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Massachusetts Federal Court Holds That LLC Operating Agreement Does Not Shield Defendants from Liability for Breaching Their Fiduciary Duties to Closely Held Corporations

A recent decision by Judge F. Dennis Saylor of the U.S. District Court for the District of Massachusetts, Butler v. Moore, C.A. No. 10-10207-FDS U.S. Dist. LEXIS 39416 (D. Mass. Mar. 26, 2015), offers an example of how fiduciary duties can continue to govern the conduct of participants in a closely held corporation or LLC under Massachusetts law, even where parties claim that those duties have been abrogated by contractual agreement.  The decision offers a cautionary tale reminding shareholders and members in closely held companies of the fiduciary duties they owe to one another and to the company under Massachusetts law, and of the resulting requirement that they should be scrupulously fair and forthright, and carefully observe corporate formalities, in their dealings with one another.

Butler v. Moore will take an important place in the long line of Massachusetts decisions dealing with fiduciary duties in closely held entities. It offers a comprehensive overview of fiduciary duty law and carefully applies this law to a complex set of facts. In its breadth, depth, and human interest, it is comparable to previous landmark decisions in the field such as Demoulas v. Demoulas Super Markets, Inc., 424 Mass. 501, 677 N.E.2d 159 (1997). Judge Saylor’s opinion is particularly noteworthy for:

(1) its detailed findings chronicling how the individual defendants progressively siphoned assets and opportunities from Eastern Towers through “an extensive pattern of deceit, concealment, and manipulation”;

(2) its evaluation of the relationship between Eastern Towers, Inc. and Eastern Towers, LLC, holding that the two companies should be treated as a single entity in light of the failure to observe corporate formalities and their confused intermingling of operations and assets; and

(3) its close analysis of the intersection between the principals’ fiduciary duties and the Eastern Towers, LLC operating agreement, concluding that the operating agreement did not insulate the defendants from liability.

The decision presents a clear warning to entrepreneurs and leaders of start-up businesses that, where a company is closely held, negotiations with other shareholders or members concerning corporate governance and related party transactions must be carried out with transparency, full disclosure, and good faith, consonant with the fiduciary duties incumbent upon them as shareholders, members, and/or directors of closely held companies under Massachusetts law.

The case concerns a dispute among shareholders of Eastern Towers, Inc., a small closely held Massachusetts corporation that was established in 2002 to develop and own cell phone towers.  Eastern Towers, Inc. was formed by two men with experience in the cell tower industry (Strachan and Sanford) and two experienced businessmen and investors (Moore and Rosenfeld), with the understanding that they would each be 25% shareholders.  Strachan and Sanford would work for the company and contribute their industry knowledge and contacts, as well as a cell tower they were already developing, while Moore and Rosenfeld would contribute their capital and general financial and legal expertise.

The ensuing history of the enterprise and the resulting litigation is complex and can only be briefly summarized here.  After Eastern Towers, Inc. was established, Moore and Rosenfeld proposed forming a separate limited liability company, Eastern Towers, LLC, in which they would have 60% ownership, while Strachan and Sanford would eventually own 40%, subject to vesting over time.  The LLC operating agreement also contained a provision in Section 5.2 allowing Moore and Rosenfeld to “engage or have an interest in other business ventures which are similar to or competitive with the business of the Company,” and providing that they were not “obligated to present an investment opportunity to the Company even if it is similar to or consistent with the business of the Company” and could take the opportunity “for their own account.”

Despite the defendants’ contention that Eastern Towers, LLC owned and controlled Eastern Towers, Inc., the court found that the parties had never effected such a change in control, and that LLC and the corporation remained legally separate and independent of one another.  In terms of their operations, however, the court found that there was “substantial and confused intermingling” of the business activities, assets, liabilities, income, and expenses of the two companies.  Based on the evidence at trial, including the testimony of the principals and expert witnesses, the court concluded that Eastern Towers, Inc. and Eastern Towers, LLC should be treated as a single entity (collectively “Eastern Towers”).

