Saturday, December 9, 2023

It's another internal affairs doctrine post

Two interesting matters related to the internal affairs doctrine came up recently, and since I just wrote a whole paper on this subject, I can’t resist mentioning them here.

First, VC Laster issued an opinion in Sunder Energy v. Jackson et al,.  The question was whether certain LLC members and employees violated noncompetes included in the LLC agreement, but Laster began by railing against the trend of companies attempting to avoid the employment law of states where they do business by writing employment-related terms into entity organizational documents, and then issuing equity compensation to employees.  The companies do so apparently in hopes that the employment-related terms will then be treated as entity internal affairs matters governed by the state of organization (Delaware), rather than employment terms governed by the employee’s home state.  Sunder Energy was not the first time Laster objected to the practice; earlier, he gave a long speech on the matter in his transcript ruling in Strategic Funding Source Holdings LLC v. Kirincic, which I quoted extensively in my paper

Anyway, that’s not the only thing of interest in the case; it also presents an interesting cautionary tale that will work well in the classroom.  Several people formed an LLC.  They did not, however, draft an LLC agreement.  At the moment of founding, they referred to themselves as “partners,” though they agreed that two members in particular would manage the business and receive a majority of the equity, with the remainder split among the other founders, who would be employees. 

Later, the two managing members sought legal counsel for themselves and drafted a formal LLC agreement that dramatically changed the arrangement in a manner that favored themselves and limited the rights of the other members.  The other members signed the new agreement as presented to them, but the changed terms were never explained, and the managing members implied this was just a formality recommended by entity lawyers.

Laster held that when the original LLC was formed – before the agreement was drafted – the default rules for LLC organization kicked in, which meant the managing members had fiduciary duties to the minority.  By rewriting the agreement in such a self-interested fashion – and presenting it to the minority members without disclosing what it meant – they violated those duties, rendering the new agreement unenforceable.  As Laster put it:

At the very least, Nielsen and Britton had an obligation to state plainly to the Minority Members that it was time to switch out of a mindset of fiduciary reliance and into a mindset of arm’s-length bargaining. They were obligated to put the Minority Members on notice that this was a really big deal. They needed to say, in substance, that the 2019 LLC Agreement materially and adversely altered the Minority Members’ rights, that Snell & Wilmer represented Sunder and its controlling members (viz., Nielsen and Britton) and not the Minority Members, and that the Minority Members should retain their own counsel and obtain independent advice because there were major changes in the draft agreement.

Anyway, the whole situation reminded me a little of Christine Hurt’s Startup Partnerships, about the inadvertent partnerships that form before companies formally organize.  Also, for contract and restrictive covenant mavens, there’s some great stuff on how choice of law affects the restrictive covenant analysis, and very amusing language about the overbreadth of the restrictions.

Which brings us to our next internal affairs issue, regarding the complaint filed in Adrian Dominican Sisters et al. v. Mark P. Smith, in the District of Nevada.  There, several communities of Catholic nuns filed a derivative lawsuit against Smith & Wesson, arguing that the company acted in bad faith by failing to oversee Smith & Wesson’s compliance with laws regarding the marketing of its AR-15 – functionally, a Caremark/Massey claim.  And yes, I realize this is particularly well-timed given the recent shooting at UNLV, which Ben posted about earlier this week.

The lawsuit in and of itself is interesting, but what struck me is that Smith & Wesson is organized in Nevada, but, until recently, its headquarters were in Massachusetts (they just moved to Tennessee).  The plaintiffs aver that they obtained books and records before filing their lawsuit, but as I understand Nevada law, inspection rights are only available for investors with at least a 15% stake.  So, the plaintiffs sought books and records under Massachusetts law.  And the reason that’s striking is, nothing in the complaint suggests Smith & Wesson objected – in fact, it provided records – but not long ago, in Juul Labs, Inc. v. Grove, 238 A.3d 904 (Del. Ch. 2020), VC Laster held that inspection rights are an internal affairs matter.  (Which is something I also discuss in my paper).  The choice of law for inspection rights has always been a bit fuzzy; I don’t know if Smith & Wesson acceded in in this case because of prior unfavorable precedent, or for some other reason.

As for the lawsuit itself, traditionally, religious orders have focused on shareholder proposals rather than derivative lawsuits, but it’s not surprising to me that they’re branching out because – as I previously posted – Delaware is in the process of establishing some mighty broad rules about derivative lawsuits on the grounds of intentional lawbreaking by corporate boards.  Unsurprisingly, plaintiffs are alleging even unadjudicated lawbreaking as a violation of fiduciary duty, and so, a conservative plaintiff recently latched on to that precedent to challenge Starbucks’s diversity policies, and now we’re seeing liberal-side plaintiffs claim that Smith & Wesson’s marketing of the AR-15 was illegal and rendered the company vulnerable to future liability.  (I mean, these are not Delaware companies or cases, but I think the litigants are inspired by Delaware precedent).  Also, the complaint alleges that this conduct violated the Board’s ESG Committee charter, so it turns out that Smith & Wesson has an ESG Committee.

Ann Lipton | Permalink


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