Limited liability company agreements often include procedures for member voting on significant company actions. But sometimes it is convenient to instead ask the members to sign a written consent document and thus avoid the need for an in-person meeting. The Delaware Court of Chancery last month had to decide whether an LLC agreement that allowed member voting, but said almost nothing about members taking action by written consent, precluded the use of member written consents. Paul v. Delaware Coastal Anesthesia, LLC, No. 7084-VCG, 2012 WL 1934469 (Del. Ch. May 29, 2012).
Background. Dr. Leena Paul was one of four 25% members of the LLC. The LLC’s operating agreement allowed a member of the LLC to be terminated without cause on 90 days’ notice by “the Company acting by vote” of members holding 75% of the interests in the LLC. The three members other than Dr. Paul agreed by written consent to terminate Dr. Paul’s membership in the LLC and gave her written notice of her termination.
Dr. Paul sued the LLC and the three members to set aside her termination, contending that the LLC’s operating agreement did not allow the LLC members to take action by written consent. Paul, at *1. The three members then filed a motion to dismiss the complaint.
Analysis. Dr. Paul’s complaint pointed to Section 7.8 of the operating agreement, which required that notice of any member meeting must state the place, date, and time of the meeting. It also stated: “At a meeting of Members at which a quorum is present, the affirmative vote of Members holding a majority of the Membership Shares and entitled to vote on the matter shall be the act of the Members, unless a greater number is required by the Act.” Id. at *2. Dr. Paul contended that the members’ consent was void because no membership meeting was held and proper notice of the action was not given to members.
Dr. Paul also contended that as an LLC member she had a fundamental right to vote her interests in the LLC. But the court disposed of that argument in a footnote by pointing out that Section 18-302 of the Delaware LLC Act allows LLC members to take action by written consent rather than voting at a meeting, unless otherwise provided by the LLC agreement. Id. at *2 n.10.
The other members asserted that their member action by written consent was valid under Section 18-302 of the Delaware LLC Act:
Unless otherwise provided in a limited liability company agreement, on any matter that is to be voted on, consented to or approved by members, the members may take such action without a meeting, without prior notice and without a vote if consented to, in writing or by electronic transmission, by members having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all members entitled to vote thereon were present and voted.
This section allows LLC members to take action by written consent, without a meeting, “unless otherwise provided in a limited liability company agreement.” The question for the court, therefore, was whether the operating agreement “otherwise provided,” i.e., preempted the statute’s authorization of written consents.
The court first noted that LLCs are contractual in nature, that the members have wide latitude to craft their rights and obligations, and that the LLC Act exists as a “gap filler” to supply terms not covered in the agreement. The court then turned to the language of the operating agreement.
The LLC agreement provided procedures for meetings of the members and defined the requisite vote to take action, but did not expressly bar the use of member consents. Further, the agreement’s sections on record dates and proxies allowed members to “express consent to Company action in writing without a meeting.” Id. at *2. The court concluded that, reading the operating agreement as a whole, it did not “‘otherwise provide,’ so as to preempt, actions by written consent to terminate a member,” and dismissed the complaint. Id. at *3.
Comment. This is a short and straightforward opinion, but I think it noteworthy for two reasons. One is that this issue, i.e., using written consents in lieu of member voting in person at a meeting, comes up frequently. On multiple occasions clients involved in an LLC have asked me, “Do we need to have a meeting or can we just sign a written consent?” The question is asked because scheduling or other issues may make a written consent convenient, or the written consent may be important to avoid delays.
The other point is for lawyers who draft LLC agreements. If an LLC agreement is intended to allow members the option either to vote or to take action by written consent, both should be explicitly authorized. If only one of these two approval methods is authorized, it leaves an inference that the lack of explicit authorization is intended to bar use of the other method.
Georgia Court Dismisses LLC Derivative Suit, and Declines to Adopt Futility Exception to the Pre-Filing Demand Requirement
A derivative suit is a procedural device that can be used by a member of a limited liability company to assert a claim on behalf of the LLC against a manager or managing member of the LLC that is breaching its fiduciary or contractual obligations to the LLC. But an LLC’s decision to initiate a lawsuit is normally up to the managers, so a derivative suit by its nature interferes with the managers’ authority. For that reason a member is expected to exhaust its remedies within the LLC by first making a demand on the managers that they take action to resolve the wrongdoing. This “demand requirement” is reflected in many state statutes, rules of civil procedure, and case law.
