Do Texas Inspection Laws Apply to Foreign Corporations – Part One

A very important issue of corporate law is currently pending before the Texas First Court of Appeals in the case of Hartman Income REIT, Inc. v. MacKenzie Blue Ridge Fund III, LP, No 01-20-00218-CV. The issue is whether Texas law governing a shareholder’s right to inspect corporate documents applies to foreign corporations doing business in the state. In the modern world, most larger corporations do business in many states, yet they choose to be organized under the laws of a particular state. This choice is made based on the peculiarities of the particular corporate and tax laws among the various states. Corporate law is similar among the various states but not identical. Most large business corporations choose to be incorporated in Delaware for the reason that Delaware does not tax corporations and is perceived as having very management-friendly law and courts. A great many corporations are incorporated in Delaware but have no business operations there and no contact with that state other than a resident agent to accept service of process. The question frequently arises for a Delaware corporation that is headquartered and doing business, say, in Texas, to what extent are such corporations governed by Texas law and to what extent are they governed by Delaware law.

Hartman Income REIT, Inc. v. MacKenzie Blue Ridge Fund III, LP, does not involve a business corporation but a Real Estate Investment Trust, which is a particular sort of corporation that is governed by a separate law and is utilized to own and operate real estate investments. REITs receive favorable tax treatment compared with other types of corporations. Most REITs choose to be organized under Maryland law. In this case, Hartman Income REIT, Inc. is a Maryland Real Estate Investment Trust that is headquartered in Houston, Texas. Hartman owns and operates office and retail buildings in Houston, Dallas, and San Antonio, Texas. Hartman is a public corporation but is not listed on any stock exchange. MacKenzie Blue Ridge Fund III, LP is an investment fund that invests in REITs. Mackenzie owns 0.0029 percent of the shares of Hartman. MacKenzie decided that it wanted to make a tender offer to increase its ownership in Hartman and sent a demand for Hartman’s shareholder list so that it could send offers to the other shareholders. Hartman refused to release its shareholder list. Under Maryland law, a shareholder is not entitled to inspect the shareholder list unless he owns 5% of the shares. Under Texas law, a shareholder would be entitled to inspect the list if he owned any amount of shares for 6 months. MacKenzie claimed that Texas law should govern its right to inspect documents since Hartman was headquartered in Texas. MacKenzie sued Hartman to enforce its inspection rights. Both sides moved for summary judgment. The trial court ruled in favor of MacKenzie, and Hartman filed the pending appeal. This blog post will explore MacKenzie’s argument in favor of the application of Texas law. Part Two of this post will explore Hartman’s argument for the application of Maryland law.

At issue in the appeal is the application of Texas’s internal affairs doctrine. Texas’ internal affairs doctrine is codified in Texas Business Organizations Code § 1.102 and states: “[T]he law of the state or other jurisdiction in which that foreign governmental authority is located governs the formation and internal affairs of the entity.” Section 1.105 of the Code defines internal affairs as “the rights, powers, and duties of its governing authority, governing persons, officers, owners, and members; and matters relating to its membership or ownership interests.” The United States Supreme Court has described the internal affairs doctrine as recognizing “that only one State should have the authority to regulate a corporation’s internal affairs—matters peculiar to the relationship among or between the corporation and its current officers, directors, and shareholders—because otherwise a corporation would be faced with conflicting demands.” Edgar v. MITE Corp., 457 U.S. 624, 645 (1982).

Inspection is clearly prohibited by Maryland law, and inspection is just as clearly permitted by Texas law. The issue is whether a shareholder’s right to inspect corporate documents and the corporation’s duty to supply such documents to its shareholders are an internal affair of the corporation? The intuitive answer would seem to be yes, and that Maryland law should apply. This is an issue of first impression in Texas, but many other states have ruled that shareholder inspection of corporate documents does not fall under the internal affairs doctrine. In fact, the overwhelming majority of jurisdictions deciding the issue that unequivocally conclude that a shareholder’s right to inspect a corporation’s books and records “is a recognized exception to the internal affairs doctrine as a matter of corporate law and conflicts of law . . .” Sadler v. NCR Corp., 928 F.2d 48, 55 (2d Cir. 1991).

