"Unusual Actions Breed Unusual Outcomes": Delaware Court Dismisses Non-Voting Trust's Action to Dissolve LLC Born of Estate Plan
A bench ruling and supplemental letter opinion last month in an unusual case called The Homer C. Gutchess 1998 Irrevocable Trust v. Gutchess Companies, LLC, C.A. No. 4916-VCN, adds another chapter to the growing book of Delaware Court of Chancery decisions addressing judicial dissolution of limited liability companies under §18-802 of the Delaware LLC Act. In Gutchess's dismissal of a dissolution petition, we see once again the Delaware court's elevation of the private ordering of LLC affairs, as expressed in the operating agreement, over challenges to the LLC's ongoing existence based on "equitable" factors. The transcript of counsel's argument and the bench ruling on February 16, 2010, can be read here. The supplemental letter opinion dated February 22, 2010, can be read here.
What makes Gutchess particularly interesting is the subject LLC's origin as an estate planning device and its design featuring an almost complete division of the economic interest, held by an inter vivos trust, and the voting control and management exercised originally by the grantor and subsequently by his wife and son.
The story begins in 1904, when George Gutchess founded a small lumber mill called Gutchess Lumber in upstate New York. His grandson and successor, Homer C. Gutchess, greatly expanded the company's operations, turning it into a leading supplier of hardwood lumber in the Northeast U.S. In 2002, around the same time the company transitioned to employee ownership, Homer and his estate planning advisors formed Gutchess Companies, LLC to hold Homer's shares in the operating company. The LLC's operating agreement reflects an almost complete split of the voting interest from the equity interest, with Homer retaining 100% of the voting interest but only 1% of the equity, his wife, Martha, holding another 1% equity, and the rest of the equity (98%) being held by The Homer C. Gutchess 1998 Irrevocable Trust. Later, on the advice of counsel, Homer transferred the voting interest to Martha. Homer died in 2006, after which Martha designated their son, Gary, as the LLC's sole manager.
For reasons not fully revealed in the court's rulings, a feud developed between, on the one side, Martha and Gary and, on the other side, the Trust's trustees, one of whom is Homer's brother. The transcript (pp. 12-13) refers to a pending petition brought by Martha and Gary in New York Surrogate's Court to remove the Trust's trustees for breach of fiduciary obligations to the beneficiaries, including Martha.
Sometime in 2009, the trustees petitioned in Delaware Chancery Court to dissolve the LLC. As summarized in the transcript (pp. 20-22), the trustees primarily contended that the LLC's management was deliberately squeezing the Trust and devaluing its equity stake by generating tax liabilities for the Trust while starving the LLC of income, and the Trust of distributions, to pay the taxes. The trustees also accused management of withholding access to company information.
The colloquy between the trustees' counsel and Vice Chancellor John W. Noble, starting at page 22 of the transcript, makes fascinating reading. VC Noble initially makes two points, first, that without actually asserting claims for breach of fiduciary duty, the Trust essentially alleges management misconduct for which the drastic remedy of dissolution normally is not appropriate, and second, that the Trust's powerlessness to affect management was built into the LLC. Addressing the Trust's counsel, VC Noble observes:
[Y]ou're probably in the worst venue in the world, because if there's one thing the five of us [i.e., the judges of the Chancery Court] respect, it's the right of folks to engage in the private ordering of their affairs. And Mr. [Homer] Gutchess made a decision, and from my perspective it was one that didn't turn out well, but he chose to separate the equity from the voting power, and I recognize this is done frequently for estate planning purposes, but from a corporate governance standpoint, it's somewhat unusual, and when you have unusual events, when you take unusual steps, they tend to yield unforeseen and unusual consequences. That, I suggest, is where you are. [Transcript pp. 23-24]
VC Noble's bench ruling dismissing the dissolution petition, starting at page 40 of the transcript, includes several key findings:
- "There is no deadlock here. All of the voting power is conveniently held by one person. That some who claim an interest in the limited liability company disagree with those in control does not create a deadlock" (p. 42).
