Saturday, February 20, 2021

Delaware Law Continues to Eat the World

I’ve previously expressed concern about Delaware organizational law intruding into other states’ spaces.  A new entry into the genre is VC Slights’s opinion in AG Resource Holdings, LLC, et al. v. Thomas Bradford Terral.

In AG Resource Holdings, Thomas Terral cofounded an LLC called AG Resource Management.  The business was eventually bought out by a private equity firm and restructured as a holding company, AG Resource Holdings LLC, that wholly owned the operating subsidiary, AG Resource Management LLC.  Terral was designated as one of several managers of the LLCs, and also was an officer.

Terral’s contractual obligations were embodied in separate agreements.  First, he had an Employment Agreement, which had various noncompetes, and a Delaware choice of law clause.  Second, the LLC agreements themselves required him to act in good faith and not compete, and chose Delaware law, and Delaware forums, to resolve any disputes. 

Terral was fired after it was discovered he was planning to compete with the companies, and he filed a complaint in Louisiana seeking to have the noncompete in the Employment Agreement declared unenforceable.  Terral’s argument – which a Louisiana court accepted on a motion for a preliminary injunction – was that because the work was performed in Louisiana, Louisiana law naturally governed the Employment Agreement, and under Louisiana law both the noncompete and the Delaware choice of law clause were unenforceable. 

The companies then sued in Delaware seeking to enforce the agreements.

Examining all of this, Slights agreed that, in the absence of the choice of law clause, Employment Agreement was governed by Louisiana law as the state with the greatest interest.  Louisiana would not have permitted employees to waive Louisiana law, or waive the right to compete (at least not in the way the agreement was drafted), therefore, those provisions were unenforceable.  For that reason, the Louisiana court action took precedence over the Delaware action.  So, the companies’ action to enforce the Employment Agreement was stayed in favor of the Louisiana action.

But the LLC agreements were a different story.  First, Terral had not sued under those agreements in Louisiana, so those issues were not before the Louisiana courts.  More importantly, though, those agreements were part of “the constitutive documents of a Delaware entity,” and even in the absence of choice of law/forum clauses, Delaware law would control by default.  And under those agreements, Terral had agreed to act in good faith and not to compete, and the companies had the right to enforce those agreements in Delaware.  As Slights put it:

Moreover, while Louisiana may possess a public policy interest in regulating the actions of employers toward employees within that state, Louisiana has no interest in regulating the governance or internal affairs of a Delaware entity. And, while LA. STAT. ANN. § 23:921(L) provides that, under Louisiana law, non-competes within LLC agreements will be subject to nearly identical restrictions as those within employment contracts, there is no indication that Louisiana purports to extend those restriction to fiduciaries acting within Delaware LLCs.

To state the distinction most directly, the claims under the Employment Agreement rest on Terral’s conduct as employee (regardless of whether he occupied a fiduciary status), while the claims under the LLC Agreement rest on Terral’s status as a member of the Company’s Board of Managers. In drawing this distinction, I acknowledge there may be some overlap in the litigation and adjudication of claims arising under the Employment Agreement on the one hand, and the LLC Agreements on the other, and further acknowledge there is at least some risk of inconsistent outcomes. Nevertheless, as discussed here, Terral is alleged to have engaged in wrongful conduct as a “manager” and “officer” of a Delaware entity. The Company is entitled to litigate that claim in this Court.

All of that contains a surface level appeal, but the problem is – at least as described in the opinion (it’s possible there’s more nuance to the underlying documents) – the LLC Agreements obligated Terral to basically do the same things as the Employment Agreement, as part of a relationship that substantively would be characterized as an employment relationship.  If that’s right, then it shouldn’t matter whether the LLC Agreements are labeled “LLC Agreements” or “Employment Agreements” or “Ishkabibble,” they are substantively contracts for employment and should carry with them the same restrictions.  If Terral, as someone who performs management services for the companies, is legally barred from waiving his right to compete under Louisiana law, then it shouldn’t matter what document the impermissible restriction is contained in. 

I mean, it’s absolutely possible that Terral had different responsibilities and legal rights as a member of the LLCs Board of Managers, and as an employee of the company, making it possible to distinguish between the different contracts, but if so, nothing in the opinion itself explains what the differences would be.

