Viewing the arc of Delaware Chancery Court jurisprudence over the last two decades implementing that state’s Limited Liability Company Act, and witnessing the Delaware legislature’s frequent amendments to the statute in reaction to judicial developments, you can’t help but detect a pattern of maintaining the unique attributes of the Delaware LLC, as compared to other forms of business entity, by:
- rigorously promoting freedom of contract (in the form of the LLC agreement) and its corollary, “you made your bed now lie in it”;
- deciding internal governance disputes within the bounds of the interplay of the Delaware LLC Act’s default rules and the LLC agreement; and
- strongly disfavoring judicial intervention based on open-ended notions of fairness (the main exception being when managers take on fiduciary duties by agreement or by default under the statute).
Stated simply, in Delaware certainty trumps indeterminacy.
Well, not always, as seen in a first-impression ruling last week by Vice Chancellor J. Travis Laster in In re Carlisle Etcetera LLC, C.A. No. 10280-VCL (read here), in which the court held that the assignee of an LLC membership interest, who as a non-member and non-manager lacked standing to seek involuntary dissolution under Section 18-802 of the Delaware LLC Act, nonetheless had standing to seek equitable dissolution under the Chancery Court’s common-law authority as a court of equity.
The case involves the Tom James Company (“TJC”), known throughout the U.S. and overseas as a manufacturer and retailer of custom clothing with an unusual business model in which tailors come directly to customers’ homes or offices. In 2012, TJC and a Hong Kong-based premium apparel supplier known as the Royal Spirit Group (“Royal”) formed a Delaware LLC known as Carlisle Etcetera (“Carlisle”) as a joint venture in which Royal owned its 50% interest through its affiliate, Well Union Capital Ltd. (“WU Parent”).
At inception TJC and WU Parent executed a simple form of operating agreement in which they committed to work promptly on a more detailed operating agreement to replace the original one, but never did so. The simple agreement, which created an evenly-divided, four-person Board as sole manager, was silent on the assignment of membership interests.
Meanwhile, shortly after Carlisle’s formation, WU Parent assigned its 50% membership interest to a wholly owned subsidiary (“WU Sub”). TJC was told of the transfer, did not object, and treated WU Sub as a member from that point on, as evidenced by tax filings identifying WU Sub as “member” and subsequent draft agreements doing the same. (Although not mentioned in the court’s opinion, the transcript of the oral argument indicates that at some point TJC may have assigned its membership interest to a subsidiary or affiliated entity without the formal approval of WU Parent or Sub which, in light of the court’s ruling described below, raises the possibility of an LLC with no members!)
Serious disagreements and deadlock between the two owners arose within a year. The Board deadlock effectively gave company control to TJC whose CFO served as Carlisle’s CEO. In early 2014, TJC told Royal that it no longer wished to continue the joint venture. Subsequent buy-out negotiations failed.
No Standing to Seek Statutory Dissolution
In October 2014, WU Sub filed a petition seeking judicial dissolution of Carlisle under Delaware LLC Act § 18-802 based on deadlock at the member and manager levels. TJC moved to dismiss for lack of standing, contending that under the applicable default rules in § 18-702 of the LLC Act, (a) WU Parent was no longer a member of Carlisle upon the assignment of its membership interest to WU Sub, and (b) WU Sub as assignee had no membership interest because TJC never formally consented to its admission as a member. WU Sub countered that it was a de facto member by consent of the members as “reflected in the records” of the LLC, i.e., the tax returns and draft agreements, under § 18-301(b)(1) of the LLC Act.
Vice Chancellor Laster agreed with TJC’s position, holding that notwithstanding TJC’s treatment of WU Sub as a member, the absence of TJC’s formal consent to WU Sub’s admission as member as required by the Delaware LLC Act deprived it of standing to seek judicial dissolution under § 18-802, which confers the right to petition on members and managers, not assignees.
Equitable Standing to Seek Dissolution
“In my view, [TJC] errs in contending that Section 18-802 is the exclusive extra-contractual means of obtaining dissolution of an LLC. Under the facts of this case, WU Sub has standing to seek dissolution in equity.”
