Delaware Business Law Report : Delaware Business Lawyers & Attorneys: Morris James Firm: Finance & Business Law

By:  Nicholas J. Caggiano, Jr.
        Shannon S. Frazier
        Jonathan G. Strauss

Court of Chancery holds that where majority LLC members agreed to allow a member to retire, the member was not entitled to “fair value” for his interest under 6 Del.C. §18-604.

Glenn B. Showell v.William H. Pusey et al, CA No. 3970-VCG (September 1, 2011).

This case involves a Sussex county accounting firm organized as a Delaware limited liability company (“LLC”). The LLC was governed by an operating agreement and a supplemental agreement (collectively, the “LLC Agreement”) that provided, among other things, for the LLC’s repurchase of a member’s interest upon a “Retiring Event”, which was defined as the member’s death, bankruptcy or disability. The repurchase price following a Retiring Event was based on the member’s percentage interest applied to the LLC’s liquidation value. The LLC Agreement expressly prohibited voluntary retirement or withdrawal by any member, which the court found to be consistent with the statutory default rule in 6 Del.C. §18-603. Notwithstanding this prohibition, the retiring member, Mr. Showell, and another member, Mr. Pusey, who together held 90% of the LLC interests, agreed that Mr. Showell could voluntarily retire as a member of the LLC. Importantly, although they agreed on Mr. Showell’s retirement, they did not reach an agreement regarding the value Mr. Showell should receive for surrendering his 29% LLC interest. Litigation then ensued to determine what Mr. Showell should get.

The current “default rule” in Section 18-603 of the Delaware LLC Act is that members may not voluntarily resign prior to the dissolution and winding up of the limited liability company unless the limited liability company agreement provides otherwise. This rule only applies to LLCs formed after July 31, 1996. Prior to that time, §18-603 permitted members to resign upon not less than 6 months' prior written notice and receive “fair value” for their interests under §18-604. Section 18-604, if applicable, compensates the resigning member for his “right to share in distributions” from the LLC – i.e. the “enterprise value” -- unless the LLC Agreement “provides otherwise”. Section 18-604 has remained essentially the same since 1996.

Mr. Showell argued that, since the parties agreed to his retirement, he should receive the “fair value” for his interest under §18-604. The defendants countered that he was due nothing since he had no contractual or statutory right to retire voluntarily. Alternatively, they argued that he should receive his share of the liquidation value of the LLC. The Court agreed with the defendants, finding that the LLC Agreement did not permit voluntary retirement, and had its own formula for Retiring Events, hence the “fair value” obligation in Section 18-604 was not applicable. The Court reasoned that the members’ agreement to permit Mr. Showell’s retirement was effectively a modification of the LLC Agreement to treat this as a “Retiring Event”. Hence, the LLC Agreement’s liquidation value method “provided otherwise”  negating the “fair value” default rule in §18-604.

The moral of this story is, as always, when dealing with Delaware LLCs,  “the contract is king.” The “default rules” of the Delaware LLC Act will not apply if the LLC agreement “provides otherwise”. In this case, the LLC Agreement did not precisely contemplate the situation, but the Court nevertheless found a way to apply the provisions of the LLC Agreement “in an attempt to harmonize Showell’s ‘retirement’ with the intent of the parties”. Thus, the parties’ intent trumped the statute.
 

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By:  Nicholas J. Caggiano, Jr.
         Shannon S. Frazier
         Jonathan G. Strauss

Court of Chancery holds that LLC membership interest can be assigned by 30% member to 20% member without consent of 50% member; Resulting deadlock to be resolved by anology to corporate law.

Achaian, Inc. v. Leemon Family LLC et. al, CA No. 6261-CS (August 9, 2011).

This case involves a dispute among the members of Omniglow, LLC, a Delaware limited liability company that manufactures glowsticks. Founded in 2005, the LLC originally had a single member, Omniglow Corporation, but in 2006, the LLC was sold which resulted in the LLC having three members: Leemon Family LLC (“Leemon”) owned 50%; a trust (the “Holland Trust”) owned 30%; and Achaian, Inc. (“Achaian”) owned the remaining 20%. All were admitted as members, however from a reading of the case it is evident that the limited liability company agreement (or “operating agreement”) was never properly amended to reflect the fact that the LLC no longer had a single member. A dispute as to control of the LLC emerged, with Leemon allegedly trying to assert control. The Holland Trust sold its membership interest to Achaian. Achaian then sued for judicial dissolution claiming that it held 50% of the voting interests and asserting a deadlock with Leemon.

There are 2 interesting aspects of this case. First, the Court considered the issue of whether one member could sell its voting interest to another member without the consent of the third member. Under the LLC Act, unless otherwise provided in the operating agreement, the sale by a member of its LLC interest does not entitle the assignee to become a member or have any voting power – it is purely an assignment of economic rights such as the right to receive distributions and tax allocations. Leemon claimed that the Holland Trust’s assignment to Achaian only conveyed economic rights, not voting power. Vice Chancellor Strine disagreed, reasoning that since the operating agreement defined “Interest” broadly to mean “entire ownership interest”, and provided that a Member may transfer “all or any portion of its Interest” to any person at any time, the Holland Trust could transfer its voting power to Achaian. In essence, the operating agreement modified the statutory default rule. Leemon countered that such a transfer was not possible without its consent, since the operating agreement provided that no person shall be admitted as a Member without the written consent of all members. The plaintiff, Achaian, argued that since it was already a member, it need not be re-admitted. Leemon argued that, given the statutory default rule, and no provision of the operating agreement dealing specifically with this situation, Achaian should not be able to change the voting structure of the LLC without Leemon’s consent. In other words, Leemon wanted Achaian to be separately admitted as a member with respect to its additional 30% Interest acquired from the Holland Trust. Vice Chancellor Strine agreed with Achaian and found that the operating agreement, taken as a whole, allowed the members to transfer voting power amongst themselves, and that Holland Trust had transferred voting power to Achaian. The take aways are that, in the world of Delaware limited liability companies, (i) the “contract is king” – the operating agreement will normally prevail over the statute (with certain exceptions – as there are provisions of the LLC Act that may not be altered or waived), and (ii) a limited liability company interest normally represents an economic interest only but an operating agreement may explicitly provide for a transfer of more than an economic interest. Thus, care must be taken to make sure that the operating agreement clearly and adequately addresses the needs of all members.

