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.