LLC Managers on Both Sides of Transaction Breach Delaware's Entire Fairness Standard
LLC managers tempted by the old saw “no harm, no foul” should read William Penn Partnership v. Saliba, No. 362, 2010, 2011 Del. LEXIS 91 (Del. Feb. 9, 2011). The case shows that LLC managers having a conflict of interest in an LLC’s transaction must do more than ensure that the deal is economically fair to the LLC. They must also use fair procedures and comply with the LLC agreement.
The LLC managers in William Penn were members of the LLC, and they were also investors and directors of a corporation (Buyer) that wanted to purchase the LLC’s motel, its only substantial asset. Two of the other members did not want the motel sold, and if the sale could not be stopped they wanted to purchase the motel themselves. The mangers proceeded to manipulate the LLC’s sale and approval process through repeated material omissions and misrepresentations to the other members, and failed to hold a vote as required by the LLC agreement. The property was sold to Buyer, and the other members sued the managers for breach of fiduciary duties.
The LLC’s operating agreement was silent on the managers’ fiduciary duties, so the court found that they owed the traditional fiduciary duties of loyalty and care to the LLC’s members. William Penn, 2011 Del. LEXIS 91, at **14-15. Because of their financial interest in both the LLC and the Buyer, the managers bore the burden of demonstrating the entire fairness of the transaction. Id. at **15.
The entire fairness standard requires that the fiduciary demonstrate both fair dealing and a fair price in the transaction. Fair dealing involves aspects such as how the transaction was structured, timing, disclosures, and approvals. Fair price addresses the economic and financial aspects of the transaction. Id. at **15-16. The managers argued that the deal was entirely fair because the purchase price was more than the appraised value, but the court pointed out that both elements of the entire fairness test must be satisfied.
The Delaware Supreme Court found ample evidence in the record to support the Chancery Court’s conclusion that the managers breached their fiduciary duties. They prevented a fair and open process by a variety of machinations – withholding full information, providing misleading information, and imposing an artificial deadline on the transaction. Id. at **20.
In order to determine damages, the Chancellor ordered an appraisal of the property. The appraisal came in at $5.58 million, less than the $6.6 million the property had been sold for, leaving the plaintiffs with no conventional damages remedy.
Not to be balked by the rule that litigants normally bear their own legal fees, the Chancery Court used its equitable power and awarded attorneys’ fees to the plaintiffs. The Supreme Court found that there was no abuse of discretion: “The Chancellor’s decision to award attorneys’ fees and costs was well within his discretion and is supported by Delaware law in order to discourage outright acts of disloyalty by fiduciaries.” Id. at **22.
“No harm, no foul” didn’t work – even though the managers’ breach of fiduciary duties did not result in damages to the other members, the court nonetheless stung them with an award of the members’ attorneys’ fees.
Washington Dismisses Lawsuit by Cancelled LLC and Denies Award of Attorneys' Fees to Defendant
Washington’s Court of Appeals has issued another opinion dealing with the impact on litigation of the cancellation of an LLC’s certificate of formation. Metco Homes, LLC v. N.P.R. Constr., Inc., No. 64535-8-I, 2010 Wash. App. LEXIS 2428 (Wash. Ct. App. Nov. 1, 2010) (unpublished).
Metco was a construction contractor and developed a condominium project in Everett. N.P.R. was Metco’s subcontractor and installed the project’s siding. The siding leaked, Metco sued N.P.R., and before trial Metco’s certificate of formation was administratively cancelled by the Washington Secretary of State. On N.P.R.’s motion the trial court dismissed Metco’s suit and awarded attorneys’ fees to N.P.R. based on the attorneys’ fees clause in their contract.
The Metco case is part of the progeny of Chadwick Farms Owners Association v. FHC, LLC, 166 Wn.2d 178, 207 P.3d 1251 (2009), which I previously reviewed, here. Chadwick Farms held that once a Washington LLC’s certificate of formation has been cancelled, it cannot sue or be sued and any pending lawsuits by or against the LLC abate.
An unusual aspect of Metco is the timing of Metco’s cancellation and the maneuvering of the trial date by N.P.R.’s counsel. Metco was administratively dissolved by the Washington Secretary of State on June 1, 2006, apparently for failing to file its annual report and pay its annual fee. Under the LLC Act then in effect, its certificate of formation was due to be cancelled two years later, on June 1, 2008. Metco’s trial date was originally set for trial on May 5, 2008, at which time its certificate of formation would not yet have been cancelled.
Metco was apparently unaware of its dissolution and impending cancellation. That’s odd, because the Secretary of State sends several notices to the registered agent of an LLC that fails to renew its annual report. But N.P.R.’s counsel was well aware of the impending cancellation.
