LLC Members in Online Store Venture Bound by Partnership Fiduciary Duties — Health and Body Store v. Justbrand Limited

[Post by Venkat Balasubramani]

Health and Body Store, LLC v. Justbrand Limited, 11-4132 (3d Cir.; May 11, 2012)

*Sigh.* Another group of people attempt a web venture with zero documentation and end up in court. One of the many perennial themes of this blog is that people must spell out the terms of any web venture in advance. This includes everything from a joint blogging arrangement to a jointly operated online store or a simple web development agreement. It’s not optimal to leave the documentation for later. You say you will deal with it later, but time flies, and as the value of the venture or the priorities or expectations of the parties shift, it becomes increasingly difficult to calibrate the arrangement from even ground. (In the extreme case, such as between Eric and I, a simple email or phone conversation may suffice, but I’d strongly advise against it. Reminder to Eric: if the big buyout materializes, all bets are off!)

Anyway, this is what happened here. Silverman and Singer worked for Hotheadz as sales trainees. While they worked for Hotheadz, and with Hotheadz’s permission, Silverman and Singer began to operate an independent online business; the bulk of the products sold by this business were purchased from Hotheadz. In 2007, Silverman and Singer registered [healthandbodystore.com] and [warmingstore.com] and put “substantial effort” into developing the underlying websites. These sites experienced moderate sales in 2007, but sales grew in 2008 and 2009 (from $60K to $150K and $170K, respectively).

In 2008, the CEO of Hotheadz became concerned that Silverman and Singer’s independent activities were interfering with their duties at Hotheadz. He gave them several options: (1) contribute the websites into Hotheadz; (2) leave Hotheadz and operate their ventures independently; or (3) form a joint venture. The parties exchanged a letter of intent, but this was never finalized. According to Silverman, they did not address the essential terms that he would expect to see in such an agreement.

In 2010, Hotheadz formed Health and Body Store as an LLC. The LLC had two members: Hotheadz, and Justbrand, which was an LLC operated by Silverman and Singer. Silverman and Singer continued to operate the websites, but did so allegedly with the support of Hotheadz. Among other things, Hotheadz provided warehousing, customer service, and other infrastructure. In 2011, Hotheadz sent a draft operating agreement (for HBS) to Silverman and Singer. The draft LLC agreement required payment of a “management fee” of $20,000 per month to Hotheadz and required Silverman and Singer to transfer the domain names to HBS. Silverman and Singer were less than enthused with the proposed arrangement, so they made arrangements to break off the relationship. They stockpiled inventory (ordering it from Hotheadz through an entity called “Novell Brands”). Ultimately, they resigned from Hotheadz, changed all of the passwords, and went off on their own.

District Court Proceedings: Hotheadz filed a complaint, along with a request for a preliminary injunction. The complaint asserted a variety of claims, including claims under the Computer Fraud and Abuse Act and the Lanham Act. The district court initially granted Hotheadz’s request for preliminary relief, but at a later hearing found that there was no meeting of the minds as to the essential terms of the HBS venture, and thus, no basis to impose fiduciary duties on Silverman and Singer. The court also rejected Hotheadz’s Lanham Act claim because Silverman and Singer agreed to remove any Hotheadz trademarks from the websites.

The Third Circuit Ruling: The Third Circuit reverses the district court on the fiduciary duty question. It finds that Silverman and Singer (through their entity) “cooperated with Hotheadz in the formation of HBS.” Since the parties never executed the LLC agreement, the default partnership law provisions applied and gave rise to a fiduciary relationship between the partners. This meant that in operating the websites, Silverman and Singer “were obligated to operate the Websites in a manner consistent with [their] fiduciary obligations to Hotheadz and to HBS.” The court finds that Sliverman and Singer owe fiduciary obligations through their ownership interest in Justbrand (which was a member of the LLC, along with Hotheadz) but potentially in their individual capacities as well. Silverman represented at times that he was a “partner,” “owner,” “president,” or “vice president” of HBS and to the extent he held any of those positions, this may be sufficient to independently impose fiduciary duties on Silverman and Singer.

The court passes on the Lanham Act claims, noting they overlap with the fiduciary duty claims and there is insufficient evidence in the record to determine who had the valid and legally protectable interest in the appearance of the websites. (Hotheadz’s Lanham Act claim seems to span alleged misuses of its Hotheadz marks, as well as goodwill that HBS may have had in the appearance of the websites.)

Finally, the court footnotes the fact that it’s leaving the appropriate relief for the district court to decide in the first instance, hinting that no relief at the injunction stage may be appropriate:

[i]t is possible, of course, that no remedy at all should be given, even if there has been a breach, since the balance of equities may make a preliminary injunction inadvisable.

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Eric has posted on a slew of cases that deal with online “divorces” where joint site operators split up with each other. Mikhlyn v. Bove is the paradigmatic example: “Cautionary Tale of Website Co-Ownership–Mikhlyn v. Bove.” The most recent involved parties squabbling over a Tea Party-related Google Group: “Tea Partiers Wage War Against Each Other Over a Google Groups Account–Kremer v. Tea Party Patriots.” Based on how often we see these disputes, parties can’t be reminded of the necessity for clear documentation often enough.

Hotheadz’s trademark claims based on the “Hotheadz” marks were muddled and the court does not address them, but they seemed tenuous at best. As a reseller, HBS (or Singer and Silverman) should have the right to refer to Hotheadz to accurately describe the products sold by HBS. As to any claim based on the “Health and Body Store” mark, these overlapped with the fiduciary duty claim and it made sense to focus on the fiduciary duty claim. These types of disputes often spur claims under the Computer Fraud and Abuse Act or theories of conversion, but these claims really piggyback on the underlying ownership claim.

It was unfortunate for Silverman and Singer to have agreed to form the LLC and consented to filing the formation papers, without having ironed out the details of the underlying relationship. The court’s opinion is unclear on to what extent they “cooperated” with Hotheadz in this process. It could have been as menial as counsel for Hotheadz filing the certificate of formation and obtaining email confirmation from Silverman and Singer. Something like this shouldn’t sign Silverman and Singer up for fiduciary duties, but this is yet another pitfall of online marriages. If you form an entity with another person, you may sign up for a lot more in the way of duties than you intended to. Half-papering the arrangement may be just as bad as not having any contracts in place at all. It certainly put Silverman and Singer in a worse off position here. Interestingly, the court notes that Hotheadz helped Silverman and Singer and provided support for the business, but the court’s order wasn’t overly detailed on this point.

Related posts:

Tea Partiers Wage War Against Each Other Over a Google Groups Account–Kremer v. Tea Party Patriots

Cautionary Tale of Website Co-Ownership–Mikhlyn v. Bove.

Web Vendor Dispute Gets Ugly–Ground Zero Museum v. Wilson

Holding on to a Domain Name to Gain Leverage in a Business Dispute Can Constitute Cybersquatting — DSPT Int’l v. Nahum

Another Cautionary Tale of Joint Website Ownership–TEG v. Phelps [UPDATED]

Web Developer Didn’t “Convert” Website–Conwell v. Gray Loon

Ohio Appeals Court: GoDaddy can be Held Liable for Wrongly Transferring Control Over Domain Name and Email Accounts — Eysoldt v. ProScan

Eric’s essay on co-blogging:

Co-blogging Law

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