Alter Ego Doctrine Applied To Nevada LLCs

© Neal A. Klegerman

A recent federal appeals court opinion is the latest to address whether and in what manner the alter ego doctrine applies to Nevada LLCs.

The alter ego or piercing the corporate veil doctrine has been codified as to corporations as follows.

Liability of stockholder, director or officer for debt or liability of corporation.

  1. Except as otherwise provided by specific statute, no stockholder, director or officer of a corporation is individually liable for a debt or liability of the corporation, unless the stockholder, director or officer acts as the alter ego of the corporation.
  2. A stockholder, director or officer acts as the alter ego of a corporation if:

(a)  The corporation is influenced and governed by the stockholder, director or officer;

(b)  There is such unity of interest and ownership that the corporation and the stockholder, director or officer are inseparable from each other; and

(c)  Adherence to the corporate fiction of a separate entity would sanction fraud or promote a manifest injustice.

  1. The question of whether a stockholder, director or officer acts as the alter ego of a corporation must be determined by the court as a matter of law.

NRS 78.747

The codification appears to be based on the language of Nevada Supreme Court opinion. Frank McCleary Cattle Co. v. Sewell, 317 P.2d 957 115 (Nev. 1957)

There is no parallel provision in NRS chapter 86 which governs limited liability companies. In a recent opinion the U.S. Court of Appeals for the Ninth Circuit addressed whether NRS 78.747 applies to LLCs. Volvo Constr. Equip. Rents, Inc. v. NRL Rentals, LLC, 2015 U.S. App. LEXIS 9791, n.1 (9th Cir. Nev. June 11, 2015).

The court assumed without deciding that the corporate statute applies to Nevada LLCs. The court essentially followed the same approach as the Nevada Supreme Court in a recent case. Webb v. Shull, 270 P.3d 1266, 1271 n.3 (Nev. 2012). The Ninth Circuit quoted the following text from the Nevada Supreme Court opinion: “The parties assume that NRS 78.747, which is part of the statutory chapter governing corporations, applies to the alter ego assertion against Shull and Celebrate, an LLC. Accordingly, for purposes of this appeal, we likewise assume, without deciding, that the statute applies and analyze their alter ego arguments under that standard.” The Ninth Circuit followed the same course in applying the corporate alter ego formulation to a Nevada LLC.  See also, JSA, LLC v. Golden Gaming, Inc., 2013 Nev. Unpub. LEXIS 1449, 2013 WL 5437333 (Nev. 2013).

It makes sense that the Ninth Circuit would not decide any issue unless clearly required to predict how the Nevada Supreme Court would rule. It is a little puzzling why the Nevada Supreme Court reserved the issue in 2012.

Nonetheless, it seems likely that if and when the issue is decided, the corporate alter ego formulation will be applied to Nevada LLCs. As early as 2004, the U.S. Bankruptcy Court addressed the issue in some detail and concluded it highly likely that the Nevada Supreme Court would extend the corporate alter ego doctrine to LLCs. In re Giampietro, 317 B.R. 841 (Bankr. D. Nev. 2004). The court examined the legislative history of NRS 78.747 and did not find any intent to make the alter ego doctrine inapplicable to LLCs by enacting the legislation only as to corporations. The court found that as an equitable doctrine intended to prevent abuse, courts would apply the doctrine to LLCs. This makes sense in that notwithstanding the statutory codification, the codified rules were initially judicially created in the McCleary Cattle opinion. See also, Montgomery v. Etreppid Techs., LLC, 548 F. Supp. 2d 1175 (D. Nev. 2008).

Consistent with the likelihood that the corporate alter ego doctrine will be applied to LLCs is the recent  case of Excellence Cmty. Mgmt., LLC v. Gilmore, 131 Nev. Adv. Rep. 38 (Nev. 2015) which is the subject of our recent article.  http://www.ekcounsel.com/non-competition-agreements-in-sale-of-nevada-llcs/

In that opinion, the Nevada Supreme Court decided that its previous opinion on the enforceability of employee non-competition agreements after a sale of 100% of the stock of a corporation also applies  to a sale of 100% of the membership interest of a LLC.

 

Non-Competition Agreements in Sale Of Nevada LLCs

© Neal A. Klegerman

In Excellence Cmty. Mgmt., LLC v. Gilmore, 131 Nev. Adv. Rep 38 (Nev. 2015) decided June 25, 2015, the Nevada Supreme Court addressed the enforceability  of an employee non-competition agreement  after the sale of a 100% of the membership interest of the LLC which was the employer.    The Court had addressed a similar issue in the corporate context in HD Supply Facilities Maintenance, Ltd. v. Bymoen, 210 P.3d 183 (Nev. 2009).

The law in Nevada as to enforceability of employee non-competition agreements after a corporate transaction may be summarized as follows:

  • Merger–Non-competition agreement remains enforceable.
  • Sale of stock–Non-competition agreement remains enforceable. This result was implicit in HD Supply but made explicit in Excellence Cmty. Mgmt.
  • Sale of Assets—Non-competition agreement not enforceable unless the employee expressly consents or the noncompetition agreement included an express assignability clause which was negotiated at arm’s length for separate consideration. Traffic Control Services, Inc. v. United Rentals Northwest, Inc., 87 P.3d 1054 (Nev. 2004).