- "The company is not insolvent. Its operations may be relatively passive now. It may not be managed as efficiently as it could be, but there is nothing indicating that the company is in any imminent danger of going under or failing in some other sense of the term" (p. 43).
- "The trust's unhappiness, thus, is the product of two considerations: First, Mr. Gutchess' informed and carefully advised decision to split equity and voting, and second, the current manager's conduct. As for Mr. Gutchess' decision, the Court must respect the private ordering of affairs. As for the manager, there are no fiduciary duty claims asserted. Simply because things have not worked out as the trust might have liked does not afford the Court a basis for dissolving the limited liability company" (pp. 44-45).
In his bench ruling VC Noble distinguishes his November 2009 decision in the Lola Cars case, where he granted dissolution based on deadlock, and he likens Gutchess to Chancellor Chandler's September 2008 decision in the Seneca case, where the court dismissed a minority member's dissolution petition involving a moribund LLC with a broad purpose clause.
VC Noble's February 22 supplemental letter ruling offers further case law analysis, focusing on a pair of VC Strine opinions in Haley v. Talcott (2004) and Arrow Investment (2009). The Trust apparently relied heavily on Haley which, it insisted, ordered dissolution due not to deadlock but based on "equitable grounds". VC Noble disagreed, noting that by Homer Gutchess' design the LLC "was never intended to be a joint venture" between the Trust and the member holding voting control. Haley, VC Noble noted further, "was very much concerned with the fact that the company's founders envisioned co-equal management, and that one of the members was unable to influence the path upon which the company was traveling."
As for Arrow Investment, even though the court there dismissed a dissolution petition, the Trust cited dicta from VC Strine's opinion indicating that, "in unusual circumstances," the court's equitable power to dissolve may be invoked even absent deadlock and despite a broadly defined purpose clause. VC Noble discounted this assertion under the circumstances presented in Gutchess, stating that the Trust "has not alleged the type of absolute frustration or futility required in the absence of unachievable business purpose and/or deadlock."
The flexible design of LLCs makes them ideal vehicles for estate planning. An LLC formed for such purpose typically reflects the wishes of a single person, namely, the person planning for the disposition of his or her wealth. The resulting LLC operating agreement is not a negotiated contract between two or more persons as in a normal business formation setting. Nonetheless, Gutchess predictably tells us that the Delaware courts, and likely others, will treat such entities no differently in the dissolution context when it comes to respecting the organizer's private preferences as expressed in the operating agreement.
My thanks to Kurt Heyman of Wilmington's Proctor Heyman LLP for passing on Gutchess in which his firm represented the company opposing dissolution.
Two-Member LLC Operating Agreement Contains Recipe for Dissension and Litigation
Last month, in Lola Cars International, Ltd. v. Krohn Racing, LLC, No. 4479-VCN (Del. Ch. Nov. 12, 2009), Vice Chancellor John W. Noble of the Delaware Court of Chancery issued a 31-page letter opinion addressing a number of important issues, including the adequacy of a deadlock dissolution claim, in a dispute involving a two-member Delaware LLC that built and sold Daytona-class Lola race cars (pictured). The case is noteworthy in the business divorce arena for two reasons, one spot-lighted by the decision and the other further off-stage.
The plaintiff, Lola Cars International, Ltd. ("LCI"), as 51% member teamed with defendant Krohn Racing, LLC ("Krohn"), as 49% member, to form Proto-Auto, LLC ("Proto") to manufacture and sell Grand Am Series professional race cars. Despite LCI's majority interest, under Proto's operating agreement the two members were equally represented on its governing board. As one of Krohn's primary obligations under the Operating Agreement, it agreed to provide the services of its manager, Jeff Hazell, as Proto's chief executive officer. LCI and Krohn had a falling out within the first two years of their venture, prompting LCI to sue for dissolution.
