Tuesday, May 19, 2015

Delaware LLC Case Sends Wrong Signal, Unnecessarily Expands Equitable Standing

Vice Chancellor Laster recently issued an opinion in In re Carlisle Etcetera, LLC (available here), that has the potential to encourage (or at least fail to punish) sloppy practices and unnecessarily expands equitable standing for judicial dissolution.  In doing so, the case increases litigation risk for LLCs. 

The case involves an LLC made up of two member parties that formed Carlisle Etcetera, LLC. (Carlisle): WU Parent and Tom James Co. (James). The LLC agreement called for a manager-managed board, that would serve as sole manager.  WU Parent appointed two board designees, as did James.  Board decisions required "unanimous approval."  At some point, for tax reasons, WU Parent assigned its membership interest to WU Sub. Thereafter, Carlisle identified WU Sub as a 50% member interest in tax filings and the LLC's accountants referred to WU Sub as "an equal member" of the LLC.  The parties discussed an updated LLC agreement that would have made clear that an initial member of the LLC could transfer ownership to a wholly owned affiliate that would retain membership status, though that agreement was never finalized.  

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As one might expect, given that litigation resulted, the members had a disagreement that meant a breakup was inevitable.  A buyout could not be agreed upon, and the case moved forward.  James was in control of the LLC because the LLC's CEO was a James appointee. WU Sub petitioned the court for dissolution, and James moved to dismiss under Del. Code sec. 18-802 stating that neither WU Sub or WU Parent were members, and  thus both lacked standing to seek statutory dissolution. The court agreed that neither WU entity was a member, but determined that WU Sub could seek dissolution in equity.

I have two primary concerns about how this case is handled. First, when VC Laster provided WU Sub the option to sue in equity, that outcome suggested that any assignee can sue in equity for dissolution, even though the assignee is clearly not a member.  This could lead to longer litigation for cases that are without merit given Delaware's relaxed pleading standard of "reasonable conceivability." Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Hldgs. LLC, 27 A.3d 531, 536 (Del. 2011).  

Second, VC Laster went on to note that he believes "the ability to waive dissolution under Section 18-802 does not extend to a party‘s standing to seek dissolution in equity."  This, too, is concerning because LLCs are specifically designed to be creatures of contract.  I concede that VC Laster is correct that the Delaware  legislature moved to keep equitable remedies available, but I don't see that there is anything inherently inequitable about enforcing a contractual provision that parties agreed to.  That is, would be one thing for a court to decline to enforce a non-dissolution clause in an LLC operating agreement because the clause was shown to be unconscionable or because a party had adequate support to seek reformation of the contract to exclude such a provision.  It's quite another thing to allow a member to seek equitable dissolution even where there is such a clause merely by claiming it's somehow inequitable not to dissolve the LLC.

I think it's right for the court to send the message to WU Parent and WU Sub that assignments without other planning are a bad idea if either party wishes to be a member of the LLC. However, the outcome here doesn't clearly send that message. Instead, the decision suggests that, even where you clearly did not follow the mandates of the statute and the LLC agreement, there may be an equitable bailout.  

In Litigating LLCs, Larry Ribstein warned that "the vagueness of the grounds for judicial dissolution [of LLCs] creates a risk of costly litigation." (footnote omitted).  Adding vague equitable standing for non-members to seek dissolution makes this even more true.

It seems to me that this case provides facts for another better outcome that would achieve the same result but provide a more limited scope of facts to support an entity like WU Sub's request for judicial dissolution. Instead of providing equitable standing, the court could have found that WU Sub became a member through the actions of the LLC, which was controlled by James.  

VC Laster states, "It makes sense that the LLC Act would require formal member action to accept a new business partner, rather than contemplating de facto membership or the constructive admission of assignees." It's not clear to me that has to be true, but even if it is, there is evidence that James and its representatives ratified WU Sub as a member (or acquiesced to such membership) through its actions.  

By allowing WU Sub to make the case that it became a member by ratification or acquiescence, it would send a message to both parties. The WU entities here goofed, but so did James. James clearly knew why WU Parent sought to change membership -- for tax purposes.  James' representatives took the steps necessary to fulfill that request with the company filings.  To sit back and then deny the WU Sub took the place of WU Parent seems, at a minimum, a little slimy.  This type of outcome would at least require a pleading that suggests more than a mere request for equitable dissolution by an assignee and would not extend the equitable request to virtually anything, regardless of what was in the LLC agreement.   

I admit, I think that LLCs should be respected as largely, if not exclusively, creatures of contract. And, to be clear, I would hold open the option that the court could have reviewed the facts and determined that WU Sub did not demonstrate enough action on the part of James to allow WU Sub to become a member. I would be okay with that outcome, too, because at least it would signal that better planning and better drafting are paramount in LLCs.

My reading of the facts suggests that the parties agreed to have WU Sub become a member, and that is only reason I would support letting the case move forward.  Absent find such an agreement, I think the court should have let this case go. 

http://lawprofessors.typepad.com/business_law/2015/05/delaware-llc-case-sends-wrong-signal.html

Delaware, Joshua P. Fershee, LLCs | Permalink

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