By the end of 2002 Eastern Towers was facing cash flow problems, and Moore sought additional financing from a bank with which he had an ongoing relationship.  The bank approved a loan, but Moore advised Strachan and Sanford that the bank’s terms were unacceptable.  Moore and Rosenfeld then created yet another entity, Eastern Properties, LLC, controlled solely by them, and executed between themselves an agreement that enabled Eastern Properties to purchase completed cell towers from Eastern Towers at less than half of their true market value.  Meanwhile, Moore and Rosenfeld withdrew nearly all of the capital that they had contributed to Eastern Towers and, without informing Strachan and Sanford, arranged to transfer most of the bank’s proffered financing to their new entity, Eastern Properties.  The end result was that Eastern Properties wound up with all of the towers developed by Eastern Towers, while Eastern Towers was left insolvent or “perilously close to insolvency.”  Moore and Rosenfeld subsequently terminated Strachan, and proceeded to purchase additional cell towers and sites – many of them initially scouted or developed by Eastern Towers – for Eastern Properties or other companies they controlled without offering these opportunities to Eastern Towers.

Strachan filed suit against Moore and Rosenfeld and their companies.  After Moore and Rosenfeld put Eastern Towers, Inc. into bankruptcy, the bankruptcy trustee for Eastern Towers, Inc. joined Strachan as a plaintiff, as did a tower construction company that Moore and Rosenfeld refused to pay in full for its work for them.

After a 20-day bench trial, Judge Saylor issued a comprehensive and exhaustively detailed 205-page opinion in which he concluded that Moore and Rosenfeld had breached their fiduciary duties to Strachan, Eastern Towers, Inc., and Eastern Towers, LLC, and that Strachan had been frozen out of the enterprise.  He ordered Moore and Rosenfeld to transfer to the bankruptcy trustee 32 cell towers that they had purchased or diverted from Eastern Towers, awarded Strachan damages for his lost salary, and held that the construction company was entitled to double damages and attorney’s fees for Moore’s and Rosenfeld’s unfair and deceptive business practices in violation of Mass. Gen. Laws ch. 93A.  He also imposed a constructive trust on the defendants as to the wrongfully diverted cell towers and any related real property, leasehold interests, rents, profits, accounts, and intangible property, and directed the defendants to render a “detailed accounting” to the bankruptcy trustee within 90 days.

Judge Saylor held that Eastern Towers, Inc. and Eastern Towers, LLC were both closely held entities and that Moore and Rosenfeld, as shareholders, directors, and/or members of these entities, owed fiduciary duties to them and their respective shareholders and members under Massachusetts law.   He concluded that Moore and Rosenfeld had breached those fiduciary duties by transferring towers from Eastern Towers for an unfair price or otherwise diverting tower investment opportunities from Eastern Towers without adequate disclosure to and approval by disinterested parties, i.e., Strachan and Sanford.

Judge Saylor further held that Section 5.2 of the Eastern Towers, LLC operating agreement did not absolve Moore and Rosenfeld from culpability for two principal reasons.  First, any effect that Section 5.2 might have had on Moore’s and Rosenfeld’s fiduciary duties was limited to Eastern Towers, LLC, and did not displace the fiduciary duties that Moore and Rosenfeld owed to Eastern Towers, Inc. and to Strachan and Sanford as its shareholders.  Second, while Section 5.2 stated that Moore and Rosenfeld were not required to “present” new investment opportunities to Eastern Towers, LLC, it did not authorize them to divert opportunities that had already been presented to the company.  The evidence supported this interpretation of 5.2 because “Moore and Rosenfeld specifically represented to Strachan and Sanford that they did not intend  to compete directly with Eastern Towers and that the provision was designed to protect their ‘existing interests’” in other towers or tower companies.

The court’s reasoning is consistent with and supported by the Massachusetts Supreme Judicial Court’s pronouncements last year in Selmark Associates v. Ehrlich, 467 Mass. 525, 5 N.E.3d 923 (2014):  “[T]he existence of a contract does not completely relieve shareholders of their fiduciary obligations, and … a claim for breach of fiduciary duty may lie when the contract does not entirely govern the rights and duties of the parties…. [T]o supplant the otherwise applicable fiduciary duties of parties in a close corporation, the terms of a contract must clearly and expressly indicate a departure from those obligations.”  Id. at 538-539.

(Mintz Levin attorneys Michael F. Connolly and A. W. (Chip) Phinney, and Saul Ewing attorney Doreen Zankowski, served as trial counsel for the plaintiffs in Butler v. Moore.)

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Breton Leone-Quick is an attorney who advises Mintz clients in the financial services industry in litigation matters and regulatory investigations. He leverages his understanding of federal securities laws and Delaware corporate laws to navigate complex crises and disputes.