In Excellence Cmty. Mgmt.  the Court found that the sale of the LLC membership interests was the effective equivalent to the sale of corporate stock and thus no new entity resulted.  Therefore, the court applied the holding of HD Supply to find that the non-competition clause remains enforceable after the sale of all of the LLC membership interests.

The Court also distinguished the transaction from Traffic Control which it emphasized was limited to asset purchases. The Court explained that the Traffic Control  rule was based on the law of contractual assignments which applies because an entirely different entity is involved, i.e., the acquirer which becomes a new employer.

Although, the issue was not addressed, there should be little doubt that that the Traffic Control rule would be applied to the sale of assets by a Nevada LLC such that the rules should be the same for a corporation and an LLC.

The Excellence Cmty. Mgmt. opinion seems the correct result in light of the existing law as there would seem to be no good reason to distinguish between a corporation or an LLC in this context.

However, as the author of this update pointed out in a an article published after the HD Supply decision, a preferable approach might be to address assignablity of non-competition agreements based on a two part test rather than on the form of the transaction.  The first part of the test would determine if the post-transaction situation would impose enough of an increased burden on the employee to warrant application of the increased burden exception to the general rule that assignment is permitted.  The second part of the test would be assessing the non-competition agreement in light of the post-transaction facts under the public policy parameters applied to any employee non-competition agreement.  See The Effect of A Sale Of Business Transaction On Nevada Noncompetition Agreements, By Neal A. Klegerman, Nevada Lawyer, p. 32 (November 2009). The following is a link to the article  NevLawyer_Nov_2009_Noncompetition_Agreements

State Business License Fee For NV Professional Corporations

© Neal A. Klegerman

Courtesy of Nevada Business Law Journal (nevadabusinesslawjournal.com)

Nevada Senate Bill 483 enacted a number of increases to business taxes and fees including a “commerce tax” on the gross revenues of certain Nevada businesses.

This article focuses only on the state business license fee which had been $200 annually for all Nevada entities.  For some reason the state business license fee was increased to $500 only for corporations whether big, small, Subchapter S, or otherwise.  As written, the statute does not raise the fees on professional corporations which are organized under NRS chapter 89. In relevant part the bill states as follows:

Sec. 75. NRS 76.130 is hereby amended to read as follows:

2. If the person applying for the renewal of a state business

license pursuant to subsection 1 is a corporation organized

pursuant to chapter 78, 78A or 78B of NRS, or a foreign

corporation required to file an initial or annual list with the

Secretary of State pursuant to chapter 80 of NRS, the fee for the

renewal of a state business license is $500.

From the plain meaning of the text, corporations organized pursuant to chapter 89, i.e., professional corporations, are not subject to the increased fee because chapter 89 is not referred to in the above text of the bill.  The Secretary of State’s Office initially issued a notice on June 11 to the effect that professional corporations would be subject to the increased $500 fee along with corporations organized under chapter 78 and the other chapters enumerated in the bill.  The confusion is understandable given that chapter 89 refers to chapter 78 for corporate filing fees (See, NRS 89.025) but these are simply the corporate filing fees.   The state business license fee is a separate fee which is under a separate chapter, chapter 76.  (By the way, the annual filing fees increased by $25 for all entities including professional corporations.)

We wish to commend the Secretary of State’s Office, particularly the Deputy Secretaries including Jeffery W. Landerfelt, Deputy Secretary for Commercial Recordings, with whom we communicated directly.  We certainly appreciate Mr. Landerfelt and his colleagues for being so open to the humble input of our law firm when we approached them on June 12 with our concerns about assessing the higher state business license fee on professional corporations.  The professionalism and courtesy are a credit not only to them but also to new Secretary of State Barbara Cegavske and her entire office.  Within a matter of days the Secretary of State’s office reconsidered the position and determined not to assess the higher state business license fee on professional corporations.  We understand that the Secretary of State’s office sought confirmation from the Legislative Counsel Bureau and the Nevada Attorney General’s office which confirmed the reconsidered result, so we express our gratitude to each of them as well.

It is certainly a sign of a finely functioning and business friendly state office that is willing to work with the private bar to reach the correct result on a matter.  We appreciate the excellent work and courtesy shown by the Secretary of State’s Office.

June 17, 2015

Neal A. Klegerman, the author of the article, is a corporate lawyer with more than 35 years of corporate law experience. Neal currently practices with the law firm of Emmel & Klegerman PC in Las Vegas, Nevada.

Please contact Neal for any questions or comments concerning this article.

