Los Angeles Partnership Law: A Fiduciary’s Loyalty, Honesty

Los Angeles partnership litigation lawyers will be interested in a case from earlier this year entitled Feresi v. The Livery, LLC.  This case involved a lawsuit between members in a Limited Liability Company.  One member filed the lawsuit against the LLC’s president and his trust, contending that the president’s claim to a security interest in the member’s share was the result of a breach of fiduciary duty of good faith and fair dealing.  The trial court declared the president’s (trust’s) security interest null and void and enjoined the president from attempting to enforce the security interest.  The president (and trust) appealed.

Issue

wsl-davidThe California Commercial Code provides that a financing statement must be filed to perfect all security interests and a perfected statement has priority over a conflicting unperfected security interest.  In this case the issue is whether the president’s perfected security interest trumps the unperfected security interest of another LLC member when the president perfected his security interest by breaching a fiduciary duty owed to the party whose security interest was unperfected.  In other words can the president benefit from his breach of fiduciary duty?

Background Facts

Feresi and Mesa married in 1995 and acquired a 25% interest in the LLC.  There were four equal investors of which Hartley and his family trust was another.  He served as the LLC’s president and managing member.

Feresi and Mesa divorced.  Feresi was awarded her community interest and therefore received 12.5% of the LLC.  Mesa was required to make monthly payments on Feresi’s home mortgage and this financial obligation was secured by his interest in the LLC and other properties.

Feresi gave Hartley and other members written notice that she had been awarded one half of the interest and that Mesa had pledged his retained share as security for his financial obligations.  The LLC books and records were amended to show Feresi as a 12.5% interest holder and the corporate tax returns showed her as a member.

Mesa began struggling financially and fell behind on his obligations to Feresi and other creditors.  Hartley then made a loan to Mesa of $200,000.  Although Hartley knew that Mesa’s membership share in the LLC secured his financial obligations to Feresi, Hartley nevertheless secured the loan with Mesa’s 12.5% ownership.  Hartley did not disclose to Feresi that he was loaning money to Mesa or that it would be secured by the same membership share that were securing Mesa’s obligations to Feresi.

Feresi notified the LLC that she would enforce the security by taking Mesa’s 12.5% interest and filed a quiet title action.  Hartley, noting that Feresi had not filed a UCC-1 financing statement to perfect her interest, “took advantage of this circumstance to acquire priority for his own, conflicting security interest in the same membership share by filing a UCC-1 financing statement reflecting” his loan to Mesa.

On January 22, 2009, a judgment was entered in the family law court conveying the 12.5% to Feresi and she promptly notified the LLC.  On October 7, 2009 Mesa defaulted on his loan from Hartley and Hartley published a Notice of Disposition stating that the 12.5% would be sold to satisfy the debt.  Feresi filed this declaratory and injunctive relief action.

The Trial Court

The trial court held a trial and found that Feresi was a 12.5% member and that Hartley “had actual notice of Feresi’s prior security interest, knew Mesa was in default on his obligations to Feresi, knew she was entitled to enforce her security interests by taking Mesa’s share of the LLC, and knew that she had filed the OSC and quiet title action to do so.”  The trial court also found that once Hartley learned in October 2009 that Mesa had transferred his 12.5% interest to Feresi, Hartley was obligated to insure that the LLC’s corporate records showed Feresi was the exclusive owner of 25% of the LLC.

The trial court (and then the appellate court) found that Feresi was a member.  Moreover, Hartley acknowledged it by identifying her as a member in the LLC tax documents.

The trial court ruled that Hartley breached a fiduciary duty owed to Feresi and that Hartley’s security interest was null and void.  The trial court declared that Feresi owns 25% of the LLC without any encumbrance by the claims of Hartley.  Hartley was also enjoined from trying to enforce his security interest against Mesa’s share of the LLC.

Hartley Breached the Duty of Good Faith and Fair Dealing

The Court of Appeal began by noting a 1928 New York case:

“The animating principle of a fiduciary’s duties to his charges is unfaltering loyalty and honesty.  ‘Many of forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties.  A trustee is held to something stricter than the morals of the market place.  Not honest alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.  As to this there has developed a tradition that is unbending and inveterate.  Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions.  Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd.”

In this case the court held that Hartley “is not entitled to disregard his actual knowledge of Feresi’s preexisting security interest in the same property and perfect his security interest at her expense.  Hartley’s filing of the UCC-1 financing statement was not without detriment to his partner, Feresi.  It rendered her security interest worthless.”

“Feresi had no reason to protect the priority of her own security interest in the same property because she was unaware that her partner held a conflicting interest.  Hartley took advantage of Feresi’s ignorance by concealing this from her, and betrayed her trust and confidence by perfecting his security interest ahead of hers.  In doing so, Hartley breached the fiduciary duties of loyalty and good faith he owed to Feresi.  The primacy of Hartley’s  security interest in Mesa’s share of the LLC must succumb to the infection of his duplicity and silence.  The trial court property refused to enforce the security interest held by Hartley…”

Equitable Subordination As An Exception?

Hartley argued that the UCC sets a ‘hard line’ that requires courts to ignore the equities and accept ‘harsh results’ to ensure that commercial transactions are simple, clear and uniform.  The Court of Appeal, however, concluded that if a fiduciary engages in inequitable conduct with respect to a person to whom a fiduciary duty is owed, then its claim lien or security interest may be wholly or partially subordinated.  The court has the power to do justice as circumstances dictate.

While equitable subordination should be invoked with caution, Feresi has shown that the fiduciary engaged in inequitable conduct, the misconduct resulted in injury to Feresi or conferred an unfair advantage on the fiduciary and invocation of the remedy would not be inconsistent with the Commercial Code.

A Los Angeles partnership attorney’s comments on this case…

What strikes me about this case is that it ever got to trial.  Presumably Mr. Hartley had a partnership lawyer who could look at what Mr. Hartley did and advise him to settle or otherwise resolve this case short of trial.  The facts are pretty straightforward and Mr. Hartley’s attempts to secure his own deal above that of Ms. Feresi do not appear to be subject to alternative interpretations.  An experienced partnership litigation attorney should have had a ‘come to Jesus’ talk with Mr. Hartley about the risks and probable outcome of this litigation.

Having said that, clients do not always listen to their trial attorneys, especially in partnership litigation.  Partners and other fiduciaries are often blinded by emotion and anger.  They cannot see that what they did was neither fair nor reasonable.  The ‘legal’ argument about the late filed UCC-1 may have been a tactic by an attorney who failed to see how this tactic would appear to a judge.  However, it does not pass the smell test.

Los Angeles corporate litigation attorney Laine T. Wagenseller has handled numerous partnership and corporate shareholder lawsuits in Los Angeles and around Southern California.  For more information please visit www.wagensellerlaw.com.  Mr. Wagenseller can be contacted at (213) 286-0371.