The United States Court of Appeals for the Second Circuit succinctly concluded “[a]ccess to stockholder lists is a recognized exception to the internal affairs doctrine as a matter of corporate law and conflicts of law . . .” Sadler, 928 F.2d at 55 (relying on an American Law Report to support its conclusion). The Second Circuit instead notes “states have traditionally exercised authority to require disclosure of stockholder lists of foreign corporations doing business within their borders.” Id. (internal citation omitted).

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The Texas LLC Dissolution Statute--TBOC §11.314(3)

Texas Business Organizations Code Section 11.314 provides:

A district court in the county in which the registered office or principal place of business in this state of a domestic partnership or limited liability company is located has jurisdiction to order the winding up and termination of the domestic partnership or limited liability company on application by an ower of the partnership or limited liability company if the court determines that:
(1) the economic purpose of the entity is likely to be unreasonably frustrated;
(2) another owner has engaged in conduct relating to the entity’s business that makes it not reasonably practicable to carry on the business with that owner; or
(3) it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents.

The statute provides that the company becomes subject to district court jurisdiction to order winding up and termination if a petitioning member satisfies one or more of three tests, which we will refer to as the “economic purpose test,” the “owner conduct test,” and the “reasonable practicability test.”
No Texas cases have applied section 11.314 to an LLC, and only a small number of cases apply the same statute to partnerships. However, courts in other jurisdictions have applied statutes with wording essentially identical to the three tests set forth in section 11.314 to a wide variety of circumstances. This post considers the "reasonable practicability" test under 11.314(3). This is by far the most common test applied in dissolution actions involving LLCs.

Reasonable Practicability Test
The reasonable practicability test stated in section 11.314(3) is whether “it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents.” Texas courts interpreting the “reasonably practicable” language in the limited partnership context have held that the provision “is unambiguous, and the legislature’s intent is clear; we therefore apply its plain and ordinary meaning.” The Colorado Court of Appeals interpreting identical language in the Colorado LLC statute held: “Based on these common definitions, we conclude that to show that it is not reasonably practicable to carry on the business of an LLC, a party seeking a judicial dissolution must establish that the managers and members of the company are unable to pursue the purposes for which the company was formed in a reasonable, sensible, and feasible manner.” “Not reasonably practicable” to carry on the business does not mean impossible. A Delaware court reasoned that “[d]issolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue.”
Courts have considered a number of factors in determining reasonable practicability: “These include, but are not limited to: (1) whether the management of the entity is unable or unwilling reasonably to permit or promote the purposes for which the company was formed; (2) whether a member or manager has engaged in misconduct; (3) whether the members have clearly reached an inability to work with one another to pursue the company’s goals; (4) whether there is deadlock between the members; (5) whether the operating agreement provides a means of navigating around any such deadlock; (6) whether, due to the company’s financial position, there is still a business to operate; and (7) whether continuing the company is financially feasible. No one of these factors is necessarily dispositive. Nor must a court find that all of these factors have been established in order to conclude that it is no longer reasonably practicable for a business to continue operating.”
“Not Reasonably Practicable to Carry on Business”
The reasonable practicability test has two operative concepts. The first is the practicability of carrying on the business, and the second is the practicability of doing so in conformity with the governing documents. If an LLC is simply not able to carry on the business for which it was created, then it obviously cannot satisfy the reasonable practicability test. There are a number of reasons that business have been dissolved due to the inability to carry on their business at all.

