WWDD (What Would Delaware Do) With an In Terrorem LLC Dissolution Waiver Clause?
I can't resist asking the above question in the wake of two recent decisions, one from Delaware Chancery Court invoking freedom of contract to enforce an LLC operating agreement's waiver of a member's right to seek judicial dissolution, and the other from New York's Commercial Division refusing on public policy grounds to enforce an operating agreement's in terrorem provision forfeiting the interest of any member who files for judicial dissolution.
The names if not the issues in both cases may sound familiar to regular readers of this blog.
The Delaware case is R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008) (read decision here). The factions in R&R have been waging a multi-front battle for years, with simultaneous lawsuits in Pennsylvania state and federal courts, New York state court, and most recently Delaware Chancery Court. At issue is control of nine Delaware LLCs that own and operate a number of horse farms. The Russet brothers put up most of the almost $10 million capital but gave 50% member Linda Merritt sole management authority under the operating agreements.
I recently posted about a pair of decisions in the New York case in which the Russets sued to oust Merritt as sole manager based on allegations of fraud and mismanagement (see here). In January 2008, the New York court ruled that Merritt had authority to sell company assets to pay off various debts including her own legal fees under the operating agreement's indemnity provision. The Russets then asked the judge to recuse himself based on allegations that he engaged in improper communications with a mediator who supposedly tried to "fix" the case at Merritt's behest. In a May 2008 decision, the judge denied the motion and referred the matter to the District Attorney for investigation of possible perjury.
The next month, the Russets through their membership-holding company, R&R Capital, LLC, petitioned the Delaware Chancery Court to dissolve the LLCs. The petition alleges that most of the LLCs have had their certificates of formation canceled for failing to designate a registered agent or pay annual taxes, and it also alleges fraud and self-dealing by Merritt. The LLCs moved to dismiss the petition -- I presume Merritt exercised her authority as sole manager to engage and pay for the LLCs' counsel -- on the grounds, first, that R&R lacked standing to seek dissolution of two of the LLCs (the "Pandora Entities") and, second, that R&R waived the right to seek judicial dissolution of the seven other LLCs (the "Waiver Entities") under the terms of their operating agreements.
Chancellor William B. Chandler III agreed with the LLCs on both counts. With respect to the Pandora Entities, Section 18-802 of the Delaware LLC Act confers standing to seek judicial dissolution on "a member or manager." Since R&R only held an indirect interest in the Pandora Entities, through its membership in the sole member of each, it lacked standing to seek judicial dissolution.
As for the Waiver Entities, the LLCs relied on identical provisions in the operating agreements, captioned "Waiver of Dissolution Rights," providing as follows:
The Members agree that irreparable damage would occur if any member should bring an action for judicial dissolution of the Company. Accordingly each member accepts the provisions under this Agreement as such Member's sole entitlement on Dissolution of the Company and waives and renounces such Member's right to seek a court decree of dissolution or to seek the appointment by a court of a liquidator for the Company.
Chancellor Chandler rejects R&R's arguments, that the waiver provision is unenforceable under the LLC Act and as a matter of public policy, emphasizing that "the public policy of Delaware with respect to limited liability companies is freedom of contract," and that "the freedom of contract principle must be assiduously guarded lest the courts erode the primary attraction of limited liability companies." As for the operating agreements at hand, he writes:
Here, the LLC Agreement is a contract between sophisticated parties. The business relationships between the individuals behind the petitioners and Lynda Merritt is extensive; clearly these were parties who knew how to make use of the law of alternative entities. The mere fact that the business relationship has now soured cannot justify the petitioners' attempt to disregard the agreement they made. Therefore, contrary to petitioners' argument that Delaware's public policy will not countenance their unambiguous contractual waiver, the state's policy mandates that this Court respect and enforce the parties' agreement.
The Chancellor's opinion also notes that "there are legitimate business reasons why members of a limited liability company may wish to waive their right to seek dissolution or the appointment of a receiver," such as to avoid default under loan agreements that make the filing of a dissolution petition a noncurable event of default. In response to R&R's argument that enforcement of the waiver leaves them without a remedy for abuse by Merritt, the Chancellor states that Section 18-1101(c) of the Delaware LLC Act "preserves the implied covenant of good faith and fair dealing." He continues:
It is the unwaivable protection of the implied covenant that allows the vast majority of the remainder of the LLC Act to be so flexible. There is no threat to equity in allowing members to waive their right to seek dissolution, because there is no chance that some members will be trapped in a limited liability company at the mercy of others acting unfairly and in bad faith.