Neal A. Klegerman
nklegerman@ekcounsel.com

Anomaly In Nevada D&O Liability Cases Explained

This article by Neal A. Klegerman of Emmel & Klegerman PC, Las Vegas, NV is presented courtesy of Nevada Business Law Journal (nevadabusinesslawjournal.com)

© Neal A. Klegerman

Anomaly In Nevada D&O Liability Cases Explained

LIABILITY RISKS TO NEVADA OFFICERS AND DIRECTORS POSED BY RECENT CASES; ANALYSIS AND RECOMMENDATIONS

© Neal A. Klegerman

 

Introduction

The Nevada corporate statute, NRS 78.138(7), provides officers and directors protection from monetary liability for breaches of the duty of care unless certain conditions are met. This exculpatory provision while clear on its face seems to have been misapplied by several recent Nevada Federal District Court rulings based on one sentence in a Nevada Supreme Court opinion which unfortunately may be open to misinterpretation. The sentence in the Nevada Supreme Court opinion has been construed to permit liability of an officer or director for gross negligence without regard to the conditions of NRS 78.38(7). In each case, the error was harmless in that the protections of the Nevada corporate statute were preempted by a federal statute governing the liability of officers and directors of banks. Also, each of the erroneous rulings was in a preliminary setting and to date none has been officially reported so the rulings should have limited, if any, precedential value. Nonetheless, this article is intended to assist in preventing the same error from occurring in future cases in which similar reasoning could adversely affect an officer or director whom the Nevada Legislature in its wisdom intended to protect.

The author’s firm represented a defendant in one of the federal cases. It so happens an opinion in that case seems to be the clearest example of the error. This article will focus on that case as representative of the similar opinions in the Nevada Federal District Court as well as the Nevada Supreme Court opinion containing the sentence which created the confusion. It should also be noted that the Delaware corporate statute provides comparable (or arguably less) protection than the analogue in Nevada. This is significant in that both the Nevada Supreme Court and the federal courts applying Nevada law often look to Delaware corporate law for guidance in the absence of Nevada precedent. This article attempts to explain how the opinions of the Nevada Federal District Court apparently ignored the plain meaning of the applicable Nevada statute based on confusion arising from the problematic sentence in a Nevada Supreme Court opinion. Accordingly, the courts reached a result that is potentially more onerous to directors than the Delaware statute as construed and applied by the Delaware Supreme Court.

This article also concludes that if the standard for monetary liability of an officer or director for breach of the duty of care is addressed directly by the Nevada Supreme Court and the court is presented with the relevant case law and statutory analysis, that the court will rule properly and the confusion will be removed. The article also recommends that if the issue comes before a federal court not involving bank officers or directors, that the court certify the question to the Nevada Supreme Court.

 

Business Judgment Rule and the Nevada Exculpation Statute

 

The analysis should begin, and really should end with the plain meaning of the statute. NRS 78.138(7) provides that with certain limited exceptions not relevant here, unless the articles of incorporation of a corporation provides otherwise:

a director or officer is not individually liable to the corporation or its stockholders or creditors for any damages as a result of any act or failure to act in his or her capacity as a director or officer unless it is proven that:

(a) The director’s or officer’s act or failure to act constituted a breach of his or her fiduciary duties as a director or officer; and

(b) The breach of those duties involved intentional misconduct, fraud or a knowing violation of law. (Emphasis added.)

The Apparent Misapplication of the Nevada Statute

 

The Federal District Court in FDIC v. Johnson, 2014 U.S. Dist. LEXIS 148302 (D. Nev. 2014) effectively removed the highlighted subsection in its analysis and determined that officers and directors could not be exculpated from liability for gross negligence. Gross negligence is essentially a breach of the duty of care described in clause (a) of NRS 78.138(7) with respect to the fiduciary duty of care. The court based its decision to apply the statute without regard to the limitations imposed by clause b based on its reading of one sentence of a 2006 Nevada Supreme Court opinion.

The sentence from the Nevada Supreme Court opinion that caused the confusion is as follows:

With regard to the duty of care, the business judgment rule does not protect the gross negligence of uninformed directors and officers. Shoen v. SAC Holding Corp., 137 P.3d 1171, 1184 (Nev. 2006).

 The sentence from the Shoen opinion is unfortunately misleading and arguably simply wrong as it seems to ignore the exculpatory provision in clause b. While the sentence may literally be correct with respect to the business judgment rule itself which is the court’s prerogative to define, it is not accurate in the context of officer and director liability under the Nevada exculpation statute. Although the Shoen opinion concerned whether demand on the board of directors was required for a stockholder to proceed with a derivative action so is arguably not binding precedent as to the actual standard of liability, the relevance of the business judgment rule was to determine the possibility of director personal liability. For that reason, regrettably it appears that the sentence may simply be wrong because it ignores clause (b) of NRS 138(7) with respect to a breach of duty of care consisting of gross negligence. A breach of the duty care may deprive a corporation of the benefit of the business judgment rule but that leads to a separate question of whether the officer or director of such corporation may be personally liable for monetary damages. For example, there could be a breach of the duty of care pursuant to clause (a) of NRS 138(7) but unless such breach involved intentional misconduct, fraud or a knowing violation of law, the director is not personally liable for damages.  There is simply no other possible reading of the plain meaning of the statute.

