When it comes to rulings by its Court of Chancery, what happens in Delaware definitely does not stay in Delaware.
Each year Delaware breeds for export thousands of corporations, LLCs and limited partnerships. Many of those Delaware entities have their principal place of business in New York; their internal affairs, when adjudicated by New York courts, are governed by Delaware statute and case law. In addition, the unsurpassed quality, scholarship and keen attention to precedent that characterize Chancery Court decisions make them a powerful guiding force in the judicial formulation nationwide of domestic business laws and policy.
All that being said, as I’ve commented before, one area of growing divergence between Delaware and New York law has been in the areas of LLC governance and judicial dissolution. The Delaware Chancery Court’s pronouncements strongly emphasize the members’ virtually unfettered contractual freedom to order their own relationships in the operating agreement, including enforcement of fiduciary outs and judicial dissolution waivers, and the Court’s concomitant aversion to judicial intervention. In contrast, New York courts by and large have not hesitated to impose fiduciary obligations on LLC managers and to import dissolution principles developed in the context of shareholder corporation breakups.
Case in point: In re Seneca Investments, LLC, 2008 WL 4329230 (Del. Ch. Sept. 23, 2008) (read decision here), in which the Delaware Chancery Court recently dismissed a petition to dissolve a Delaware LLC brought by a minority member who’d been removed from his management positions by the majority. This is one of the few cases construing Delaware’s LLC dissolution statute, and the result stands as a warning to any minority member who does not bargain for status protection and/or fair exit mechanisms in the operating agreement.
Chancellor William B. Chandler III’s opinion in Seneca summarizes the dispute as follows: Seneca Investments, LLC was formed in 2001 by Michael Tierney and Omnicom Group, Inc., a large publicly traded New York corporation. For three years Tierney served as Seneca’s CEO and sole director, after which he was one of three directors. In early 2008, Omnicom removed Tierney as an officer and director of Seneca. Tierney’s subsequent dissolution petition alleged that Seneca abandoned its business and that, since 2004, it has not
(1) had a business plan; (2) made an investment; (3) sought or received additional capital; (4) sought to sell any shares; (5) had a shareholders’ meeting; (6) had a meeting of the board of directors; or (7) sought to hire an employee or manager who could conduct any business on behalf of the corporation.
Seneca’s assets consisted of $2.2 million cash and stock interests in one public and one private company.
Omnicom’s answer included counterclaims against Tierney and two other companies affiliated with him, accusing them of wrongfully diverting Seneca’s funds.
Omnicom moved for judgment on the pleadings, arguing that Tierney failed to allege sufficient facts for judicial dissolution under Section 18-802 of the Delaware LLC Act, which authorizes the Chancery Court to decree dissolution of an LLC “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” (Section 18-802 closely tracks the language used in Section 702 of the New York LLC Law.)
Chancellor Chandler begins his analysis noting the paucity of case law interpreting Section 18-802, and reminding that dissolution has been granted based on deadlock that prevented the company from operating and “where the defined purpose of the entity was fulfilled or impossible to carry out.” Since Tierney does not allege deadlock, the Chancellor continues,
the inquiry must focus on whether it is now impracticable for Seneca to fulfill its business purpose. In determining whether it is reasonably practicable to carry on the business of the LLC, the Court must look to the purpose clause set forth in the governing agreements, in this case, the charter. Seneca’s charter states that “the purpose of the Company is to engage in any lawful act or activity for which corporations may be organized under the Delaware General Corporation Law.”
Chancellor Chandler essentially concludes that the breadth of the LLC’s purpose clause, together with the legal acceptability of passive investment as a company purpose, doom Tierney’s petition. Here’s what he says:
This Court has clearly stated that “a corporation may be formed and maintained as a passive instrumentality — for example, an entity that does no more than take and hold title to tangible investments is a commonly encountered phenomenon.” * * * * * Petitioner does not allege any kind of voting deadlock, and the factual claims in the petition are insufficient to support a claim that the “reasonably practicable” standard under s. 18-802 has been met. The petition states that the Company is holding shares of [two companies]. In effect petitioner has done nothing more than allege that Seneca is functioning as a passive instrumentality that is holding title to assets, a corporate function that is both lawful and common. (Footnotes omitted.)
Tierney also relied on Seneca’s alleged non-compliance with operating agreement provisions requiring the company to make cash distributions, provide reports and continue to allow Tierney to serve as a director. The Chancellor’s rejection of these grounds highlights the limited grounds for dissolution:
Even assuming that Seneca is in violation of some provisions of its operating agreement, such violations are not grounds for this Court to order dissolution of an LLC. The role of this Court in ordering dissolution under s. 18-802 is limited, and the Court of Chancery will not attempt to police violations of operating agreements by dissolving LLCs. This Court will also not attempt to divine some other business purpose by interpreting provisions of the governing documents other than the purpose clause. (Emphasis added.)
Earlier in his decision, the Chancellor echoes prior Delaware cases in stating that an LLC “is primarily a creature of contract, and the parties have wide contractual freedom to structure the company as they see fit.” The other side of that coin is that the court will refuse to impose terms that the parties did not see fit to codify in their operating agreement, regardless of the arguable unfairness visited upon a powerless minority member who lacks any means of withdrawing and liquidating his investment in the LLC.
Outside of deadlock, the narrow standard applied in Seneca for judicial dissolution of a Delaware LLC leaves a minority member little hope for relief given the common utilization of a purpose clause that authorizes any lawful business purpose. Would a New York court decide the case differently if it were a New York LLC under the New York statute? It certainly would be a closer question, particularly on a motion for summary judgment on the pleadings. A comparison can be drawn to the Youngwall case about which I previously wrote here and here, where a New York court dissolved an LLC that owned a commercial rental property after the controlling member left it vacant for a period of months with no apparent effort to find a new tenant. Owning a commercial building arguably is different than the passive-investor function of the stock investment company in Seneca, but from the perspective of the frozen-out, illiquid member alleging that the business has been “abandoned,” it’s not much different.
One final note on Seneca. The parties included in the operating agreement a provision stating that the company “will be governed in all respects as if it were a corporation organized under and governed by the Delaware General Corporation Law.” Tierney therefore also moved under DGCL Section 226(a)(3) for appointment of a custodian or receiver on the statutory ground that Seneca has “abandoned its business and has failed within a reasonable time to take steps to dissolve, liquidate or distribute its assets.” The court rejected the claim on two grounds. First, as under the LLC dissolution statute, the company’s “business” under Section 226(a)(3) is determined by the charter’s purpose clause which is satisfied by passive investment in other businesses. Second, the company’s prosecution of colorable counterclaims against Tierney, according to Chancellor Chandler, is also an “acceptable, and common, corporate function.” Acknowledging the “Catch 22” implication of such a business purpose — a company facing a dissolution petition could file non-meritorious counterclaims to defeat dissolution — the Chancellor suggests that “courts can develop mechanisms to police such abuse should it arise in the future.”
Hat tip to Francis Pileggi whose Delaware Corporate and Commercial Litigation Blog featured the Seneca case within days after its issuance (read here). Pileggi’s blog is the premier online resource for coverage of the Delaware Chancery Court.