That’s all well and good, but what if the controlling manager is the one accused of wrongdoing? How likely is it that a manager accused of breaching its fiduciary obligations to the LLC will fairly consider causing the LLC to sue itself, just because of a member’s demand? This is such a common scenario that many statutes and case law recognize an exception to the demand requirement when the plaintiff can show that making a demand would be futile. Potential plaintiffs in a derivative action often resist making a demand because of fears that the managers will cloak their refusal to take action as a reasonable business decision, or take control and manage the lawsuit in a less than diligent manner.
The Decision. The Georgia Court of Appeals recently had to decide whether the plaintiff in an LLC derivative suit should be excused from making a demand of the LLC’s majority member before commencing a derivative suit in the name of the LLC. The plaintiff had not demanded that the LLC take action before filing the derivative action in Pinnacle Benning, LLC v. Clark Realty Capital, LLC, 724 S.E.2d 894 (Ga. Ct. App. March 6, 2012). The court declined to adopt a futility exception to the demand requirement and dismissed the derivative claims. Id. at 901.
The plaintiff was a 30% member and one of two managers of Clark Pinnacle Benning LLC (CPB). The two affiliated defendants controlled CPB – one was a 70% member and the other was the second manager. CPB in turn was the managing member of an LLC that operated a military housing project at Fort Benning, Georgia. The plaintiff claimed that the two affiliated defendants controlled CPB and through it the housing project, and that they had taken steps in bad faith to audit the plaintiff’s management operations at Fort Benning and to terminate its interests as the property manager, in violation of their fiduciary obligations. Id. at 896-97.
The trial court dismissed the derivative claims because the plaintiff had not demanded, prior to filing its lawsuit, that CPB initiate suit against the defendants. (Presumably the plaintiff thought that it would be an exercise in futility to demand that the two defendants cause CPB to sue themselves.)
The Court of Appeals began by examining Georgia’s LLC Act. The Act lists five conditions under which a member may commence a derivative action in the right of the LLC, one of which is: “The plaintiff has made written demand on those managers or those members with such authority requesting that such managers or such members take suitable action[.]” Ga. Code Ann. § 14-11-801(2). The Act makes no reference to any exception to the demand requirement.
The court noted that the Georgia Business Corporation Act requires a demand on the corporation prior to commencement of a derivative suit and makes no mention of any exception. The court pointed out that the Corporation Act had previously been interpreted by the Court of Appeals to allow for no exceptions to the demand requirement. Pinnacle Benning, 724 S.E.2d at 900.
Guided by the prior corporate ruling, the court found the legislature’s intent to be clear: The LLC Act’s procedures for LLC derivative suits contain a pre-filing demand requirement with no futility exception. Id. at 900-01. The plaintiff contended that it had cured any procedural defect by filing a demand letter with its response to the defendants’ motion to dismiss the complaint, but the court found that unavailing because the LLC Act requires that the derivative suit not be commenced until at least 90 days after the demand was made. Accordingly, the Court of Appeals affirmed the trial court’s dismissal of the derivative suit.
Dismissal of the suit may only be round one of this dispute, however. That’s because, as the Court of Appeals pointed out, “the trial court’s dismissal of Pinnacle’s action was actually due to a lack of subject-matter jurisdiction based upon Pinnacle’s failure to meet a procedural prerequisite prior to filing suit.” Id. at 902. The court accordingly remanded the case to the trial court for entry of an order dismissing the derivative claims, without prejudice. Id. A dismissal without prejudice is not an adjudication on the merits, and the plaintiff could therefore refile the complaint if the jurisdictional defect can be cured.
Georgia’s Minority Position. Georgia is not the only state to require a demand of management before an LLC derivative suit can be filed, with no futility exception. Arizona, for example, has a comparable provision in its LLC Act. Ariz. Rev. Stat. Ann. § 29-831. But this appears to be a distinctly minority view.
I have checked the LLC Acts of 12 states chosen at random (including Georgia). My review showed that the LLC Acts of nine of the 12 had a futility exception from the demand requirement for an LLC derivative suit. I think this is a large enough sample to draw the general conclusion that most states include the futility exception in the derivative suit rules of their LLC Acts.