If this conclusion is correct, the court’s error is apparent from the context.  The next sentence of the Shoen opinion is as follows:

 And directors and officers may only be found personally liable for breaching their fiduciary duty of loyalty if that breach involves intentional misconduct, fraud, or a knowing violation of the law. Shoen v. SAC Holding Corp., 137 P.3d 1171, 1184 (Nev. 2006). (Emphasis added)

This sentence involves a breach of the duty of loyalty. With respect to the duty of loyalty, the court cites to the Nevada statute and correctly states that for a director or officer to be liable the breach must involve intentional misconduct, fraud, or a knowing violation of law. This sentence is correct. The problem is that the prior sentence of the Shoen opinion which addresses the duty of care is not qualified by these magic exculpatory words and there is no apparent basis in the plain meaning and structure of the statute for the court to make this distinction. Clause (a) refers to fiduciary duties generally which include both the duty of care and the duty of loyalty (as the court notes earlier in the opinion Shoen v. SAC Holding Corp., 137 P.3d 1171, 1178 (Nev. 2006). Clause (b) refers to “those duties” which must include the duty of care as well as the duty of loyalty. The magic exculpatory words, therefore, apply equally to any breach of fiduciary duty, whether duty of care or duty of loyalty.

Nor is there any apparent basis in policy or logic for the court to make the distinction. It would be illogical to provide greater protection to a disloyal director (for example, a director acting to further his interests at the expense of the corporation) than it would to a careless director.

 

 Riddle Solved in Delaware

 

 While it can be difficult to identify the precise source of a possible error, that does not seem so in the Shoen opinion. The Shoen court’s citations in support of the two sentences reveal the problem. To support the sentence regarding liability for a breach of the duty of care, the court cites to the Delaware case of Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). This is a perfectly fine case and is still good law as to the business judgment rule itself as well as other matters. However, the Aronson case was decided more than two years before the adoption of the Delaware exculpation statute which provides as follows:

 the certificate of incorporation may also contain…A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director’s duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any transaction from which the director derived an improper personal benefit. 8 Del. C. § 102(b)(7)  Emphasis added)

While the language of the Delaware statute is different than the analogous Nevada statute and the differences raise interesting questions as to the relative scope of the exculpation in the two states, those differences are not relevant for our purposes. Also not relevant here are either that (a) the Nevada statute protects officers and directors while the Delaware statute protects only directors or (b) the exculpation statute in Delaware is an opt-in and Nevada’s statute is an opt-out statute (i.e. the certificate of incorporation must contain the exculpation provision in Delaware for it to apply whereas the Nevada exculpation provision applies unless the articles of incorporation provide otherwise).  The relevant point is that at the time that the Aronson case was decided there was no need for the Delaware Supreme Court to address the second hurdle to director monetary liability because the second hurdle did not exist until the adoption of section 102(b)(7) more than two years later.  (Delaware Statutes Chapter 289, formerly Senate Bill No. 533 approved June 18, 1986, effective July 1, 1986.)

There is further evidence supporting this conclusion.  The landmark Delaware Supreme Court opinion in Brehm v. Eisner (In re Walt Disney Co. Derivative Litig.), 906 A.2d 27 (2006) was decided about one month prior to Shoen.  A review of this opinion (which likely was not available to the Nevada Supreme Court when it decided Shoen as Eisner was decided only about a month earlier) may have avoided the confusion.  This was the first Delaware Supreme Court opinion construing the scope of Section 102(b)(7), the Delaware exculpation provision, in the context of a breach of the duty of care. Although the court found that the defendants had not engaged in grossly negligent conduct, they addressed the issue of whether gross negligence (i.e. breach of the duty of care) was itself sufficient for a director to be personally liable.  To reach that result, gross negligence itself would need to constitute bad faith (i.e. not good faith as required in the statute).  While Delaware’s bad faith standard is a different formulation than the magic exculpatory words in Nevada, the point is that the bad faith standard is the second requirement that must be satisfied by a plaintiff for a director (or officer in Nevada) to be personally liable.  It is this second requirement that is apparent in Eisner and which was ignored in the sentence in Shoen. 

The following excerpts from Eisner may in themselves resolve the question:

In this case, appellants assert claims of gross negligence to establish breaches not only of director due care but also of the directors’ duty to act in good faith. Although the Chancellor found, and we agree, that the appellants failed to establish gross negligence, to afford guidance we address the issue of whether gross negligence (including a failure to inform one’s self of available material facts), without more, can also constitute bad faith. The answer is clearly no. Brehm v. Eisner (In re Walt Disney Co. Derivative Litig.), 906 A.2d 27, 64-65. (Emphasis added)…

To adopt a definition of bad faith that would cause a violation of the duty of care automatically to become an act or omission “not in good faith” would eviscerate the protection accorded to directors by the General Assembly’s adoption of Section 102(b)(7). Brehm v. Eisner (In re Walt Disney Co. Derivative Litig.), 906 A.2d 27, 65. (Emphasis added)

Subsequent Delaware cases reaffirm the conclusion.

 …we held that a failure to act in good faith requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence). Stone v. Ritter, 911 A.2d 362, 369 (Del. 2006)

Conduct constituting bad faith “is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence).” Ryan ex rel. Maxim Integrated Prods. v. Gifford, 2009 Del. Ch. LEXIS 1, 23 (Del. Ch. Jan. 2, 2009)

An argument that the differences between the Nevada and Delaware statutes could justify the standard of liability indicated by the problematic sentence in the Shoen opinion, would not be persuasive for the following reasons.  First, the Nevada Supreme Court in the one problematic sentence effectively ignored a Nevada statute to rely on a Delaware case, so why should the court have a problem relying on a subsequent Delaware case which takes into account a statutory provision which is analogous to Nevada’s statute, rather than the Delaware case decided two years before that Delaware statute was adopted?  Perhaps even more important, however, is if one examines the Eisner opinion in light of the differences between the two statues and assumes that Eisner is correctly decided, there is no apparent way that one could conclude that gross negligence in itself could cause a director (or officer in Nevada) to be personally liable for damages.