Chancellor Chandler ends his opinion on a literary note, putting a contractarian spin on Helena's soliloquy in Act I, Scene 1 of All's Well That End's Well, where she says, "Recall--lest another court these parties try--'Our remedies oft in ourselves do lie.'" Let me therefore introduce the second case for discussion, Matter of Youngwall, with another Shakespeare quote chosen for its anti-contractarian message, spoken by Claudio in Act IV, Scene 1, lines 19-20 of Much Ado About Nothing: "What men daily do, not knowing what they do!"
A few months ago, under the banner, "Judicial Dissolution of the Unprofitable LLC" (see here), I posted about a March 2008 decision in Youngwall by Nassau County Commercial Division Justice Stephen A. Bucaria in which he ordered dissolution of a real estate holding LLC owned by two brothers. The brother who opposed dissolution subsequently moved for reconsideration of the court's order on several grounds, including that the court overlooked the following waiver of dissolution provision in the operating agreement:
Neither member may seek judicial dissolution of this Company, and any withdrawal shall not be deemed an act causing dissolution of the Company. Any member who seeks judicial dissolution of the Company will be deemed to have withdrawn as a member of the Company, thereby forfeiting all rights, interests and entitlements to the Company and its assets.
This type of in terrorem clause is more typically found in a will. Perhaps it's no coincidence since, from what I can surmise from the prior Youngwall decision, the brothers' membership interests in the company were given to them by their father.
In a decision issued three weeks before Chancellor Chandler's R&R ruling (read decision here), Justice Bucaria denied the reargument motion both on procedural and substantive grounds. Procedurally, the waiver argument was not raised on the original motion and therefore cannot serve as a basis for reargument. On the merits, Justice Bucaria simply states: "The courts of this state have held that to absolutely prohibit judicial dissolution is void and unenforceable as against public policy." The decision cites to Matter of Validation Review Associates, Inc., 223 AD2d 134 (2d Dept 1996), rev'd as moot, 91 NY2d 840 (1997), where the intermediate appellate court held that a provision in a shareholders' agreement waiving common law and statutory rights to seek judicial dissolution of a closely held corporation was void as against public policy.
The Youngwall court does not base its decision on the forfeiture feature of the provision, which in my view renders the holdings in R&R and Youngwall at complete odds. This should come as no surprise to those who follow New York and Delaware case law developments concerning closely held business entities. Delaware's fervent embrace of freedom of contract in the LLC realm, made explicit in Section 18-1101(b) of the Delaware LLC Act and rigorously applied in cases such as R&R and those it cites such as Fisk Ventures, is unmatched in New York's LLC statute or case law. In fact, I would venture to say that there is a growing schism between Delaware and New York LLC jurisprudence, and that Youngwall is consistent with a growing number of New York LLC decisions that liberally draw upon case law involving closely held corporations where the courts are not hesitant to employ fiduciary and equitable principles to protect shareholder rights.
Which brings me back to my opening question: After R&R, what would a Delaware court do if called upon to enforce a Youngwall-type waiver of dissolution and forfeiture provision in an LLC operating agreement? Obviously, this begs the questions, (1) Who in their right mind, in an arm's-length transaction, who would ever agree to such a forfeiture provision?, and (2) Who in their right mind would file for dissolution without first seeking a declaratory judgment as to the provision's enforceability? That aside, I read R&R as compelling enforcement of the bargain including its draconian forfeiture. On the other hand, maybe there's some superseding Delaware doctrine, along the lines of equity abhors a forfeiture, that might leave the petitioner without a dissolution claim but still holding his or her membership interest.
Finally, there are some terrific posts by Francis Pileggi who first broke news of R&R (here), Professor Larry Ribstein whose work is cited in R&R (here) and Professor Gary Rosin at the Unincorporated Business Law Prof Blog (here and here) for anyone looking for more extensive analysis of the R&R decision.
Delaware and New York Courts Agree that 50% LLC Member May Not Hire Lawyer to Represent Company Adverse to Other 50% Member
There's been a recent flurry of courtroom battles over the authority of one 50% owner to engage counsel to represent the company adverse to the other 50% owner in dissolution proceedings or other types of internecine corporate warfare. I've previously written about some of these cases, including Sports Legends, Inc. v. Carberry, in which the court dismissed as unauthorized a suit by the corporation initiated by one 50% shareholder against the other for conversion of company assets (read here), and the infinitely fascinating Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, where one 50% LLC member hired company counsel in a multi-faceted litigation with the other 50% member that included dueling dissolution applications (read here and here).
Two new decisions reinforce the general proscription against the hiring and militant alignment of company counsel by one 50% owner against the other. One comes out of the Delaware Court of Chancery, which many -- present company excluded, I'm a dyed-in-the-wool New York partisan -- consider the premier business law court. The other decision appears to be the final word in the Caplash saga.
