In the world of business divorce litigation, this summer saw everything but a slowdown. We witnessed (and blogged about) Justice Crane cap a long-running fair value proceeding with helpful guidance on appraisals and discounts, watched the birth of a potential claim for equitable dissolution of Delaware LLCs, and heard from the Court of Appeals on the internal affairs doctrine.
Now, along with shorter days, crisper mornings, and the sound of school buses returning to their routes, comes more fresh cases and hot topics. Especially in the context of limited liability companies, the ingenuity of closely held business owners, the variety of their arrangements/disputes, and the creativity of counsel all ensure that the already rich body of caselaw governing LLCs and their members will grow even richer.
This week’s post kicks off the season with some fall table-setting. Two cases, both of which should cause an LLC to think twice about what it means to award equity to an employee, are worth closely watching as the leaves turn.
Grant of “Profits Interest” Spells Membership Mess for Colorado Chew Toy Manufacturer.
Our first case takes us to County Court in Denver, Colorado in a dispute over the ownership of the KONG Company LLC (“KONG”), the manufacturer of dog-owners’ beloved KONG chew toys.
The “Equity” Grant.
In 2008, KONG—then 50/50 owned, indirectly by Joseph Markham and John Nelson—entered into an employment agreement with Kathy Decker for Decker to serve as President of the company. Decker’s “Employment Agreement” stated that Decker would be compensated with a salary and bonus equal to 10% of KONG’s net profit.
In 2019, the parties amended Decker’s Employment Agreement to give Decker something more. Here is the relevant language of the amendment. As you read it, ask yourself whether this amendment is sufficient to make Decker a full-blown member of KONG:
The Company hereby grants to Executive an equity interest in the Company (“Profits Interest”) which the parties agree is a “profits interest” for purpose of federal income tax laws . . . Executive has no capital account with respect to the profits interest. The parties agree that Executive is admitted as an additional member of the Company. Executive agrees and acknowledges that she is a member of the Company and bound by (and has the rights and obligations of a member in) the Company’s Operating Agreement . . .
Executive has no voting rights with respect to the Profits interest, and therefore any requirement for member vote, approval, or consent shall not include Executive in any such vote, approval or consent. Notwithstanding the foregoing, the Operating Agreement may not be amended without Executive’s vote, approval or consent if any such amendment adversely affects Executive.”
Whoa. So Decker has an “equity interest,” but only a “profits interest,” but she is “admitted as a member,” but she has “no voting rights,” or maybe no voting rights only “with respect to the Profits interest,” but otherwise has the rights of a member in the operating agreement? I need to lie down.
The Dispute.
With that language, it’s no surprise to see litigation over whether Decker is or is not a member of KONG. That started with a 2022 complaint from Markham’s wholly owned entities alleging that Decker and Nelson had conspired to sideline him from the business, despite the fact that (according to Markham) he still holds a 50% membership interest and 50% voting control over the Company.
Nelson and Decker shot back with counterclaims for an accounting and for a declaratory judgment establishing the membership of each member—Decker included.
Is Decker a Member, an Economic Interest Holder, or Something Else?
Last week, Markham moved for partial summary judgment seeking to establish that Decker is not a member of KONG and has no right to vote any interest on any issue.
Apropos Professor Kleinberger’s observations on the subject (see The Plight of the Bare Naked Assignee), Markham’s motion argues that the 2019 Amendment reflects a clear intention to bifurcate Decker’s “membership” in KONG into an economic interest and a management interest, and Decker was only given the economic interest in KONG’s distributable profits.
In opposition, Decker will no doubt argue that there was no such bifurcation. The contested language admits her as a member, gives her all the rights of a member, and only divests her of “voting rights with respect to the Profits interest”—i.e., she cannot vote to give herself more of the profits. Aside from that narrow divestiture, Decker insists she is a full-blown member.
That argument is also likely to have the weight of practical application behind it. Decker and Nelson contend in their Answer that Markham—consistent with his no longer having a 50% voting interest—stepped away from a role in the Company long ago, and Decker and Nelson have been managing the operations without Markham’s involvement or interest.