The following table focuses on the key operative words of the two statutes which necessary for a director (or officer in Nevada) to be personally liable for damages. For reasons discussed below, the operative words which are identical are struck to highlight both the similarities between the key concepts of two statutes and to focus on the one difference.

 Nevada

intentional misconduct, fraud or a knowing violation of law

Delaware

not in good faith or which involve intentional misconduct or a knowing violation of law

In deciding whether Eisner would be decided the same way if the Delaware Supreme Court had been construing the Nevada key words instead of Delaware’s, we should note that two-thirds of the alternative requirements necessary to find a director liable for damages are the same in both states.  In both statutes if a plaintiff proved either intentional misconduct or knowing violation of law the director could be liable.  The difference is in the third alternative requirement.  In Nevada it is “fraud” and in Delaware it is “not in good faith” (or as the Eisner opinion sometimes refers to it, “bad faith.”)  A detailed comparison of these two concepts is beyond the scope of this article but suffice it say that bad faith (or not in good faith) is if anything a more plaintiff friendly requirement than fraud.  It is clear that the Nevada statute is, if anything, more protective than the Delaware statute.  For our purposes, all we need to prove is that if the Eisner court found that gross negligence without more cannot constitute bad faith then that same court would not possibly have found that gross negligence without more can constitute fraud. The question if asked properly simply cannot be answered any other way, mere gross negligence does not constitute fraud.

The following excerpt from a Delaware Supreme Court opinion holds that while fraud must be pleaded with particularity bad faith need not and that bad faith requires proof of tortious state while fraud requires proof of all of the elements of fraud. The implication is that fraud constitutes more egregious and difficult to prove conduct.

In effect, defendants assert that plaintiff’s allegations of bad faith should be treated as a claim of fraud. Defendants argue that the pleading requirements for sustaining a claim of bad faith or claim of fraud are the same. They assert that the Court of Chancery’s grant of judgment on the pleadings was “correct” because plaintiff failed to plead facts with sufficient specificity to support its allegations of bad faith. Desert Equities responds that a claim of “bad faith” is not identical to a claim of “fraud,” and contends that bad faith need not be pled with particularity. Defendants’ argument that an allegation of bad faith must be pled with particularity is legally flawed, for the reasons which follow.

Generally, the Court of Chancery rules of procedure, which adopt the philosophy of “notice pleading,” do not require a plaintiff to plead a claim with particularity. See generally Ct. Ch. R. 8; Non. Daniel L. Herrmann, The New Rules of Procedure in Delaware, 18 F.R.D. 327, 339 (1956) (particularized pleading is abolished in favor of general pleading). Due to the unique nature of a fraud claim, the drafters of the rules decided that notice pleading would not apply to fraud. Accordingly, Chancery Court Rule 9(b) provides:

In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge and other condition of mind of a person may be averred generally.

Del. Ct. of Ch. Rules 9(b). To require that fraud be pleaded with particularity “serves to discourage the initiation of suits brought solely for their nuisance value, and safeguards potential defendants from frivolous accusations of moral turpitude”. U.S. ex rel Joseph v. Cannon, 206 U.S. App. D.C. 405, 642 F.2d 1373, 1385 (1981), cert. denied, 455 U.S. 999, 71 L. Ed. 2d 865, 102 S. Ct. 1630 (1982) [23] (footnotes omitted).

Intent and state of mind, on the other hand, may be averred generally because “any attempt to require specificity in pleading a condition of mind would be unworkable and undesirable.” 5 Wright & Miller, Federal Practice and Procedure: Civil 2d § 1301 at 674. The underlying rationale for requiring a claim of fraud to be pleaded with particularity does not apply to an allegation of bad faith which relates to state of mind. The essential elements of a claim of fraud are materially different from those required to establish a tortious state of mind. While a claim of fraud has five components, see Stephenson v. Capano Dev., Inc., Del. Supr., 462 A.2d 1069, 1074 (1983), a claim of bad faith hinges on a party’s tortious state of mind. Under Rule 9(b), state of mind may be pled generally. That is because it may be virtually impossible for a party plaintiff to sufficiently and adequately [24] describe the defendant’s state of mind at the pleadings stage. 5 Wright & Miller, Federal Practice and Procedure: Civil 2d § 1301 at 674. Therefore, we hold that Desert Equities is not required to plead bad faith with particularity. Desert Equities, Inc. v. Morgan Stanley Leveraged Equity Fund, 624 A.2d 1199, 1207-1208 (Del. 1993) (Emphasis added)

 To put the Nevada-Delaware nexus in context, the Nevada Supreme Court as well as the Federal District Court of Nevada and the 9th Circuit Court of Appeals frequently look to Delaware court cases for guidance in deciding Nevada corporate law issues. It is not reasonably conceivable that if the issue is directly before it that the Nevada Supreme Court would ignore the Eisner case if that case was properly presented to the court. In other words, even if under Nevada common law, Delaware corporate law cases may be so persuasive on occaison as to trump the text of a Nevada corporate statute, in this situation the Nevada courts need only choose the right Delaware corporate law case to reach the correct result.