Maitland
The Delaware case, Maitland v. Int'l Registries, LLC, 2008 WL 2440521 (Del. Ch. June 6, 2008), is an action to inspect books and records brought by a 50% member of a member-managed Delaware LLC. The other 50% member hired counsel who filed an answer on the LLC's behalf opposing the relief. The plaintiff moved to strike the answer and disqualify company counsel.
In his letter ruling granting the plaintiff's motion, Chancellor William B. Chandler III focuses on the operating agreement's provision vesting management of the LLC's affairs in the members by majority rule. So long as the LLC has only two co-equal members, the Chancellor concludes, neither one "can unilaterally control the LLC". "Where they disagree," he continues, "the LLC is deadlocked" and a "deadlocked LLC cannot validly retain counsel and file an answer." Were the rule otherwise, the Chancellor further notes, the court might face the impossible situation of two competing company counsel hired separately by each member.
Does that leave the company defenseless against the plaintiff's action? Chancellor Chandler deals with this by granting the non-party LLC member leave to intervene as a party defendant with authority to defend on behalf of the LLC. Assuming the non-party member could have intervened in the first place, you might further ask, what's this skirmish over representation really about? The answer: legal fees. As hinted in the letter ruling, both sides appear to be jousting in an effort to have the LLC foot the bill for their side's fees (but not the other's), either in the first instance or by way of indemnification. Footnote 1 of the letter ruling puts this to rest by clearly indicating that, per the so-called American Rule, each side must pay its own legal fees.
Caplash
When we last visited this case, Monroe County Commercial Division Justice Kenneth R. Fisher issued a mid-trial decision (1) denying Dr. Salahuddin's summary judgment application to dismiss Dr. Caplash's request to dissolve the LLC for lack of standing, and (2) dismissing counterclaims against Dr. Caplash filed on behalf of the LLC by a lawyer hired by Dr. Salahuddin. On the first issue, the central inquiry requiring completion of the trial was whether the putative company lawyer was authorized to accept Dr. Caplash's December 2007 letter resigning from the LLC which, in turn, depended on which of the two doctors held the office of President in the aftermath of a June 2007 member meeting. This issue took on importance because of Justice Fisher's finding that, under the terms of the operating agreement, the LLC was managed by the President absent a superseding directive by a majority of the members. A secondary issue requiring trial was whether the resignation letter was unequivocal or conditioned on the release of Dr. Caplash from restrictive covenants and, therefore, ineffective because the conditions were not accepted regardless of the lawyer's authority.
Justice Fisher's 21-page post-trial decision (20 Misc 3d 1104(A), 2008 NY Slip Op 51216) is characteristically rich with evidentiary detail and analysis. Court opinion junkies will particularly enjoy reading the judge's descriptions and resolution of the conflicting witness accounts of the June 2007 member meeting, and of the fast-paced procedural ping-pong preceding and post the December 2007 Caplash resignation letter. The court ultimately finds that Dr. Caplash was validly elected President at the June 2007 meeting, hence the putative company lawyer was not authorized to accept the resignation letter, hence Dr. Caplash had standing to file his request for dissolution following the letter, hence the LLC's dissolution is ordered based on unquestionable, dysfunctional deadlock. Justice Fisher also finds that Dr. Caplash's resignation letter was conditional on the LLC releasing him from his employment agreement containing restrictive covenants, which release was never accepted. "Any other result," Justice Fisher writes, "would lead to manifest unfairness."
Justice Fisher's opinion cites Chancellor Chandler's Maitland letter ruling in rejecting Dr. Salahuddin's contention that, as a 50% member of the LLC, he was authorized to hire company counsel. I don't think either case would come out differently in a court of either state, but I find interesting the somewhat different approaches taken in the Delaware and New York cases addressing LLC governance. Delaware case law views LLCs as creatures of contract (see, e.g., Fisk Ventures, LLC v. Segal, 2008 WL 1961156 [Del. Ch. May 7, 2008]) and decides governance disputes strictly based on the terms of the operating agreement, as reflected in Maitland. The New York cases, particularly those involving member-managed LLCs, implicitly if not explicitly cut against Delaware's contractarian approach in the ease and frequency with which they will resolve LLC governance disputes based on equitable, common law principles including the imposition of implied fiduciary duties. Professor Larry Ribstein's Ideoblog and the Unincorporated Business Law Prof Blog are good places to explore more learned viewpoints on the subject, including Professor Gary Rosin's recent posting on the Maitland and Caplash cases.
