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Early-Stage Corporate Decisions Create Later-Stage Consequences

Jan. 31, 2022, 9:45 AM

Tax considerations often drive the formation of closely held businesses. One challenge when advising clients who want to start businesses, or investors who contemplate backing them, is getting them to consider worst-case scenarios. What if the business doesn’t succeed? What if it does, but the founding partners have a falling out?

Launching the company and realizing the return on investment is always a priority, but the what-if questions need to be considered. The decisions of which type of business to choose and which requirements will be imposed on those who manage that investment are critical. The recent case of Benjamin v. Island Management, LLC, illustrates the importance of these decisions.

Island Management is a Connecticut manager-managed limited liability company. It was formed by William Ziegler to manage and grow his family’s assets. There are six equal members in the company, each a trust for the benefit of one of Mr. Ziegler’s adult children. The Ziegler siblings are the trustees of their respective trusts.

After Mr. Ziegler’s passing, a dispute arose among his children over the annual amounts distributed to the respective trusts. That led to a series of demands from one of the Ziegler siblings to inspect the books and records of the company. Each of these demands referenced Connecticut’s Uniform Limited Liability Company Act, Conn. Gen. Stat. § 34-255i(b)(2).

According to the statute, a “member may inspect and copy full information regarding the activities, affairs, financial condition and other circumstances of the company as is just and reasonable if: (A) The member seeks the information for a purpose reasonably related to the member’s interest as a member; (B) the member makes a demand in a record received by the company, describing with reasonable particularity the information sought and the purpose for seeking the information; and (C) the information sought is directly connected to the member’s purpose.”

The plaintiff maintained that she needed the requested information to determine her trust’s interest in Island Management and that without it, she could not exercise her rights in an informed manner.

Island Management produced much of the requested information for inspection but not all of it. By the time of the trial, there were four categories of documents that Island Management refused to produce:

  • Its general ledger;
  • Information relating to its management service agreements for two investments;
  • Compensation information for its managers, officers, and employees; and
  • Records showing payments made to third parties on behalf of the plaintiff’s trust.

The trial court agreed with the plaintiff that she was entitled to the information the company had withheld and ordered the company to provide the requested information.

On appeal, Island Management argued that the plaintiff failed to meet the requirements of the statute for three reasons:

  1. The plaintiff failed to offer credible proof that mismanagement had occurred;
  2. The information requested was not “directly connected to the member’s purpose"; and
  3. The plaintiff’s requests for the information had not been made with “reasonable particularity.”

None of these arguments prevailed.

In this case of first impression, the Connecticut Supreme Court declined to follow Delaware’s construction of its statute, Del. Code Ann. Title 8, §220(b), which provides that investors are not entitled access to company records unless they have reasonable basis to suspect mismanagement that is supported with facts. The Connecticut Court concluded that Delaware’s heightened standard precludes investors from gathering the very proof that might be necessary to justify their suspicion.

The Court noted that §34-255i(b)(2), unlike its counterpart under the Model Business Corporation Act, Conn. Gen. Stat. §33-946(d), contains no requirement that a request “be made in good faith.” The Court found that in the absence of this “good faith requirement for current LLC members cut strongly against imposing a credible proof requirement on such members.” The Court also observed that Island Management’s operating agreement did not impose any restriction on the availability and use of information otherwise available under §34-255i, noting that such restrictions would certainly have been permissible and would have been enforced.

The Court broadly construed the plaintiff’s request as one attempting to determine the condition and affairs of the company so that she may exercise her rights as a member in an informed manner. It declined to adopt the company’s argument that the requested information should be strictly necessary for the stated purpose, as required under Delaware law.

Connecticut’s statute, in the Court’s view, only required that there be some relevance between the requested information and the proper purpose. A demonstration of indispensable need is not required.

Although the outcome in this case resulted from the interpretation of a Connecticut statute, Island Management underscores a divide between the states as to an investor’s right to inspect company records, making the message clear for all who are considering launching a business. The decisions you make early about your choice of entity and the care taken in the creation of its formative documents can have a significant impact on the company’s future.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

James T. (Tim) Shearin is chairman of Pullman & Comley and former chair of the firm’s Litigation Department. He has wide-ranging experience in federal and state courts at both the trial and appellate levels, and before arbitration and mediation panels, and is a Fellow of the American College of Trial Lawyers.

Timothy G. Ronan is co-chair of Pullman & Comley’s Litigation Department. He practices in the areas of complex commercial litigation and alternative dispute resolution, and represents clients in the federal and state courts and in domestic and international arbitrations on a wide variety of business issues.

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To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com

To contact the editors responsible for this story: Patrick Ambrosio at PAmbrosio@bloombergindustry.com; Butch Maier at bmaier@bloombergindustry.com