Why Diversity Jurisdiction Poses Investment Fund Hurdles
Imagine litigating a case for six years, going to trial and winning an award of over $10 million, only to have the judgment vacated on appeal because subject matter jurisdiction had not been established.
This is a development no client wants to hear. But it’s what the U.S. Court of Appeals for the First Circuit did last December in BRT Management LLC v. Malden Storage LLC,[1] a case where the parties, organized as limited liability companies, failed to sufficiently demonstrate that diversity jurisdiction existed.
And as highlighted below, particularly in the July decision in Anham USA Inc. v. Afghan Global Insurance Ltd., federal courts continue to apply the exacting rules of diversity jurisdiction to LLCs and similar entities, presenting particular challenges for investment funds. In the absence of any prospect for reform in the near term, those involved in managing such funds should bear these rules in mind.
Investment Fund Structure
Investment funds are often organized as limited partnerships or limited liability companies. These structures offer advantages to firms seeking to pool capital from large numbers of investors, some of which may themselves be other investment funds, resulting in vehicles that take the form of “funds of funds.”
The structures generally allow firms more flexibility to govern themselves while limiting the potential liability of their participants. But when litigation arises, the very structures that facilitate the efficient pooling of capital can cause enormous headaches.
When a dispute involves questions of only state law — such as whether a contract has been breached or whether a director has breached a fiduciary duty — a party seeking to litigate in federal court must satisfy the requirements of diversity jurisdiction. Among other things, diversity jurisdiction requires that no plaintiff can be domiciled in the same state as any defendant.
Entity Domicile
For a business entity like a corporation, the question of domicile is straightforward.[2] A corporation is considered to be the citizen of (1) the state of its incorporation, and (2) the state in which it has its principal place of business.
Entities like LPs and LLCs, however, receive different treatment. When assessing the domicile of an LP or LLC for the purpose of determining diversity jurisdiction, federal courts look to the domicile of all limited partners or members of such entities, as the U.S. Supreme Court instructed in 1990 in Carden v. Arkoma Associates.[3]
In other words, an LP or LLC will be considered to be a citizen of each state in which a member is domiciled. And if just one of those states of domicile matches the state of domicile of any party on the other side, diversity jurisdiction will be defeated.
This isn’t always a problem. Where such an entity has a limited number of easily identified partners or members, the question of domicile can be relatively simple. But problems arise in some situations of particular relevance to investment funds.
Domicile Difficulty: Confidentiality
First, where a fund’s investors value confidentiality, having to affirmatively disclose the identity of those members may make federal court unattractive. In Anham USA Inc. v. Afghan Global Insurance Ltd., the U.S. District Court for the Southern District of New York in July dismissed, for lack of diversity jurisdiction, a case naming as defendants “Certain Underwriters of Lloyd’s, London.”[4]
Lloyd’s has a unique, unincorporated structure in which anonymous underwriters come together in groups, called syndicates, to underwrite insurance policies. This structure meant that, for complete diversity to exist, the Virginia plaintiffs had to establish diversity as to each anonymous underwriter in the Lloyd’s syndicate underwriting the policy at issue in the case.
Despite alleging — and providing a letter from Lloyd’s confirming — that “none” of the anonymous underwriters at issue were Virginia citizens, the court nonetheless held such allegations were insufficient because they “fail to specifically state the facts upon which diversity jurisdiction depends, i.e., the citizenship and identity” of a syndicate’s individual members.[5]
Domicile Difficulty: Complexity
Second, as the size and complexity of a fund increases, the task of validating diversity jurisdiction can become a complex undertaking. Investment funds structured as LPs or LLCs can have hundreds or even thousands of members.
The complexity is compounded where limited partners or members are themselves LPs or LLCs. In such cases, the analysis requires the party asserting jurisdiction to determine the citizenship of those entities in a similar fashion.
The analysis continues up the chain until all individual members are identified, regardless of how many layers of ownership must be analyzed to get there.
For example, in Platinum-Montaur Life Sciences LLC v. Navidea Biopharmaceuticals Inc. decided in the U.S. Court of Appeals for the Second Circuit in 2019, the defendant removed the case to federal court but noted that the citizenship of one of the plaintiffs, a limited partnership, was unclear.[6]
The U.S. District Court for the Southern District of New York ordered “informal jurisdictional discovery,” which revealed that the LP consisted of “hundreds of feeder funds, multiple LLCs, [and] unincorporated entities” in its ownership structure, such that the plaintiff could not determine whether any of its members was nondiverse.[7]
The district court assumed diversity jurisdiction and ruled on the merits of the case. On appeal, the Second Circuit reversed and held that the “scrupulous enforcement of [] jurisdictional rules” required the district court to either conduct further jurisdictional discovery or remand the case back to state court.[8]
You might assume that courts will engage in a more practical analysis the more complex and more corporation-like an entity gets, but you would be doing so at your own risk. Dismissal may occur, as it did in Icon MW LLC v. Hofmeister, even if “less than one percent of membership” is nondiverse, and regardless of whether the nondiverse members may be more akin to passive shareholders.