The second interesting aspect is that the Court stated that since Achaian had successfully obtained 50% voting power, the judicial dissolution of the LLC would be treated like a dissolution of a 50/50 joint venture corporation under Section 273 of the Delaware General Corporation Law. Vice Chancellor Strine originally took this approach in Haley v. Talcott. Under Section 18-802 of the LLC Act, the test for judicial dissolution depends only on a finding that it is “not reasonably practicable to carry on the business in conformity” with the operating agreement. However, by incorporating the corporate test, the Court seems to be requiring that in the case of a deadlocked 50/50 LLC joint venture, a plaintiff seeking judicial dissolution must plead the three elements of DGCL 273: that there are (1) two 50% stockholders; (2) engaged in a joint venture; (3) who are unable to agree upon whether to discontinue the business or how to dispose of its assets.

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Earlier this month, the Treasury Department issued the long-awaited proposed regulations regarding the Federal tax classification of series limited liability companies. 

In a nutshell, the proposed regs provide that, regardless of whether a series of an LLC is considered a "person" for local law purposes, such series will be treated as a separate entity for Federal tax purposes.

Given the similarity under Delaware law between series LLC's and series trusts, it will be interesting to see if the regs are ultimately expanded to apply to series trusts, as well.  It will also be interesting to see how far the "separate entity" theory with respect to the individual series can stretch-- can an individual series stand as a debtor in bankruptcy, for instance?  Based on this recent article in the Delaware Journal of Corporate Law, that may well be the case. 

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While the majority of case law in Delaware suggests that a Delaware court will apply default fiduciary duties when a limited liability company agreement (an “LLC agreement”) is silent as to the existence and application of fiduciary duties, the Delaware Supreme Court has not yet weighed in and therefore this issue is not settled law. 

Can an argument be made that default fiduciary duties violate the strong policy favoring freedom of contract established by Delaware’s legislature, and that Delaware courts should not apply default fiduciary duties even if the parties have not specifically provided for the elimination of fiduciary duties?

In an article for the American Business Law Journal, Chief Justice Steele contends that “default fiduciary duties violate the strong policy favoring freedom of contract established by Delaware’s legislature,” and “Delaware courts should not apply default fiduciary duties even if the parties have not specifically provided for the elimination of fiduciary duties.” See Myron T. Steele, Freedom of Contract and Default Contractual Duties in Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221, 223-224 (2009). He argues that courts “should not read any default fiduciary duties into an LLC agreement because the parties’ prescribed and proscribed conduct in their operating agreement contains the entire agreement that the parties intend and expect.”  The Chief Justice also reasons that the court should “favor the contracting parties’ ex ante calculation of costs and benefits of fiduciary duties, and courts should not, on their own, endeavor to reassess that decision ex post.”  In his article, Chief Justice Steele asserts that the Court of Chancery itself is split on the issue of default fiduciary duties, and points to two decisions by Chancellor Chandler which support not applying default fiduciary duties.

I wonder how likely it is that Chief Justice Steele could persuade his fellow Justices to support this theory?

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One of the hallmarks of the Delaware Limited Liability Company Act (the "Delaware LLC Act") is its flexibility. Indeed, the Delaware LLC Act seeks “to give maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”  To that end, the Delaware LLC Act expressly permits “written, oral or implied” LLC agreements, and generally allows parties to enforce unwritten, unsigned LLC agreements.

In October 2009, however, the Delaware Supreme Court was called upon in the case of Olson v. Halvorsen to review of the application of the statute of frauds to LLC agreements.  Construing the Delaware LLC Act and the statute of frauds together, and finding that the General Assembly did not clearly intend the Delaware LLC Act to render the statute of frauds inapplicable, the Delaware Supreme Court held that the statute of frauds does, in fact, apply to LLC Agreements.  As a result, according to the Delaware Supreme Court, the statute of frauds prevents enforcement of oral LLC agreements that require more than one year to complete.

It appears that this outcome is not the one intended by the Delaware legislature in drafting the Delaware LLC Act. In light of the Olson decision, on June 10, 2010, the Governor signed House Bill No. 372, which (in part) amends Section 18-101(7) of the Delaware LLC Act to provide “[a] limited liability company agreement is not subject to any statute of frauds…” (emphasis added).

Furthermore, although the Olson decision related solely to limited liability companies, the legislature made similar amendments to the Delaware Partnership Act and the Delaware Limited Partnership Act, clarifying that the operating agreements of such entities are likewise exempt from any statute of frauds.

These amendments will go into effect on August 2, 2010. 

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