There are numerous examples of the Nevada courts looking to Delaware cases in the corporate law area.  A few are as follows:  Hilton Hotels Corp. v. ITT Corp., 978 F.Supp. 1342,1346 (D. Nev. 1997); Shoen v. AMERCO, 885 F.Supp. 1332,1341 n.20 (D.Nev.1994); Brown v. Kinross Gold U.S.A., Inc., 531 F.Supp.2d 1234 (D.Nev.,2008); Umbriac v. Kaiser, 467 F. Supp. 548 (D. Nev. 1979); Morgan Stanley v. Jecklin, 2007 WL 923836 (D.Nev. March 23, 2007); Cohen v. Mirage Resorts, Inc., 62 P.3d 720, 726 n. 10 (Nev. 2003); Bedore v. Familian, 125 P.3d 1168, 1173 (Nev. 2006); Shoen v. SAC Holding Corp., 137 P.3d 1171, 1184 (Nev. 2006); Nevada Classified School Employees Ass’n v. Quaglia, 177 P.3d 509 (Nev. 2008); Am. Ethanol, Inc. v. Cordillera Fund, L.P., 252 P.3d 663 (Nev. 2011);  Kahn v. Dodds, 252 P.3d 681 (Nev. 2011).

Further Delaware cases are also illuminating. In a federal appellate court opinion in a derivative action after the adoption of the Delaware exculpatory clause but before Eisner, the court described the second hurdle to director liability under the exculpation statute in addition to the Aronson business judgment hurdle:

Plaintiffs faced difficulty establishing liability on the merits (i.e. proving defendant directors breached fiduciary duties by failing to prevent the sales practices giving rise to the Bell of Pennsylvania matter and settlement). The district court, in an earlier ruling, held the charter’s so-called “raincoat” provision shielded individual defendant directors from any liability resulting from their negligent acts taken as directors. See Del. Code Ann. tit. 8 § 102(b)(7) (1991) (allowing shareholders to amend the charter to exonerate directors from monetary liability to corporation or shareholders for breach of fiduciary duty of care not involving intentional misconduct, improper payments of dividends, improper stock purchase or redemptions, or breach of duty of loyalty). So plaintiffs not only would have had to overcome the usual business judgment hurdle, the “presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action was in the best interest of the company,” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), [28] but also would had to have shown reckless and possibly intentional misconduct by the directors. Bell Atl. Corp. v. Bolger, 2 F.3d 1304, 1312 (3rd Cir. 1993 (Emphasis added)

In a subsequent Delaware opinion in a similar procedural posture as Shoen, the court applied the Aronson test but took into account the exculpation statute in finding that directors were disinterested because they could not be liable under that statute.

Under the first prong of Aronson, the “mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge . . . the disinterestedness of directors . . . .” Demand is not excused simply by naming the directors as defendants in the suit or alleging that they participated in the challenged transaction. Rather, the plaintiff must plead facts sufficient to show that approval of the transaction was “so egregious on its face that . . . a substantial likelihood of director liability exists.”

The derivative claim asserted by MCG with respect to the Compensation Increases alleges, at most, a breach of the duty of care. MCG’s complaint proffers a straightforward theory to support its duty of care claim; San Miguel and Mills were grossly negligent in seeking only the advice of Barr and Austin to determine if MCG’s consent rights applied to the Compensation Increases. MCG asserts that San Miguel and Mills should have consulted independent counsel on this decision because Austin had previously been retained by Maginn to represent Jenzabar and because Barr was dependent on Maginn and Chai for his employment as general counsel.

Assuming MCG could prove that San Miguel and Mills conduct was a breach of the duty of care, San Miguel and Mills still face no threat of personal liability for this claim. The Charter contains an exculpatory provision pursuant to 8 Del. C. § 102(b)(7) that protects San Miguel and Mills from liability against monetary damages for grossly negligent behavior, which is what MCG seeks in Count Five. 116 “When the certificate of incorporation exempts directors from liability, the risk of liability does not disable them from considering a demand fairly unless particularized pleading permits the court to conclude that there is a substantial likelihood that their conduct falls outside the exemption.” Conduct outside the Section 102(b)(7) exemption, for which directors may not be exculpated, includes (i) breaches of the duty of loyalty, (ii) acts or omissions not in good faith or which involve intentional misconduct or knowing violations of the law, or (iii) transactions from which the director derives an improper personal benefit. 118 MCG’s complaint does not plead particularized facts sufficient to establish that San Miguel and Mills conduct with respect to the Compensation Increases fell outside the exemption. Neither San Miguel nor Mills derived a personal benefit from the Compensation Increases, neither stood on both sides of the transaction, and there are no facts alleged demonstrating bad faith or intentional misconduct on their part with respect to the Compensation Increases. The major question that was brought to San Miguel and Mills’ attention was whether MCG had a right to consent to the Compensation Increases. To get this question answered, San Miguel and Mills sought the advice of Barr and Austin, in-house and outside counsel. Perhaps it would have been more prudent to procure counsel that had no previous affiliation with Maginn or Chai whatsoever, but failure to do that was, at most, a breach of the duty of care. 119 Thus, San Miguel and Mills were protected by the Section 102(b)(7) provision in the Charter, did not face a substantial likelihood of personal liability, and therefore did not have a personal interest in the Compensation Increases. MCG Capital Corp. v. Maginn, 2010 Del. Ch. LEXIS 87, 67-70, 2010 WL 1782271 (Del. Ch. May 5, 2010)(Emphasis Added)