Failure of Stated Purpose
Limited liability companies fail the reasonable practicability test if they were formed for a specific purpose and are then unable to pursue that purpose for some reason. Examples include a company formed for the purpose of operating TGI Fridays restaurants at DFW airport that loses its lease at the airport, a company formed to operate a horse racing track that fails to obtain a racing license, and a company formed to operate a professional hockey team that fails to obtain the franchise. When a company “cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created,” dissolution has been allowed.
Courts often look to an LLC’s company agreement to determine the “purpose” of the business when determining whether an LLC should be dissolved under the reasonable practicability test. However, this analysis is of limited utility for most companies in Texas because LLCs formed in Texas may state that they are formed for “any lawful purpose.”

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LLC Oppression Under Section 11.314(3)

Texas Business Organizations Code Section 11.314 provides:

A district court in the county in which the registered office or principal place of business in this state of a domestic partnership or limited liability company is located has jurisdiction to order the winding up and termination of the domestic partnership or limited liability company on application by an owner of the partnership or limited liability company if the court determines that:

     (1) the economic purpose of the entity is likely to be unreasonably frustrated;

     (2) another owner has engaged in conduct relating to the entity’s business that makes it not reasonably practicable to carry on the business with that owner; or

     (3) it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents.

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LLC Dissolution Claims Under TBOC 11.314(1) and (2)

Texas Business Organizations Code Section 11.314 provides:

A district court in the county in which the registered office or principal place of business in this state of a domestic partnership or limited liability company is located has jurisdiction to order the winding up and termination of the domestic partnership or limited liability company on application by an owner of the partnership or limited liability company if the court determines that:

     (1) the economic purpose of the entity is likely to be unreasonably frustrated;

     (2) another owner has engaged in conduct relating to the entity’s business that makes it not reasonably practicable to carry on the business with that owner; or

     (3) it is not reasonably practicable to carry on the entity’s business in conformity with its governing documents.

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LLC Oppression Remedies Under §11.314

Texas Business Organizations Code section 11.314 provides that the limited liability company becomes subject to district court jurisdiction to order winding up and termination if a petitioning member satisfies one or more of three tests, which we will refer to as the “economic purpose test,” the “owner conduct test,” and the “reasonable practicability test.” 

No Texas cases have applied section 11.314 to an LLC, and only a small number of cases apply the same statute to partnerships. However, courts in other jurisdictions have applied statutes with wording essentially identical to the three tests set forth in section 11.314 to a wide variety of circumstances. Each of the three tests has been used to provide a remedy to dissension and oppression. Section 11.314 should provide meaningful relief and the possibility of a compulsory buy-out to oppressed members of Texas LLCs.

Remedy

Unlike other states in which dissolution is mandatory and the only remedy,  the Texas statute is unique. Section 11.314 provides that, if the court determines one of the three tests is satisfied, the district court “has jurisdiction to order the winding up and termination of the domestic partnership or limited liability company.”  A court with jurisdiction over an LLC presumably retains the discretion to order winding up and termination or not to do so. In fact, section 11.054 makes clear that a district court with jurisdiction to order the winding up of an LLC, in fact, has extremely broad powers to act:

Subject to the other provisions of this code, on application of a domestic entity or an owner or member of a domestic entity, a court may:

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The Limited Liability Company—Is it Right for Your New Business?

You’re starting a new business and need to decide which business form to choose. This blog post will discuss the basics of the limited liability company, or LLC.

LLCs are formed by a Company Agreement which set forth whether the LLC will be member- managed or manager-managed, the officers of the company, the membership interests and other internal affairs of the company. Importantly, the Company Agreement can only be amended if each member of the company agrees. This is an important protection for all members. It guarantees, for example, that one day you don’t walk into the office to find out that two other members have removed your voting powers. The Company Agreement should be carefully considered with your lawyer, as this is the governing document for your new business and states your rights as a member of the LLC.

An LLC may be either member-managed or manager-managed. This is established in the Company Agreement, which also may establish other classes of members. Generally, in a member-managed LLC, all members of the company have the same rights and vote on required matters. In a manager-managed LLC, however, some members will be designated as managers and others will remain members. Depending on the Company Agreement, the Managers will run the company and have voting rights. Members will not have voting rights except as outlined in the Texas Business Organizations Code, which includes the above-mentioned protection that the Company Agreement may not be changed without the agreement of all members.

