Oregon Supreme Court overrules Court of Appeals: LLC manager with a known conflict of interest does not have authority to bind LLC

An LLC manager that causes its LLC to enter into a transaction where the manager has a conflict of interest can create havoc. Case in point: An Oregon LLC manager extended the term of a loan agreement between his LLCs and a borrower, but the manager was at the same time chairman of the board and treasurer of the borrower, as well as an investor in the borrower. When the LLCs’ members learned of it later, they attempted to reject the extension on grounds that, because of his conflict, the manager lacked authority to bind the LLCs to the extension.

The trial court dismissed the plaintiffs’ claims on summary judgment and the Court of Appeals affirmed. I wrote about the Court of Appeals’ decision and criticized part of its reasoning, here.

The Oregon Supreme Court reversed the Court of Appeals, holding that the manager’s conflict of interest invalidated the transaction unless the borrower could show at trial that the transaction was fair to the LLC. Synectic Ventures I, LLC v. EVI Corp., 2012 WL 6628093 (Or. Dec. 20, 2012).

The Loans. Three LLC investment funds (Synectic) loaned a total of $3 million to EVI Corporation in 2003. The written loan agreement required EVI to repay the loans by December 31, 2004, but EVI had the right to convert the loans into shares of EVI stock if it received additional financing of at least $1 million before the December 31 deadline.

The Conflict. The Synectic LLCs were managed by Craig Berkman, through entities he controlled. Berkman was involved with parties on both sides of the loans, because he was also the chairman, treasurer, and a shareholder of EVI.

The Amendment.  In September 2004 Berkman executed an amendment to the loan agreement on behalf of Synectic that extended EVI’s repayment deadline one year, until December 31, 2005. He also executed a Unanimous Consent on behalf of EVI’s board of directors, which approved the amendment.

The Synectic members were not aware of the amendment at the time it was made and did not discover its existence until early 2005. Berkman was removed as manager in the meantime, in December 2004. In August 2005 the Synectic members notified EVI that the amendment was unauthorized and that EVI was in default on the loan.

EVI raised $1 million in additional investment before December 31, 2005, from another fund managed by Berkman, and purported to convert the loan into equity. The Synectic LLCs filed suit to recover on the loan agreement, based on EVI’s nonpayment as of the original due date. EVI defended on grounds that the loan amendment extended the maturity date, and that the loan had been properly converted into EVI stock.

Supreme Court.  The Supreme Court began by reviewing Oregon’s LLC Act and the parties’ operating agreements. The LLCs were manager-managed, and the court concluded that Berkman was their manager and had authority under the statute and the operating agreements to cause the LLCs to enter into contracts such as the amendment to the loan agreement. The LLCs contended, however, that Berkman lacked authority to enter into this particular transaction, the amendment, because he had a conflict of interest.

The court agreed: “An agent ordinarily lacks authority to act on behalf of a principal in a transaction in which the agent has a conflict of interest.” Id. at *6. The court also observed that Berkman had a conflict of interest because as manager of the LLCs and chairman and treasurer of EVI he was acting as agent for two principals with conflicting interests. But the court then pointed out that Oregon’s LLC Act permits self-interested transactions so long as they are fair to the LLC. Id.; Or. Rev. Stat. §§ 63.155(6), 63.155(9)(b).

The court saw the fairness or lack of fairness of the amendment as a factual issue and held that “there was a genuine issue of material fact regarding whether Berkman had a conflict of interest that breached his duty of loyalty in a manner that deprived him of authority to enter into the amendment.” Id. at *7.

The defendants contended that the parties’ operating agreements permitted Berkman to act on behalf of the LLCs notwithstanding any conflict of interest. The agreements provided in Section 3.2 that “[a]ny Member … may engage independently or with others in other business and investment ventures of every nature and description and shall have no obligation to account to the Company for such business or investments or for business or investment opportunities.” Id. at *7. Berkman was referred to in the operating agreements as the “Managing Member,” and the defendants argued that he was therefore allowed by Section 3.2 to act despite his conflict of interest.

The argument that Section 3.2 exculpated Berkman from his conflict of interest was accepted by the Court of Appeals, but in my prior post I pointed out the illogic: Section 3.2 applied to members, but Berkman had a conflict while acting as a manager, not as a member. The Supreme Court likewise rejected the argument that Section 3.2 had any relevance to Berkman’s actions as a manager. Id. at *10.

The defendants also argued that under the operating agreements they were entitled to rely on Berkman’s apparent authority without making any further inquiry. The court disagreed, pointing out that because Berkman was chairman of the board and treasurer of EVI, everything he knew was imputed to EVI and it was therefore well aware of the conflict and Berkman’s resulting lack of authority. Id. at *11.

Bringing out the final arrow in their quiver, the defendants claimed that the LLCs’ seven-month delay in objecting to the amendment amounted to a ratification by silence of the unauthorized amendment. The court said that was an issue of fact, to be decided at trial. The court accordingly reversed the decision of the Court of Appeals and the trial court’s judgment, and remanded for trial.

Comment. Lack-of-authority cases often involve two innocent parties, one of whom will bear the loss resulting from the manager’s unauthorized activities. I have previously written about such cases from Missouri (members bore the loss when manager without authority caused LLC to borrow money and encumber LLC’s real estate, and then misappropriated the loan proceeds), and from Mississippi (bank bore the loss when manager without authority caused LLC to convey real estate to manager’s separate company, and then borrowed money from bank, secured by lien on the real estate).

Synectic was in some ways an easier case because it did not involve two innocent parties. The LLCs’ members were innocent because they had no knowledge of Berkman’s execution of the amendment until months afterward. But EVI was not an innocent party – Berkman’s knowledge of his conflict and lack of authority was imputed to EVI because of his role as EVI’s chairman and treasurer.