Two states of particular interest to me, Washington (where I practice) and Delaware (a leading state for LLC formations), have in their statutes a futility exception to the pre-filing demand requirement for LLC derivative suits. Washington’s LLC Act gives members the right to bring a derivative suit if either (a) the managers or managing members have refused to bring the action, or (b) “an effort to cause those managers or members to bring the action is not likely to succeed.” Wash. Rev. Code § 25.15.370. This is consistent with Washington’s limited partnership statute, which requires a pre-filing demand before a limited partner can bring a derivative suit, unless “[a] demand would be futile.” Wash. Rev. Code § 25.10.706.
The Delaware LLC Act excuses a pre-filing demand for LLC derivative suits in language similar to Washington’s. Del. Code Ann. tit. 6, § 18-1001. The same is true for the Delaware limited partnership statute, which excuses a pre-filing demand for limited partnership derivative suits if a demand is not likely to cause the general partners to bring the action. Del. Code Ann. tit. 6, § 17-1001.
Reformation is an equitable remedy that courts use to “reform” or correct a mistake in a written agreement, to conform it to what the parties actually intended their agreement to say. The Delaware Court of Chancery recently reformed the cash distribution waterfall provisions of the limited liability company agreements for three real estate joint ventures in ASB Allegiance Real Estate Fund v. Scion Breckenridge Managing Member, LLC, No. C.A. No. 5843-VCL, 2012 WL 1869416 (Del. Ch. May 16, 2012).
Background. Investors and Developer entered into five real estate deals in 2007 and 2008, each structured as an LLC. In each deal the Investors put up 99% of the cash and Developer put up 1%. Each agreement provided that when the LLC’s property was sold, the sale proceeds would be distributed to the members according to a hierarchy that established the order in which funds would be distributed, often called a “waterfall.” The waterfall from the first two deals, using simplified language, was:
(a) First, 99% to Investors and 1% to Developer until each has received an 8% preferred return (similar to an annual interest rate) on its invested capital;
(b) Then 99% to Investors and 1% to Developer until each has received the return of its invested capital; and
(c) Then 20% to Developer, and 80% to be divided 1% to Developer and 99% to Investors.
In other words, both parties receive interest on their investment, then they get their investment back, and then they share, not based on the 99%-1% ratio of invested capital, but based on a ratio that gives the Developer a higher percentage return. The higher level of return to the Developer, after the threshold amounts are paid out, is intended as an incentive for the Developer. It is often referred to as a “promote” by real estate professionals. The above waterfall has a 20% promote.
When the parties negotiated the third of the five deals, they agreed on a two-tiered promote. This was similar to the waterfall above, except that the final level, which defines the promote, shifts to a higher promote percentage for the Developer after a specified amount has been distributed. In the example above, the third level would have a limiting cap added, and a fourth level would be added with the higher promote.
The Mistake. Unfortunately, in the process of preparing the written LLC agreement for the third deal, the return of capital paragraph was mistakenly placed after the first promote paragraph. That’s a much better deal for the Developer, which would receive the first portion of its promote before the parties get their capital returned. Thus the Developer could get its promote even if the overall deal were a loss and did not return any of the parties’ invested capital. This written agreement was approved and signed by the parties, even though it was not what they had negotiated.
This mistake happened because the responsible partner at the Investors’ law firm, who was heavily involved in the first transaction, turned the second deal over to an inexperienced associate lawyer. The terms of the second transaction mirrored the terms of the first, but when the terms of the waterfall changed in the third transaction the associate accidentally placed the key paragraph in the wrong position. The partner either did not read the final agreement or did not notice the mistake, and the error remained in the final agreement.
The court found that the in-house lawyer at the Developer knew of the mistake and knew that it was favorable to Developer, but said nothing about it to the Investors’ counsel. The executive in charge of the deal for the Investors reviewed the agreement, but did not notice the mistake and signed the agreement.
To compound the error, in short order the parties entered into two more real estate ventures, using the same structure and copying the same erroneous waterfall language. In both cases the waterfall as written by the Investors’ lawyer was not what the parties negotiated, the Developer knew of the mistake and knew that it was favorable to Developer, the Developer said nothing, and the Investors did not catch the mistake.
This situation inevitably led to conflict, which was precipitated by the Developer’s exercise of a put right in one of the three LLC agreements with the mistaken waterfall. The Developer’s buyout price under its put right was based on the agreement’s distribution provisions and the venture’s fair value.
The venture was underwater, since it had a fair market value of $35.5 million and the Investors had invested $47.3 million. As written, the waterfall entitled the Developer to $1.83 million, but as negotiated, the waterfall would have entitled the Developer to only $348,000. The result would be that instead of the Investors and the Developer sharing the loss 99%-1%, the Developer would make a 282% profit and the Investors would lose roughly 30% of their investment. Id. at *10.