From my perch as an outsider, I think it will take a mountain of parol evidence (and perhaps even a trial) before a court determines whether Decker is or is not a member. Add KONG to the list of companies mired in litigation over the question, “is you is or is you ain’t [a member]” (thanks again, Professor Kleinberger).
Moonlighting CEO Lands Himself and His Undercover Employer in Litigation.
Back on the East Coast, a fresh dispute between a start-up wholesale and retail mortgage company, Universal Lending Depot (“ULD”), and its former CEO James Hooper has already kicked off some noteworthy precedent, with more to potentially come.
The Executive Agreement.
According to ULD, it retained Hooper as its president and CEO in September 2022 pursuant to an “Executive Agreement.” A few days later, ULD adopted an operating agreement that granted Hooper a 5% membership interest in the Company, but also contained a specific performance provision requiring Hooper to perform his duties: “(i) in good faith, (ii) in a manner he reasonably believes to be in the best interests of the Company, and (iii) with the care that an ordinarily prudent person in a like position would use under similar circumstances.”
About six months later, in March of 2023, Hooper secretly commenced a second employment with competitor Quontic Bank. Due to that employ, ULD alleges, Hooper failed to deliver his good faith efforts to ULD, leading to ULD’s failure to reach certain strategic goals. Likewise, ULD alleges that Hooper wrongfully solicited certain of ULD’s employees to join Quontic.
ULD Commences Dual Lawsuits Straddling the Hudson.
ULD filed two lawsuits.
The first was a New Jersey Action against Hooper for breach of fiduciary duty, and breach of the operating agreement, among other claims (Universal Lending Depot, LLC v Hooper, No. 2442-23 [NJ Super. Ct. Law Div., Union County]).
In the New Jersey Action, ULD seeks a judgment finding that based on his breaches of fiduciary duty and actions as a faithless servant, Hooper has forfeited his 5% membership interest in ULD and his salary during the time of dual employment. Hooper shot back with incendiary counterclaims alleging that ULD’s other 95% owner is a mere figurehead for Joseph Natale, who had been convicted on federal criminal charges, was on probation, and barred from being employed in the banking industry.
Will ULD’s faithless servant claim be enough to get its 5% membership interest back from Hooper? If so, it will be the first case I’m aware of in which a defendant’s breach of fiduciary duty resulted in an undoing of a membership interest grant.
ULD’s second action is a New York-based suit against Quontic for aiding and abetting breach of fiduciary duty and intentional interference with contract (Universal Lending Depot, LLC v Quontic Bank, No. 654911/2023 [Sup Ct, NY County]). Those claims hinge on the theory that by employing Hooper while knowing he was a member and employee of ULD, Quontic aided Hooper’s breach of fiduciary duty, and intentionally and wrongfully interfered with the Executive Agreement.
Justice Chan Keeps Quontic on the Hook.
Quontic moved to dismiss those claims, arguing mostly that there were no detailed allegations supporting ULD’s theory that Quontic “knowingly participated” in Hooper’s breach. In a decision and order published last week, New York County Commercial Division Justice Chan denied that motion, finding that Quontic’s feigned ignorance about Hooper’s employment with ULD didn’t add up:
As a Federal Savings Association chartered by the OCC, defendant is a sophisticated and highly regulated financial institution that would have checked on at least the work history of any applicant let alone one who is offered a high-level executive position. Plaintiff adds that during Hooper’s hiring, defendant likely inquired about Hooper’s current and past employers and became aware of his contractual duties and obligations . . . These allegations are sufficient to show that defendant had at least constructive knowledge of Hooper’s breach, and acted with scienter in hiring Hooper and the other two executives while they were working for plaintiff.”
Justice Chan’s decision means that ULD has a live, two-front discovery battle against both Hooper in New Jersey and Quontic in New York, all based on the 5% membership interest awarded to Hooper at the outset.
Conclusion.
As these cases unfold, they will undoubtedly provide more clarity—and add to the long list of cautionary tales—for LLCs and their members navigating the complex and often overlapping relationship between “employee” and “member.”