Gift of LLC Interest Leads to Litigation

On February 3, 2021, the Iowa Court of Appeals issued an opinion in a father-son dispute over their member-managed LLC. The court recognized that the father, a farmer who created the LLC and gifted 50 percent of the shares to the son, did violate the operating agreement and engage in mismanagement. Overall, however, the court agreed with the district court that the farmer did not generally breach his fiduciary duties and did not harm the LLC through his actions as alleged in the son's derivative action. The court did find that the farmer acted in bad faith when enrolling the LLC-owned property in the CRP without the son’s permission, but that the district court acted properly by seeking to monitor—not remove—the father as manager.  

Background Facts

In 2012, a farmer transferred the title of farmland into an LLC to further the goals of his estate plan. The farmer gifted half of the membership units, which consisted of Class B non-voting units, to his son. The farmer and his wife retained the remaining shares consisting of both part Class A voting units and part Class B non-voting units. The operating agreement named the farmer as the manager of the LLC. The pre-existing mortgage on the farmland stayed in the farmer’s name.

The son continued to farm the land pursuant to a crop-share arrangement under which he received 70 percent of the income and the LLC received 30 percent. The son paid most of the expenses. The son also rented a pasture and hay ground from the LLC. The farmer used the LLC’s farm income to pay the mortgage. By the time of the trial, the farmer had paid off the debt on the land.

Initially, the farmer used his own personal bank account to deposit income and make payments on behalf of the LLC. After the farmer’s tax advisor discovered that the farmer had comingled funds from his personal account, the LLC, and a second LLC created for another child, he “strongly suggested” the farmer separate the personal and business accounts. After learning of the comingling, the son asked his father for the LLC’s financial records. The farmer did not immediately comply, and the son filed this lawsuit.

After the son filed the lawsuit, the farmer terminated the LLC’s farm lease with the son and enrolled the land in the Conservation Reserve Program four months before the lease expired. Although regulations require a tenant’s consent to enroll leased farmland in the CRP, the farmer did not seek his son’s consent. Instead, he used a power of attorney previously executed by the son to authorize the enrollment.

Lower Court Proceedings

At trial, the district court found that the farmer did not breach fiduciary duties or the operating agreement when he used LLC funds to pay personal debts related to the farm. The court did award the son damages for annual distributions he did not receive, but declined to remove the farmer as the manager. The district court, “refus[ing] to create further financial burdens and add more fuel to an already extensive and painful dispute between family members,” did not award attorney fees to either party. Specifically, the district court stated that both parties prevailed on certain aspects of the claims.

Fiduciary Duties for LLC Managers

On appeal, the son argued that the district court erred when it found that the farmer did not breach his fiduciary duties to the LLC by using company funds to pay off the farm mortgage.

In evaluating the argument, the court reviewed Iowa law regarding a manager’s duties of loyalty and care.

A manager of an LLC owes a statutory duty of loyalty and care. Iowa Code § 489.409(1). The duty of loyalty requires a manager to refrain from self-dealing or competing with the company. If the transaction was fair to the company, then there is no violation of this duty. A duty of care requires managers to act in the best interest of the company. Under the business judgment rule, if the manager can show that the alleged violation was performed in good faith, the court will assume that the manager made an informed decision in the best interest of the company.

The parties agreed that the LLC never became liable for the farm mortgage. However, the court agreed that the farmer created the LLC intending that the business income would pay for the farm debts. The son was not an initial owner of the LLC and only obtained interest in the company after his father gifted him shares of the LLC.

At the time of the trial, the debt was paid off. The court found there was no evidence the farmer’s asset reinvestment or debt repayment hurt the LLC. These actions were done in good faith and were in the best interest of the company. Therefore, the court agreed with the district court that the actions did not harm the son or the LLC and that the duties of loyalty and care were not breached.

General Mismanagement

The son next claimed that the farmer breached the operating agreement by filing inaccurate tax returns and refusing to provide the requested financial documents. The operating agreement required the manager to maintain accurate financial records; to provide the members with financial information after receiving reasonable notice; and to create annual reports and file tax returns.

The court agreed with the district court’s determination that the farmer failed to abide by terms of the operating agreement and was responsible for a number of omissions. However, the court agreed that these omissions were in good faith, and the father was working to preserve the company’s assets for his son.

Removal of Manager

The son also argued that the district court erred by failing to remove the farmer as the manager of the LLC. Instead, the district court had imposed reporting requirements followed by a compliance hearing to confirm the farmer’s dedication to the role of manager and his future willingness to comply with the operating agreement. The court agreed that the district court acted within its discretion in fashioning this equitable remedy. The court also rejected the son’s request to impose an injunction requiring the farmer to follow the operating agreement.

Damages

The court affirmed the lower court’s award of $47,866 in damages to the son for the annual distributions “he should have received” as a member of the LLC, but rejected the son’s request for additional damages from lost distributions.

The court did reverse the lower court’s ruling regarding the denial of rent reimbursement. Because the son was not able to use the farmland for four months due to the farmer’s wrongful use of a power of attorney, the court awarded him $2985.76 in damages for loss of use of the property. The court also found that the father was ineligible for indemnification of his attorney fees because of his bad faith in renewing the CRP contract.