One distinguishing feature of LLCs is how voting is handled. Each member receives one vote, regardless of his or her ownership interest. For example, in a member-managed LLC, the ownership interests may be 50%, 25%, and 25%. Each member would receive one vote. The 50% member’s vote would carry the same weight as the 25% owner.

As a member of an LLC, it is important to note that unless otherwise addressed in the Company Agreement, you may not withdraw from the Company and your fellow members may not expel you from the Company. However, you may sell your interest to another member or may even assign your membership interest to another, in accordance with the Company Agreement. The Company Agreement may provide for certain events in which your membership interest must be offered for sale back to the Company and/or its members, such as termination of your employment.

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The Texas Limited Liability Company—Who Runs Things?

You’re looking at forming your business as a limited liability company, or LLC. One thing to consider is how the company will be governed. This post will give an overview of how an LLC operates.

LLCs are governed by either members or managers. This is determined in the Company Agreement. In a member-managed LLC, the members control the Company. A manager-managed LLC adds another layer to the Company. At least one (or all) of the current members may be named managers of the company. For example, three people may start a manager-managed LLC with all three members named managers. However, later, new members are added to the LLC who remain members. Alternatively, managers do not necessarily have to be members of the Company. These managers will not vote on issues that require the members to make decisions, such as amending the Company Agreement.

The managers manage business of the LLC as outlined in the Company Agreement. Members may be employees of the LLC. In this situation, members will only have voting rights as allowed under the Company Agreement; however, certain situations require agreement of all members of the LLC, such as altering the Company Agreement in any way. It is important to note that this particular right can be removed in the Company Agreement. Therefore, when forming the LLC this is a significant point to discuss. When joining an LLC, you and your lawyer will want to review the Company Agreement to determine the status of this right.

There must be at least one manager in a member-managed LLC. The Company Agreement will state the number of managers. This number can be changed only by amending the Company Agreement.

The manager or managers serve for a set term. Managers are selected in one of three ways: 1) by the members; 2) by the Managers; or 3) by a class determined in the Company Agreement. A class will be described in the Company Agreement and could include a subset of members that are voting members and the rest of the members do not have voting rights.

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Inspection Rights of Former LLC Members Currently Before the Texas Supreme Court

The Amarillo Court of Appeals held in Davis v. Highland Coryell Ranch, LLC, 578 SW3d 242 (Tex. App.—Amarillo 2019, pet. filed), that a former member of an LLC has the right to inspect books and records if the member has a proper purpose. Highland filed a Petition for Review in September 2019.

Mark Davis was one of Highland Coryell Ranch’s original members. Id. at 245. He relinquished his interest in the Ranch in 2005. Davis requested documents from the LLC after he was no longer a member. Some information was provided; other information was not. Davis sued the Ranch to obtain the remaining information. The Ranch moved for summary judgment based on the argument that Davis had no right to the information, as he was no longer a member of the LLC. Id.

The court first examined the LLC inspection statute, Texas Business & Organizations Code § 101.502(a), which allows a “member of a limited liability company or an assignee of a membership interest on written request and for a proper purpose” to examine certain business records. Id.

The court also examined the definition of member in section 1.002(53)(A) of the Code: “a person who is a member or has been admitted as a member in the limited liability company under its governing documents.” Davis was no longer a member and therefore did not fit into the first category of this definition. Id. at 246.

Here is where the interests of fellow grammarians and law review nerds will be peaked. The court “harken[ed] back to high school English” and examined the tense of “has been” as used in the statute. Id. “Has been” was categorized as the “present perfect tense of the verb ‘to be.’” Id. Several examples of how present perfect tense is used are given, but the key example is that is may “describe a past action that simply occurred at some time or another without continuing effect.” Id. “’[H]as been admitted as a member’ of a limited liability company could mean that the person was admitted at some time or another in the past without requiring that his status as a member continues.” Id.

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