Indemnity Provision Can Tilt the Playing Field in Litigation Between Business Partners
For the business owner without access to the company checkbook, and who therefore must foot his own legal bills, about the only thing worse than litigating a business divorce with a co-owner is seeing her use company funds to pay her lawyer.
Case precedent makes it pretty clear that, in a straightforward dissolution proceeding in which the company is a nominal party rather than an active litigant, neither side has the right to tap company funds for legal fees. But often the dissolution claim by the non-controlling owner is tied to other claims seeking to impose personal liability against officers or managers of the company. When that happens, the defending officer-owners may invoke a contractual right to indemnity including advancement of legal expenses by the company. Alternatively, where the defending officer-owners have board control, they may authorize indemnity and advancement under indemnification statutes.
The latter occurred in Van Der Lande v. Stout, 3 AD3d 261 (1st Dept 2004), where a minority member of an LLC brought a derivative action accusing the majority members of waste, fraud and mismanagement, alongside a separate proceeding to dissolve the LLC. Over the plaintiff's objection the defendant majority members made a substantial capital call upon all members -- including the plaintiff -- to fund the advancement of legal fees in defense of the derivative action. The plaintiff moved for a preliminary injunction to prevent the LLC from compelling him to make contributions. The trial court denied the motion. The appeals court upheld the order under the authority of Section 420 of the New York Limited Liability Company Law, which allows the LLC to advance and pay its members' legal expenses absent a final adjudication that the individual defendants acted in bad faith, were dishonest or personally gained profit to which they were not entitled. "That plaintiff commenced the lawsuit which caused the need for the additional contribution", the court added, "does not constitute an exception to his obligations to the LLC."
An interesting indemnification fight of the contractual variety took center stage in a recently decided case called R&R Capital LLC v. Merritt, 2008 NY Slip Op 30087(U). The court's January 4, 2008 decision, written by Justice Charles E. Ramos of the New York County Supreme Court's Commercial Division, describes the case as arising out of a failed business relationship between plaintiff R&R Capital LLC and defendant Linda Merritt who as 50-50 members formed nine Delaware LLCs for the purpose of investing in horse farms and other real property located in Pennsylvania. R&R's 38-page complaint filed in November 2005 sought Merritt's ouster as sole manager of the LLCs and an award of damages based on allegations of fraud and mismanagement. Early in the proceedings the court ordered that Merritt give R&R 48 hours notice before selling, transferring or encumbering any assets of the LLCs.
In 2007, after R&R objected, Merritt applied to the court for permission to sell some of the properties to satisfy about $2.8 million in company liabilities including $1 million borrowed by Merritt in her own name for the benefit of the LLCs and another $1 million bank loan guaranteed by Merritt. Also included in that sum was over $200,000 for Merritt's legal fees incurred in the litigation against R&R.
Justice Ramos turned to the parties' operating agreement which included a provision requiring the company to indemnify any member
from and against any and all losses, claims, damages, liabilities, expenses . . . judgments, fines, settlements, and other amounts . . . arising from any and all claims . . . in which such indemnified party may be involved . . . by reason of such indemnified party's service to . . . or management of the affairs of the Company, its properties, business or affairs . . . provided that such Indemnification Obligation resulted from a mistake of judgment, or from action or inaction . . . that did not constitute gross negligence, wilful misconduct or bad faith.
Based on this provision Justice Ramos held that Merritt was entitled to indemnification. "There was no evidence", the court wrote, "that suggests the Indemnification Obligation arose [from action or inaction constituting gross negligence, wilful misconduct or bad faith]."
There's a fascinating footnote to this case. Following the adverse indemnification decision, R&R filed a motion asking Justice Ramos to recuse himself based on an allegation that an attorney engaged by the parties as a neutral mediator "confessed" that he engaged in improper communications with the court regarding the case. According to affidavits submitted by some of the owners of R&R, the mediator told them in a "moment of remorse" that he had been asked by Merritt's attorney to attempt to, and actually did, "fix" the case against R&R. The mediator submitted a sworn statement denying he ever made such a statement. Justice Ramos in his May 7, 2008 decision denying the recusal motion (2008 NY Slip Op 31352(U)) also stated that the communication never occurred. His order referred the matter to the District Attorney "with this Court's strongest possible recommendation that immediate investigations be conducted into the circumstances surrounding these remarkable allegations".
Update 11/25/08: Justice Ramos's decision denying the recusal motion was affirmed on appeal.
Update 10/10/09: R&R subsequently filed a lawsuit in Delaware Chancery Court seeking to validate its removal of Merritt as manager of the several LLCs under the for-cause removal provisions in the operating agreements. In a ruling dated September 3, 2009, Chancellor Chandler granted summary judgment in favor of R&R.