So begins Vice Chancellor Laster’s fascinating discussion of equitable dissolution at pages 15-27 of his opinion. The opinion cites, among other authorities, Justice Story’s and Pomeroy’s ancient treatises on equity jurisprudence in support of the Chancery Court’s “traditional equitable jurisdiction” over partnership disputes. The statutory dissolution provision for LLCs, § 18-802, “does not state that it establishes an exclusive means to obtain dissolution,” Vice Chancellor Laster wrote, “nor does it contain language overriding this court’s equitable authority.” Had it done so, he continued, the statute’s validity “would raise serious constitutional questions” under the state constitution’s article generally giving the Court of Chancery all the equity jurisdiction of the English chancery courts as it existed prior to American independence. To those who ask, What knickers-wearing, tricorn-topped American colonists possibly could have imagined LLCs back in the 1700’s?, Vice Chancellor Laster answered:
I cannot accept the contention that because the nascent practice of entity law as it existed at the time of the colonies’ separation had not yet envisioned LLCs, they fall outside the domain of equity. Decisions addressing the dissolution of LLCs have recognized the continuing role of equity.
Perhaps anticipating the reaction of creative drafters of LLC agreements, Vice Chancellor Laster’s opinion noted that “the ability to waive dissolution under Section 18-802” — as has been upheld in prior Chancery Court rulings including the R&R Capital and Huatuco cases — “does not extend to a party’s standing to seek dissolution in equity.” In that same vein the opinion also poked at the “purely contractarian view” of LLCs, stating what perhaps is the core theoretical justification for the court’s decision:
To my mind, when a sovereign makes available an entity with attributes [such as limited liability] that contracting parties cannot grant themselves by agreement, the entity is not purely contractual. Because the entity has taken advantage of benefits that the sovereign has provided, the sovereign retains an interest in that entity. That interest in turn calls for preserving the ability of the sovereign’s courts to oversee and, if necessary, dissolve the entity. Put more directly, an LLC agreement is not an exclusively private contract among its members precisely because the LLC has powers that only the State of Delaware can confer.
Turning to the facts of the Carlisle case, Vice Chancellor Laster found adequate grounds for equity to intervene, namely, absent dissolution “the Company will continue, with [Royal] locked-in as a silent and powerless passive investor,” in a “situation . . . contrary to the bargain the parties struck,” where “both sides recognized the need to go their separate ways,” and with a non-functioning Board designated as the sole manager, leaving Carlisle:
operating contrary to the governance structure set forth in its constitutive agreement. [¶] When considering whether holders of equity in other entities can pursue equitable causes of action, despite their lack of formal ownership status, this court has relied on the substance of the relationship and permitted the suits to proceed. . . . Consequently, I believe that WU Sub has standing in equity, as an assignee, to seek dissolution of the Company under the facts alleged in the petition.
Vice Chancellor Laster issued his Carlisle opinion on April 30, 2015. Two business days later, on May 1st, he issued an Order granting WU Sub’s motion for summary judgment on its petition to dissolve the LLC (read here). The Order applies the standard for dissolution developed under Section 18-802 and cites deadlock, the parties’ acknowledgement of the need to separate, and the lack of an exit mechanism as warranting dissolution and the appointment of a custodian.
I suppose you could analogize Carlisle‘s recognition of equitable LLC dissolution to New York’s recognition of common-law dissolution for closely held corporations, which generally comes into play when oppressed minority shareholders lack the minimum 20% stock interest required by the dissolution statute, BCL § 1104-a. Standing under LLC Law § 702, New York’s statute authorizing judicial dissolution of LLCs, is even narrower than Delaware’s statute, limiting the right to petition to members, i.e., excluding both managers and assignees. I know of no New York case addressing a non-member’s equitable standing to seek common-law dissolution of an LLC.
Hat tip to Kurt Heyman of Proctor Heyman Enerio LLP for alerting me to the Carlisle case in which Kurt represents the petitioner.