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.