To put it another way, if someone is labeled an LLC “manager,” does that mean their relationship with the LLC is necessarily a question of Delaware organizational/entity law, or is there some particular type of relationship that is more appropriate for regulation under business organizational law rather than employment law, and if so, what is the scope of that relationship?

Interestingly, VC Laster confronted a somewhat similar situation a few months ago in Focus Financial Partners v. Holsopple.  There, an employee working out of California received as compensation certain units of a Delaware LLC.  As a condition of his employment, he signed “unit agreements” regarding the transfer of the units, which contained various noncompete/nonsolicit clauses, and stated they were governed by Delaware law with a Delaware forum selection clause.   Additionally – and I’m simplifying, there were amendments over time, it was a whole thing – the LLC itself had an operating agreement with a Delaware forum selection clause.

There was eventually a dispute over whether Holsopple had violated the noncompetes, and Focus Financial sued in Delaware.  The only way that Delaware would have personal jurisdiction over Holsopple was through the choice of forum/law provisions of the unit agreements and the operating agreement.  Holsopple, however, claimed that these provisions were all part of his employment contract, his employment contract (in the absence of these agreements) would be governed by California law, and California law would render them unenforceable.  Laster agreed.  Notwithstanding the fact that the provisions did not appear in the employment agreement per se – they appeared in unit transfer agreements and the LLC operating agreement – they were functionally part of his employment contract. 

Now, Laster had an easier time of it than did Slights in AG Resource Holdings, because Holsopple was not a manager of the LLC.  In fact, as Laster pointed out, “the units generally did not have ‘any voting or other consent or approval rights.’ Focus Parent is a manager-managed LLC in which holders of units have minimal rights.”  But that only begs the question whether – going back to to AG Resource Holdings – Slights should have conducted a more searching inquiry of Terral’s powers and responsibilities to determine if even his “manager” role was functionally that of an employee.

Notably, in Focus Financial, Laster had a very interesting footnote where he anticipated the corner into which Delaware had boxed itself:

Delaware court have confronted with increasing frequency situations in which parties have attempted to use choice-of-law provisions selecting Delaware law to bypass the substantive law of sister states. In this court, the conflicts most often involve agreements containing restrictive covenants.  … This court has also confronted a conflict between agreements selecting Delaware’s contractarian regime and the substantive law of a foreign jurisdiction. … Other Delaware courts have confronted similar issues in other contexts. …Because Delaware’s role as a chartering jurisdiction depends on other states deferring to the application of Delaware law to the internal affairs of entities, the increasing frequency with which parties use Delaware law to create conflicts with the substantive law of other jurisdictions raises significant public policy issues for this state. See Diedenhofen-Lennartz v. Diedenhofen, 931 A.2d 439, 451–52 (Del. Ch. 2007) (“If we expect that other sovereigns will respect our state’s overriding interest in the interpretation and enforcement of our entity laws, we must show reciprocal respect.”).

The point is, Delaware’s increasingly contractual approach to entity is organization is putting pressure on the boundaries of the internal affairs doctrine.  Also relevant here is the growing prevalence of shareholder agreements – studied by Gabriel Rauterberg in this paper and Jill Fisch in this one – which may very well select a law other than Delaware’s, so that the entity is organized under Delaware law but crucial governance matters are controlled by the law of another state.  See, e.g., KT4 Partners v. Palantir Technologies (shareholder may obtain books and records under Section 220 to investigate violations of stockholder agreements governed by California law).  These are going to create thorny choice-of-law issues going forward and, I worry, undermine the utility of the internal affairs doctrine itself.

Ann Lipton | Permalink


Ought the outcome differ depending upon employment compensation compared to return on investment? Say, four friends agree to form a lucrative business and each will receive a token $40,000 per year in compensation pursuant to an Employment Agreement. But each will also receive $150,000 per year in distributions from their LLC employer pursuant to an Operating Agreement. Both Agreements have strict CNTCs and both are governed by Delaware law, with forum selection in Delaware. The business is global but primarily officed in Wilmington. Do Louisiana and California law prevail in a CNTC enforcement action against one of the four?

Posted by: Craig L Sparks | Feb 20, 2021 9:38:54 AM

Hi Craig. That might be part of it - I was actually thinking more like the tests we already have in various contexts (i.e., antidiscrimination law) that distinguish employees from other actors. In those contexts, sharing in profits might be a factor to consider (along with things like, how easily you can be fired, etc)

Posted by: Ann Lipton | Feb 20, 2021 10:07:43 AM

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