ATT’s lawyers advised management that the merger would eliminate Allison’s “ability to interfere with company operations” and that, over time, the company could reduce Allison’s interest to “a smaller and smaller ownership position.”
Having accomplished everything necessary to effectuate the plan, Eriksson and company management met with Allison and informed him of the merger. They advised Allison to contact the company’s lawyers if he wanted copies of the new operating agreement and other company documents for the surviving entity. Over the ensuing months, the new Delaware LLC issued additional preferred interests to Eriksson and management, substantially reducing the interests of Allison and the other minority members in the surviving company.
In May 2015, Allison and the company’s other minority members sued, among others, the law firms that had acted as outside counsel to the company, along with the individual attorneys who had advised Eriksson and company management, alleging, among other claims, breach of fiduciary duty. The Superior Court dismissed the fiduciary duty claim and Allison and other minority members appealed.
Massachusetts law has long provided enhanced protections to minority shareholders in closely held corporations. In Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 593 (1975), the SJC held that shareholders in a closely held company owe each other a fiduciary duty of utmost good faith and loyalty, akin to the duties owed among partners in a partnership. And, in Schaeffer v. Cohen, Rosenthal, Price, Mirkin, Jennings & Berg, P.C., 405 Mass. 506, 513 (1989), the SJC observed that “there is logic in the proposition that, even though counsel for a closely held corporation does not by virtue of that relationship alone have an attorney-client relationship with the individual shareholders, counsel nevertheless owes each shareholder a fiduciary duty,” though the SJC’s decision in Schaeffer did not require it to determine that issue.
In Baker, the Appeals Court invoked a decision of the Michigan Court of Appeals holding that the lack of an attorney-client relationship between a fifty percent shareholder in a closely held professional corporation and counsel for the corporation did not necessarily preclude a fiduciary relationship between the shareholder and corporate counsel. Baker, 91 Mass. App. Ct. at 843-44 (citing Fassihi v. Sommers, Schwartz, Silver, Schwartz & Tyler, P.C., 107 Mich. App. 509, 309 N.W.2d 645 (1981)). Rather, a fiduciary relationship may arise when “one reposes faith, confidence, and trust in another’s judgment and advice,” and the existence of that relationship is largely a question of fact. Id. (quoting Fassihi, 107 Mich. App. at 514-15).
The Appeals Court observed that the defendants in Baker undertook their representation of ATT “with full knowledge” of the protections that the operating agreement afforded the minority members, that they “knew, or should have reasonably foreseen” that company counsel was “constrained by the operating agreement, and the consensual decision-making it imposed on important matters,” and that counsel could not act “in concert with the majority members, for the very purpose of eliminating those protections.” The court also noted counsel’s “purposeful steps” to conceal their activities from the minority members, even though the minority members “should have been able to repose trust and confidence that any counsel hired by the company would have communicated and consulted with them prior to undoing [the minority] protections.” Noting that the existence of a fiduciary relationship “is largely a question of fact,” the Appeals Court could not conclude that the defendant attorneys owed no fiduciary duty to the minority LLC members in this case based on the facts alleged in the complaint. Accordingly, the court reversed the dismissal of the complaint and remanded the case to the Superior Court so that the lawsuit could proceed. The defendants did not file a petition for further appellate review in the SJC.
The Baker decision yields at least two crucial practice points for attorneys working with LLCs and other closely held companies:
- Respect the Role of Company Counsel, and Remain Faithful to Your Client
An attorney retained by a corporation represents the corporate entity, not its shareholders, members, officers, employees, directors, or other constituents. Cf. Mass. R. Prof. Conduct 1.13(a) (attorney represents the organization), 1.13(f) (attorney shall explain identity of client to organization’s constituent with whom he is dealing if organization’s interests are adverse to that person). The corporate attorney may also represent a corporate constituent, but counsel must address potential conflicts of interest in accordance with the dual-representation rules. Mass. R. Prof. Conduct 1.13(g) (referring to Mass. R. Prof. Conduct 1.7). Attorneys engaged as company counsel owe allegiance to the entity, and they should be mindful of potential conflicts of interest involving those persons giving instructions and of the ways in which the interests of the entity and (all of) its owners may differ from the interests of those directing company counsel. The defendant lawyers in Baker would have been wise to suggest that Erikkson and management retain separate counsel to address personal interests.
- Respect Negotiated Contractual Rights
The members of ATT had agreed upon a set of rights intended to ensure that all members moved together, and they provided in the operating agreement that these rights could be varied only by express agreement of the members. The Appeals Court took a dim view of the use of a merger transaction, orchestrated by company counsel, to involuntarily deprive the minority LLC members of those rights, notwithstanding that the operating agreement did not expressly prohibit a merger or impose enhanced approval requirements in connection with a merger. Company counsel should ensure that advantageous contractual rights are changed only through a process that respects the “faith, confidence and trust” that members of an LLC may repose in company counsel.
Michael J. Cohen is a Partner in Brown Rudnick LLP’s U.S. Corporate and Capital Markets practice group, and is based in the firm’s Boston office. Michael represents early stage and mid-market companies in connection with mergers and acquisitions, joint ventures and strategic alliances, financing transactions and general corporate and commercial matters at all stages of the corporate life cycle. Michael also advises venture capital and private equity funds and would-be portfolio companies in connection with deal terms and transaction structuring.
William T. Cushing is an Associate in Brown Rudnick LLP’s U.S. Corporate and Capital Markets practice group, and is based in the firm’s Boston office. While at Boston University School of Law, Will was an Executive Editor for the Review of Banking & Financial Law. In 2014, Will worked as a legal Intern at the Massachusetts Attorney General’s Office in the Gaming Division.