Subsequent Nevada Opinion

 

It is also worth noting that in a subsequent unpublished decision, the Nevada Supreme Court cites Shoen, discusses the fiduciary duties of care and loyalty, and refers to NRS 78.138(7) without citing the problematic sentence.  Although the case appears to involve the duty of loyalty rather than duty of care, the formulation seems another indication that the federal courts’ reading of the Shoen sentence will not endure if directly presented to the Nevada Supreme Court.

A breach of fiduciary duties is established by a preponderance of evidence. Bedore v. Familian, 122 Nev. 5, 12, 125 P.3d 1168, 1172 (2006). A directors’ fiduciary relationship with the corporation and its shareholders imparts upon the directors duties of care and loyalty. Shoen v. SAC Holding Corp., 122 Nev. 621, 632, 137 P.3d 1171, 1178 (2006). The duty of care consists of an obligation to act on an informed basis and the duty of loyalty requires the board and its directors to maintain, in good faith, the corporation’s and its shareholders’ best interests over anyone else’s interests. Id. The business judgment rule “applies only in the context of valid interested director action, or the valid exercise of business judgment by disinterested directors in light of their fiduciary duties.” Id. at 635-36, 137 P.3d at 1181 (noting that “the subject of shareholder derivative complaints is not necessarily always a business decision by the directors”). NRS 78.138(7) provides that the business judgment rule does not apply to a “director’s or officer’s act or failure to act [which] constitute a breach of his or her fiduciary duties” and involve “intentional misconduct, fraud or a knowing violation of law.” Nutraceutical Dev. Corp. v. Summers, 2011 Nev. Unpub. LEXIS 1015, 12-13, 2011 WL 2623749 (Nev. 2011) (Emphasis added)

The Federal District Court Opinions

 

To clean up some issues relating to the Federal District Court cases, while it appears they did not construe the Nevada statute correctly, the error is understandable in light of the one sentence in the Shoen opinion.  Moreover, in the federal cases the error was harmless which is why it was not pursued at least in the Johnson case. That case which has been settled involved bank officers and directors.  The applicable federal statute reads as follows.

A director or officer of an insured depository institution may be held personally liable for monetary damages in any civil action by, on behalf of, or at the request or direction of the Corporation, which action is prosecuted wholly or partially for the benefit of the Corporation–

(1) acting as conservator or receiver of such institution,

(2) acting based upon a suit, claim, or cause of action purchased from, assigned by, or otherwise conveyed by such receiver or conservator, or

 (3) acting based upon a suit, claim, or cause of action purchased from, assigned by, or otherwise conveyed in whole or in part by an insured depository institution or its affiliate in connection with assistance provided under section 13 [12 USCS § 1823],

for gross negligence, including any similar conduct or conduct that demonstrates a greater disregard of a duty of care (than gross negligence) including intentional tortious conduct, as such terms are defined and determined under applicable State law. Nothing in this paragraph shall impair or affect any right of the Corporation under other applicable law. 12 USC 1821 (k)

The United States Supreme Court construed this provision as follows. “We conclude that state law sets the standard of conduct as long as the state standard (such as simple negligence) is stricter than that of the federal statute. The federal statute nonetheless sets a “gross negligence” floor, which applies as a substitute for state standards that are more relaxed.”  Atherton v. FDIC, 519 U.S. 213, 215 (1997).  In other words, any standard of conduct more favorable to an officer or director is preempted by the federal statute.  Therefore, one could consider the construction of Nevada law on director liability in Johnson as dictum.  One of the similar opinions, while making the same error as  in Johnson, went on to recognize the federal statute as dispositive so in effect explicitly rendered the finding as to Nevada law on director liability as dictum.   FDIC v. Delaney, 2014 U.S. Dist. LEXIS 90147; 2014 WL 3002005 (D. Nev.  2014). The other two Nevada Federal District Court opinions which drew the wrong conclusion from the Shoen sentence were FDIC v. Jacobs, 2014 U.S. LEXIS 157449 (D. Nev. 2014) and FDIC v. Jones, 2014 U.S. Dist. Lexis 131738 (D. Nev. 2014).

Because the root of the problem was the sentence in Shoen and the Nevada law question was not dispositive in the federal district court cases, it is not necessary to analyze any of those opinions in depth.  However, the following excerpt from the Johnson case should make the danger apparent.