In Icon, an LLC brought a state court action against a defendant, who removed the action to the Southern District of New York in 2013 on the basis of diversity.[9]
The LLC had its principal place of business in New York and consisted of two funds also operating principally in New York. The two funds had a combined membership of 17,317 individuals, of which 159 were citizens of Kentucky, and which the defendant argued were “more analogous to shareholders than participatory members.”[10]
But the court rejected that argument outright. Because the defendant was a citizen of Kentucky, any Kentucky members of the plaintiffs destroyed complete diversity.[11]
Rule Update
It’s no wonder, then, in a change made effective at the end of 2022, that the Federal Rules of Civil Procedure updated Rule 7.1 to require that, where jurisdiction is based on diversity under Title 28 of the U.S. Code, Section 1332(a), a party or intervenor must a file disclosure statement that “must name — and identify the citizenship of — every individual or entity whose citizenship is attributed to that party or intervenor.”
Under this rule, when a case gets to federal court, either because it’s initiated there or gets removed from state court, LLCs and LPs must be proactive in identifying their members, even where that might be a daunting task. This is a substantial improvement as the rule encourages parties to determine their citizenship at the outset of a federal case before expending substantial resources on discovery and trial.
Citizenship of a limited liability entity is determined by the time-of-filing rule, which fixes jurisdiction based “upon the state of things at the time of the action brought,” according to the decision in Grupo Dataflux v. Atlas Global Group LP.[12]
In that case, limited partnership dropped its two nondiverse members a month before trial, and the jury had already returned a verdict in favor of the limited partnership when the issue of diversity jurisdiction was raised. The Supreme Court in 2004 found diversity was lacking because the limited partnership had nondiverse members at the time of filing the complaint.[13]
Thus, even if an LLC’s members satisfied diversity jurisdiction requirements at the time of a jury verdict, failure to satisfy diversity jurisdiction at the time of filing the complaint can warrant dismissal.
The time-of-filing rule may foreclose jurisdiction in many cases, but an LP or LLC may still have options. At least one court has allowed a limited liability entity to refile a lawsuit after dropping its nondiverse members in an attempt to invoke diversity jurisdiction.
In Castillo Grand LLC v. Sheraton Operating Corp., the Second Circuit in 2013 found a plaintiff LLC’s refiling of a lawsuit after dropping its nondiverse members did not constitute improper jurisdictional maneuvering.[14]
Many have argued for a more functional approach to rules around diversity citizenship for LLCs, LPs and other noncorporate business entities. But until those rules change, we recommend that investment funds take the following actions to avoid the pitfalls of diversity jurisdiction.
Recommendations
When forming an investment fund, consider requiring limited partners or members to report their residency as well as the residency of any of their limited partners or members, and to do so on a periodic basis for the duration of their participation in any investment vehicle.
The fund should carefully document this information. This can help minimize the cost of jurisdictional discovery.
Consider the importance of investor confidentiality both at the time of fund formation and when making strategic decisions about where to litigate a dispute. Where confidentiality is paramount, revealing investor identities, even just to potential adversaries, may implicate nondisclosure agreements and confidentiality provisions.
Even if disclosing investor identities does not violate a legal obligation, doing so may risk alienating investors. In such cases, avoiding federal courts in diversity cases may be preferable.
Some states have specialized courts focused on commercial matters, which may provide a viable alternative to federal court for resolving commercial disputes.
Where possible, funds concerned about investor confidentiality should consider including forum selection clauses in their agreements that designate such specialized commercial courts to hear disputes.
A limited liability entity seeking diversity jurisdiction should carefully investigate the residency of its members prior to initiating litigation and consider dropping any nondiverse members, if appropriate, to satisfy diversity jurisdiction. This is because diversity jurisdiction is determined by membership makeup at the time of filing, not at any other point of litigation.
Parties asserting federal court jurisdiction may not always be well situated to determine the citizenship of the opposing party. After making a good faith effort to determine the opposing party’s citizenship, consider requesting limited jurisdictional discovery to fill in any gaps.
There may be good reasons for a litigant to want to be in federal court. But investment funds should think twice and consider taking the precautions described above before making that choice.
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Written by Justin Sher and Vikram Shah.
This article was originally published by Law360. A link to the original article may be found here.
[1] 68 F.4th 691 (1st Cir. 2023).
[2] See 28 USC § 1332(a).
[3] 494 U.S. 185, 195-96 (1990).
[4] No. 23-CV-2763, 2024 WL 3362991 (S.D.N.Y. July 10, 2024).
[5] Id. at *7.
[6] 943 F.3d 613 (2d Cir. 2019).
[7] Id. at 615.
[8] Id. at 619.
[9] 950 F.Supp.2d 544, 545 (S.D.N.Y. 2013).
[10] Id.
[11] Id. at 546.
[12] Grupo Dataflux v. Atlas Global Group, LP , 541 U.S. 567, 570 (2004).
[13] Id. at 582.
[14] 719 F.3d 120 (2d Cir. 2013).