Often the harshest business disputes are those taking place where there ought to be the most love: in the midst of family. That is the context of this week’s case, which is the culmination of 10+ years of familial issues: Kesselring v. Kesselring, No 78764-1-I, 2020 WL 1675788 (Wn. App. Apr. 6, 2020). Highlighted in Kesselring is the significance of the fiduciary duty standard within Washington corporations. In this article, I compare the corporate standard of care to Washington LLCs.
Family Issues
The business at the heart of the dispute is the Kesselring Gun Shop, Inc. (“KGS”), a gun shop in Skagit County. (Interestingly, KGS has become famous—or infamous—throughout the Greater Seattle area as the events surrounding KGS were quite outrageous, as noted in various news articles which may be found here, here, and here.) Four Kesselring brothers—Donald, Keith, Brad, and Jerry—were shareholder of KGS. Donald and Keith served as directors and officers, while Jerry and Brad participated in some day-to-day operations but never held executive positions. By all available measures, KGS was financially successful.
Despite financial success, there were substantial management issues within KGS. A 2005 audit of KGS by the ATF revealed significant violations of federal regulations applicable to KGS on account of its license to deal firearms. The audit revealed hundreds of firearms were not recorded in various logs required by federal law. Then, in 2009, the brothers discovered Brad embezzled approximately $850,000 from KGS. After confronted, Brad returned an initial sum of $130,000 to KGS, but soon thereafter committed suicide.
Jerry continued his own investigation, and in addition to problems with Brad’s embezzlement, Jerry took issue with the salaries Donald and Keith paid themselves as officers and directors. Additionally, Jerry discovered significant under reporting of KGS’s inventory, to the tune of $5 million. As an S corporation, the under reporting of inventory created substantial tax liability for KGS’ shareholders.
The Litigation
In June 2010, after discovering the extent of these issues, Jerry instituted this action wherein he sued Donald and Keith for inter alia breach of fiduciary duty, sought the appointment of a receiver, dissolution of KGS, liquidation of the assets of KGS, and distribution to the shareholders. In October 2012, ATF notified KGS that it’s license to sell firearms had been revoked. Soon thereafter, KGS’s board of directors voted to dissolve and liquidate KGS, and the trial court entered an agreed order stipulating as much. In 2013, KGS made distributions to Donald totaling over $1.3 million, while Jerry and Keith each received nearly $600,000.
The parties continued to trial, where the trial court ultimately found in favor of Donald and Keith. In particular, the trial court found Donald and Keith were not personally liable for their various poor management decisions. Jerry appealed this decision, and what followed was some very interesting fiduciary duty analysis by the Division One Court of Appeals.
The Duty of Care of Directors and Officers in Corporations
In addressing Jerry’s claims for breach of fiduciary duty against his brothers, the Court looked to Washington’s corporate statute to discern an officer’s fiduciary duty of care. RCW 23B.08.300 states the standard of care for directors (RCW 23B.08.420 also applies an identical standard for officers), and includes the following language: “A director shall discharge the duties of a director … with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” (Emphasis added.)
The Court found this standard to be ambiguous, so it turned to the legislative history to determine the legislature’s intent. Buried in the legislative history the Court found this discussion:
The combined phrase “in a like position … under similar circumstances” is intended to recognize that (a) the nature and extent of responsibilities will vary, depending upon such factors as the size, complexity, urgency, and location of activities carried on by the particular corporation, (b) decisions must be made on the basis of the information known to the directors without the benefit of hindsight, and (c) the special background, qualifications, and management responsibilities of a particular director may be relevant in evaluating the director’s compliance with the standard of care.
Significantly, this standard is a negligence standard.
After engaging in this statutory analysis, the Court went on to apply the negligence standard to KGS and its directors. In doing so, it found that trial court did not err when it held that Keith and Donald had carried out their duties in good faith and with the care of an ordinarily prudent person in a like position.
Corporate v. LLC Fiduciary Duties – Ordinary Negligence v. Gross Negligence
Washington’s LLC Act does not contain this negligence standard of “in a like position…under similar circumstances” language of RCW 23B.08.300. Rather, RCW 25.15.038 states that the standard of care (which can be modified by an LLC agreement) is “…limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law in the conduct and winding up of the limited liability company’s activities.”
Considerations
This provides interesting considerations for practitioners dealing with fiduciary duty issues in both a corporate and an LLC context. In a corporate context, the duty of care, a negligence standard, cannot be modified. In an LLC context, the duty of care, a gross negligence standard, can be (and often is) modified. Furthermore, practitioners ought to be cautious when attempting to analogize between corporations and LLCs for purposes of breaches of fiduciary duties. I have written in the past about significant differences between LLCs and corporations (see here), and the difference in the default duty of care between corporations and LLCs is yet another difference. I will say this again, LLCs are not corporations and Kesselring illustrates that difference for us.
For more Washington business entity law considerations, refer to this blog every Wednesday at 12 PM, noon.