One fiduciary duty of directors and officers is the duty of care. See Shoen v. SAC Holding Corp., 137 P.3d at 1184. “With regard to the duty of care, the business judgment rule does not protect the gross negligence of uninformed directors and officers.” Id. The business judgment rule typically requires that breach of fiduciary duty involve “intentional misconduct, fraud or a knowing violation of law.” NRS § 78.138(7)(b). However, Schoen makes clear that gross negligence suffices and further scienter is not required. Thus, the question before the Court is whether there is a possibility of overcoming the business judgment rule found in NRS § 78.138 via a showing of gross negligence. The Court finds, for all of the reasons above, that there is a definite possibility of overcoming the rule. Accordingly, Defendant has failed to meet his burden, and this question is reserved to the trier of fact. FDIC v. Johnson, 2014 U.S. Dist. LEXIS 148302, 12-13 (D. Nev. Oct. 17, 2014)  FDIC v. Johnson, 2014 U.S. Dist. LEXIS 148302, 12-13 (D. Nev. Oct. 17, 2014) (Emphasis added)

If this issue were to arise in the federal courts in a case where it mattered one would hope that the court would certify the question to the Nevada Supreme Court pursuant to the Nevada Rules of Appellate Procedure (N.R.A.P. 5) and we believe as noted above that if the issue were presented properly and in the correct procedural setting the Nevada Supreme Court would likely resolve it correctly.

 

Conclusion

 

The Shoen opinion addressed demand futility in a derivative action case. It did not directly address officer or director liability but rather the likelihood of liability for purposes of determining the disinterestedness of the board of directors and the formulation may not have been critical in the context of the opinion as the case was remanded to the district court for further proceedings.  Accordingly, a change in formulation from the problematic sentence should be viewed as a clarification similar to the formulation in the subsequent Nutraceutical Dev. Corp. opinion and the sentence in Shoen should not be viewed as binding precedent on the issue of liability. Similarly, in the federal district court cases, the gross negligence standard applied as a matter of federal preemption of the Nevada exculpation statute rendering the findings of Nevada law on director liability for the duty of care dicta and of no precedential values.

If the liability standard set forth in the federal court opinions were to be applied in a case involving directors or officers of a Nevada corporation which is not a bank or similar entity, this conclusion would deprive the defendants of the protection clearly provided by the Nevada legislature and would put Nevada at a serious disadvantage to Delaware and other states in attracting not only quality directors and officers but corporations themselves. As concluded above, the author believes this is unlikely and if the liability standard for gross negligence is directly presented it will be decided correctly by applying the requirements of the Nevada exculpatory statute.

*                       *                       *

The author Neal A. Klegerman, nklegerman@ekcounsel.com, a stockholder of the law firm of Emmel & Klegerman PC in Las Vegas, Nevada and former partner of Baker & McKenzie in Chicago has practiced corporate, securities, and transactional law for more than 35 years Neal gratefully acknowledges the contributions to this article by Allen D. Emmel, aemmel@ekcounsel.com, also a stockholder of Emmel & Klegerman PC from his perspective as the hands on litigator in the Johnson case. Allen has practiced in the areas of business litigation and commercial real estate for more than 25 years.

 

March 2015

Choice Of Law And Choice Of Forum Clauses: A Proposal

This  article by Neal A. Klegerman of Emmel & Klegerman PC, proposes a new Nevada statute for contractual choice of law and choice of forum clauses. The link to the article published March 2015 is courtesy of Nevada Business Law Journal.(nevadabusinesslawjournal.com)

Link To Article:

http://www.nevadabusinesslawjournal.com/wp-content/uploads/2015/03/Contractual-Choice-Of-Law-And-Forum-Under-Nevada-Law-Article-4-14.pdf

 

Contractual Choice of Law and Forum in Nevada after Atlantic Marine
Charting a course to greater freedom of contract in the wake of a unanimous U.S. Supreme Court decision.

This article proposes enacting a new statute, the Nevada Contractual Choice of Law and Choice of Forum Act (NCCA). This article is accessible via the link here: Contractual Choice of Law and Forum in Nevada after Atlantic Marine

The purpose of the NCCA is to provide greater flexibility and certainty to parties negotiating contracts, both Nevada parties and those contracting with Nevada parties, in choosing the law governing their contract and the forum where any disputes would be settled. Additionally, as some features of the NCAA would be unique to Nevada it is hoped that it would be an additional factor favoring Nevada when businesses choose a state for their domicile.
Only contracts involving a threshold amount or involving a particular type of parties would be covered by the NCCA. The attached article also provides a brief overview of : Existing Nevada law on contractual choice of law and forum,
Atlantic Marine Construction v. United States District Court for the Western District of Texas, 134 S. Ct. 568 (2013) which is a recent United Supreme Court decision,
The Bremen v. Zapata Off-Shore, 92 S. Ct. 1907 (1972) which is another United States Supreme Court decision, and Statutes in several other states addressing choice of law or forum.The article argues that the Atlantic Marine case together with the trends discussed in the article points toward the solutions provided in the NCCA.

Neal A. Klegerman, the author of the article, is a corporate lawyer with 35 years of corporate law experience. Neal currently practices with the law firm of Emmel & Klegerman PC in Las Vegas, Nevada. Please click the link for biographical information.

Please contact Neal for any questions or comments.

Neal A. Klegerman
nklegerman@ekcounsel.com