Header graphic for print
NY Business Divorce Information on Dissolution and Other Disputes Among Owners of New York Corporations, LLCs and Partnerships

LLC’s Quick Success Breeds Mutual Misbehavior in Delaware Case

Posted in Deadlock, Delaware, LLCs, Operating Agreement

In his post-trial opinion issued last week in Grove v. Brown, CA No. 6793-VCG (Del Ch Aug. 8, 2013), Vice Chancellor Sam Glasscock, III of the Delaware Chancery Court begins with a spot-on observation about the risk of failure faced by small, start-up businesses — including those that fail when business partners resort to misbehavior and are driven apart by the very success of their co-venture. Here’s what he wrote:

It requires a certain kind of courage to forgo a salary and strike out on one’s own. When individuals launch a small business with little equity beyond their own sweat and dreams, what follows is often a long, hard struggle leading, ultimately, to failure. When that happens, the results should evoke admiration for their efforts and sympathy for their misadventure. This matter involves a rarer bird altogether: here, four individuals launched a small and poorly capitalized business and were, from the outset, wildly successful. Unfortunately, those individuals were unable to cooperate to enjoy the fruits of that success, choosing instead acrimony and, ultimately, this litigation.

The parties in Grove who chose acrimony over cooperation are two married couples, Marlene and Larry Grove and Melba and Hubert Brown. In 2010, the Groves and Browns started a home-care staffing agency in Newark, Delaware, organized as a member-managed Delaware limited liability company called Heartfelt Home Health, LLC (“Heartfelt”) in which each of them held a 25% membership interest. At inception they entered into an operating agreement providing that each member was to make an initial $10,000 capital contribution.

Heartfelt became an instant financial success when it snagged a contract to provide home care staffing for a major hospice provider. Each of the four members was actively involved in running the business, and they worked well together in the first year, until early 2011 when discussions began about possibly expanding into Maryland and southern Delaware.

The court’s opinion details the conflicting narratives given at trial by the Groves and Browns surrounding the expansion discussions. In a nutshell, the Groves contended that they approached the Browns about opening new home health care operations in other locations and that the Browns took a pass, while the Browns contended that they did not decline the opportunity but only wanted to table consideration of expansion until a later time, and that they never granted the Groves permission to enage in a competing business.

The Disputed Capital Contributions

In March 2011, without informing the Browns, the Groves formed a Maryland LLC called Heart-N-Hand Home Care, LLC based in Maryland about 10 miles from Heartfelt’s offices. The following month, in connection with preparation of Heartfelt’s 2010 tax return, a dispute arose over shortfalls in the initial capital contributions made by Larry Grove and Melba Brown. Melba thereupon made up her shortfall in cash, but Larry purported to do so partially in cash and partially by his donations of furniture and equipment.

The Browns disputed the value of Larry’s in-kind contribution and took the position, based on the collective cash contributions by the two couples, that the Browns owned 63% versus the Groves’ 37% of Heartfelt. As the dispute over contributions and ownership continued to fester, the Groves offered to sell their interest in Heartfelt to the Browns for over $900,000 even as the Groves continued establishing their own competing health care businesses in Maryland and a second agency they established in southern Delaware.

The Threatened Dissolution and Merger Lead to Litigation

In July 2011, the Groves notified the Browns of their intention to file a certificate of dissolution, to liquidate Heartfelt, and to notify its sole client of the dissolution. In response, the Browns filed papers with the Delaware Secretary of State effecting a freeze-out merger of Heartfelt with a newly formed LLC having almost the identical name, and purportedly requiring the Groves to redeem their membership interest for less than $75,000.

The Groves filed suit against the Browns in Delaware Chancery Court, seeking damages for breach of fiduciary duty and challenging the merger’s validity. The Browns countersued for breach of fiduciary duty and usurpation of corporate opportunity based on the new agencies opened by the Groves in Maryland and southern Delaware. VC Glasscock held a three-day bench trial in January 2013.

The Court’s Post-Trial Rulings

The threshold issue, according to his decision issued last week, was whether the terms of the operating agreement limited the Browns’ ownership interest in Heartfelt to 50%, in which event they lacked the majority voting power required to effectuate the merger under §18-209 of the Delaware LLC Act.

To answer that question, VC Glasscock examined the language of the operating agreement’s provision for initial capital contributions which, he found, unambiguously granted each of the four members a 25% interest in consideration of a $10,000 contribution. He also relied on §18-502(c) of the Delaware LLC Act, which authorizes the operating agreement to provide for “specified penalties for, or specified consequences of,” a member’s failure to make a required contribution including “reducing or eliminating the defaulting member’s proportionate interest in a limited liability company.”

Since Heartfelt’s operating agreement did not make the membership interests contingent on the members’ actions post-signing and did not include any provision for reduction or divestiture of membership interest for failure to make a required contribution, VC Glasscock concluded, the Browns’ combined membership interest never exceeded 50% and, therefore, they lacked authority to cause the merger which was a “legal nullity.”

VC Glasscock also rejected the Browns’ asserted justification for the merger as a protective reaction to the Groves’ threat to dissolve Heartfelt, writing as follows:

Perhaps recognizing that tit for tat is not a justification for breach of fiduciary duty under Delaware law, the Browns provide no legal argument to support their position in post-trial briefing. I note, also, that the “threat” of dissolution was illusory. The Groves had no more authority to unilaterally dissolve Heartfelt than the Browns did to seize it for themselves.

Next, it was the Groves’ turn to take the heat for setting up two new home care agencies while serving as managing members of Heartfelt. VC Glasscock found that the two new agencies were “the type of business that, absent a waiver from Heartfelt, would qualify as a corporate opportunity” and that Heartfelt was “financially capable of capitalizing on that opportunity.” Finding that the Groves failed to meet their burden of demonstrating waiver by Heartfelt, VC Glasscock concluded that the Groves breached their duty of loyalty owed to the other members.

And what about the remedy where, as VC Glasscock put it, “[b]oth parties have taken for themselves benefits that should have been shared with the other”? Each side was ordered to account to Heartfelt (and thus to one another) for the profits they wrongfully kept for themselves. VC Glasscock wrapped up with a suggestion that “the parties could, in the interests of economy, present a petition for dissolution to be considered concurrently with the accounting” which would allow the parties to “divide their interests and pursue them separately.”

How Would Grove Play in New York?

It’s highly likely a New York court, if presented with a similar dispute over capital contributions involving a New York LLC, would reach the same result as in Grove. That’s because the default rule under §502(c) of the New York LLC Law, like §18-502(c) of the Delaware LLC Act, requires any penalties or consequences for the failure to make contributions to be specified in the operating agreement.