The Developer demanded the higher amount based on the language of the waterfall. The Investors examined the agreement and determined that it was in error and was not in accordance with what they had negotiated. The Investors had what their executive called “a very, very tough conversation” with their law firm, and put the law firm on notice of a malpractice claim. Id. The executive said at trial that he was “incredibly upset that this had happened because it was clear what the document said, and that it was just wrong.” Id.
The Lawsuit. The Investors filed suit and sought an order reforming the waterfall provisions in the three disputed LLC agreements to match what had been negotiated. The Developer counterclaimed, seeking to enforce the agreements as written. The trial lasted four days and included nine fact witnesses, two expert witnesses, 300 documentary exhibits, and 25 deposition transcripts.
The court applied the doctrine of unilateral mistake, which allows reformation of a contract if the party seeking reformation can show by clear and convincing evidence that it was mistaken and that the other party knew of the mistake but remained silent. The plaintiff must show that there was a specific prior contractual understanding that conflicts with the terms of the written agreement. Id. at *13.
After a detailed review of the evidence, the court found that the Investors had demonstrated by clear and convincing evidence that they were entitled to reformation of the three LLC agreements. The court also dismissed the Developer’s defenses that (a) the Investors’ representative had not read the agreements, (b) the Investors had ratified the agreements, and (c) the Investors had unclean hands. The court accordingly rewrote the waterfall provision, placed the corrected language in its opinion, and ordered the two other disputed LLC agreements to be corrected in the same way. Id. at *21.
The court also awarded the Investors their attorneys’ fees, under the contractual fee-shifting provisions of the disputed agreements. The Developer argued that the Investors had not incurred any attorneys’ fees because the Investors’ law firm was not billing for its fees. (The same law firm that had made the mistakes in the three agreements represented the Investors in the lawsuit. Presumably it was not charging for the litigation because without its mistakes on the three agreements there would have been no litigation.) The court found that the arrangements between the Investors and their law firm to allocate the litigation costs did not affect the Developer’s obligations under the fee-shifting provision in the agreements. Id. at *20.
For a more detailed review of the court’s analysis, see Francis Pileggi’s post on his Delaware Corporate & Commercial Litigation Blog, here.
Comment. This strikes me as a surprising case. Not because of the legal doctrine of reformation or the court’s legal analysis, but because of how the business transactions played out and the roles of the lawyers involved.
For one thing, lawyers and business people who work on large real estate ventures such as these know that the waterfall provisions are not boilerplate – they are at the heart of the deal. Who puts how much money into the deal and who gets how much out are major components of what real estate partnerships and LLCs are all about.
For another thing, waterfall provisions, and especially the ones in this case, are not all that hard to read. They are a series of fairly short clauses in reasonably simple language that specify an algorithm to pay out the cash from the venture to the members. The sequential order of those clauses is key to how the waterfall works. Getting the paragraphs out of order is roughly comparable to getting a divide and an addition out of order in an algebraic expression. The result will usually be wrong.
These truisms make the mistakes that took place here, on both sides, rather startling. I say on both sides because the Investors’ law firm made the drafting mistakes, but the Developer’s lawyer made a mistake in judgment by not revealing the drafting mistake.
The drafting mistakes appear to reflect a classic organizational blunder by the Investors’ law firm. A senior partner turns over responsibility for a series of transactions to an associate lawyer who lacks the experience to understand the terms of the waterfall. The associate makes the mistake, and then the partner either doesn’t read the agreement or if she did, doesn’t focus on the key terms of the waterfall. The Investors’ representative relies on the partner at the law firm, and the partner relies overmuch on the inexperienced associate.
The Developer’s attorney, on the other hand, showed bad judgment in not revealing the error. The court found that he was a sophisticated and experienced real estate venture attorney who recognized the error but intentionally remained silent in order to capture an undeserved benefit for the Developer. Id. at *15.
As Francis Pileggi pointed out in his blog post, here, the court did not address the legal ethics issues in its opinion. But even setting that aside, in deals of this magnitude it’s foolish to think that a fundamental drafting error, inconsistent with what the parties clearly had agreed on, will not be discovered when it comes to light and would cost the other party a lot of money unless corrected. And as the court’s opinion shows, basic contract law can provide relief in this type of situation.
This is not a case where the lawyers appear at their best.