Center stage in Lola is Vice Chancellor Noble's analysis of the standard for judicial dissolution of LLCs under Section 18-802 of the Delaware LLC Act, which substantially resembles Section 702 of New York's LLC Law in requiring a showing that it is "not reasonably practicable to carry on the business in conformity with" the LLC operating agreement. Lola makes no new law. Rather, it builds on Chancellor Chandler's analysis in Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del Ch. Jan. 13, 2009) (read my prior post on Fisk with a link to that decision here), summarized as follows in Lola:
The Court in Fisk laid out three factual scenarios this Court should consider when ordering judicial dissolution under Section 18-802's reasonable practicability standard: (1) whether the members' vote is deadlocked at the Board level; (2) whether there exists a mechanism within the operating agreement to resolve this deadlock; and (3) whether there is still a business to operate based on the company's financial condition. The Fisk court explained that none of these factors is individually conclusive, nor must each be found for a court to order dissolution. Rather, they provide guidance to the ultimate inquiry of whether the company can continue to pursue its stated business purpose with reasonable practicability.
In denying a pretrial motion to dismiss the complaint for failure to state a claim, Vice Chancellor Noble found that LCI's allegations satisfied two of Fisk's three criteria. First, the complaint alleged that the two, co-equal managers were irreconcilably deadlocked over replacement of Proto's chief executive officer, Hazell, whom LCI accused of managing Proto more for Krohn's benefit than Proto's. Second, the complaint raised serious doubt whether Proto could continue to operate in its current financial condition which allegedly rendered the company insolvent. In response to Krohn's counter-argument regarding company finances, the Vice Chancellor echoed a theme sounded in Fisk and other dissolution precedents involving LLCs as well as limited partnerships, that the standard for judicial dissolution is not "whether the Company cannot possibly continue its business in accord with the Operating Agreement, but rather whether to do so would be reasonably practicable" (emphasis added).
The Fisk factor not satisfied in Lola, i.e., whether the operating agreement lacks a deadlock-breaking mechanism, is my segue into what I above called the off-stage aspect of the case and the basis for the title of this post. Proto's Operating Agreement did indeed contain a buy-out mechanism in the event of a member dispute or, as Vice Chancellor Noble colorfully described it, a "self-help disentanglement provision." However, as he also noted, the mechanism was entirely voluntary and, predictably, was exercised by neither of the two members. In addition, the Operating Agreement contained a termination clause that could be invoked by either member after a breach of the Operating Agreement by the other. Under this provision, the non-breaching member must notify the other member of the breach as well as the consequences of a failure to rectify the breach which, if not cured within 21 days, authorizes the non-breaching party to terminate the Operating Agreement. Alongside its dissolution complaint, LCI filed a second lawsuit seeking to enjoin Krohn from interfering with LCI's sole management of Proto based on LCI's prior notice of breach given to Krohn and the latter's alleged failure to cure.
What's wrong with this picture? Plenty. First of all, a voluntary buy-out provision, i.e., one that gives neither member the right to put its interest to the company or the other member, is as good as no buy-out provision at all. Second, the termination clause in this case is one of the surest-fire recipes for dissension and litigation I've ever come across. Termination of Proto's Operating Agreement automatically means governance under the Delaware LLC Act's default provisions, which means LCI as 51% owner gains sole control of Proto under Section 18-402. In other words, the termination provision gives LCI a powerful incentive to declare Krohn in breach of the Operating Agreement, and an equally powerful incentive to Krohn to contest any alleged breach. By the same token, the provision is useless to Krohn for the obvious reason that it would not want to gift sole control to LCI by invoking termination based on LCI's breach. No one should be surprised that this venture ended up in Delaware Chancery Court.
It's possible that the termination clause was the quid pro quo for LCI's agreement to give 49% member Krohn equal management rights on Proto's board of managers. Yet there are dysfunctional incentives built into the bargain that render it extremely short-sighted. It's not always easy, but sophisticated business partners with experienced counsel usually are able to devise and include in the operating agreement a workable, compulsory buy-sell agreement that will keep them out of destructive and expensive court proceedings, or at least will limit potential disputes to appraisal issues.
Read here Professor Ribstein's analysis of the Lola case, in which he queries whether the court should have held that the statutory dissolution remedy was foreclosed by the contractual termination remedy.