As alleged by Metco, N.P.R.’s counsel misrepresented a scheduling conflict and successfully importuned Metco to reschedule the trial to a later date, after June 1, 2008. Simultaneously she was drafting motion papers to dismiss Metco’s suit on grounds of cancellation of its certificate of formation (which would not happen until June 1). After Metco was cancelled on June 1, she filed N.P.R.’s motion for dismissal of Metco’s lawsuit.
The Court of Appeals found the allegations regarding N.P.R.’s counsel to be disturbing, if true. Metco, 2010 Wash. App. LEXIS 2428, at *8. But even if true, said the court, reinstatement of Metco’s lawsuit would not be required.
[I]t is simply inaccurate to say the alleged deception “caused” the cancelation. Regardless of the alleged actions of NPR’s counsel, Metco could have renewed the LLC at any time in the two years after it was administratively dissolved. Under these circumstances, the trial court’s decision was neither untenable nor was it based on an incorrect standard of law. The trial court did not abuse its discretion in denying the motion to vacate.
Id. Because N.P.R. prevailed at trial, the trial court awarded N.P.R. its attorneys’ fees against Metco, pursuant to the attorneys’ fees clause in their contract. The Court of Appeals reversed and rather straightforwardly applied Chadwick Farms. “[A] lawsuit to enforce contractual duties owed by a LLC, including a duty to pay attorney fees and costs, cannot be maintained after the LLC has been cancelled.” Id. at *8-9.
The court’s emphasis on Metco’s ability to avoid cancellation by simply filing its annual report and paying the fees, and the court’s unwillingness to reinstate the lawsuit even if misrepresentation by the defendant’s counsel were to be established, show the draconian results of the Chadwick Farms ruling. Fortunately, the relevant provisions of Washington’s LLC Act have since been amended to eliminate the possibility of cancelling an LLC’s certificate of formation. I previously described those changes, here.
Washington LLCs: Dissenters' Rights and Attorneys' Fees
The Washington Supreme Court recently reversed a trial court and Court of Appeals decision on an award of attorneys’ fees to an LLC dissenter. Humphrey Indus., Ltd. v. Clay St. Assocs., LLC, No. 82687-1, 2010 Wash. LEXIS 1004 (Wash. Nov. 10, 2010). The Humphrey case stands out because there are so few reported cases on LLC dissenters’ rights, and because the five-to-four decision required the LLC to comply strictly with the statute’s 30-day period for paying the dissenter the value of its LLC interest. Clay Street Associates, LLC was formed in 1997 to hold a single real estate property. In 2004 most of the members decided to approve a sale of the property. The LLC agreement required unanimous member approval, and member Humphrey Industries, Ltd. refused to approve the sale. Circumvention of Unanimity. The other members then eliminated the unanimity requirement by approving a merger of the LLC into a new LLC that did not require unanimity for a sale of the property. (Unless the LLC agreement provides otherwise, a merger requires the approval of only a majority of the member interests, measured by their capital contributions to the LLC. RCW 25.15.400.) Members have the right to dissent from a merger of a Washington LLC and obtain the fair value of their member interest in cash. RCW 25.15.430. Humphrey exercised its dissenter’s right and demanded the fair value of its LLC interest. Dissenters’ Rights. Dissenters’ rights, sometimes called appraisal rights, originated with corporations: Essentially, an appraisal is the method of paying shareholders for taking their property; it is the statutory means whereby shareholders can avoid the conversion of their property into other property not of their choosing and is given to shareholders as compensation for the abrogation of the common-law rule that a single shareholder could block a merger. The purpose of these statutes is to protect the property rights of dissenting shareholders from actions by majority shareholders that alter the character of their investment. 12B William Meade Fletcher, Fletcher Cyclopedia of the Law of Corporations § 5906.10, at 386-87 (rev. vol. 2009) (footnotes omitted). Some but not all of the states have provisions for dissenters’ rights in their LLC Acts. For example, besides Washington, California, Florida, Minnesota, and New York have statutory provisions for LLC dissenters’ rights. Delaware’s LLC Act has no provision for dissenters’ rights, but it authorizes an LLC’s operating agreement or a merger agreement to provide contractual appraisal rights. DLLCA § 18-210. The Merger. The LLC’s merger became effective December 7, 2004. The LLC was required by the statute to pay Humphrey the fair value of its member interest within 30 days, RCW 25.15.460(1), but the LLC lacked funds. It proceeded to sell the real estate, and on May 27, 2005 paid Humphrey its estimate of the fair value of Humphrey’s member interest as of the merger date, plus interest. Humphrey disputed the LLC’s valuation and demanded a larger amount. Litigation ensued, the LLC made a settlement offer, settlement talks broke off, and the litigation went to trial. The trial court found that the LLC had undervalued Humphrey’s interest and ordered the LLC to pay Humphrey an additional $60,588. Attorneys’ Fees. Then the parties argued over attorneys’ fees. The statute says that in a proceeding over the valuation of a dissenter’s member interest, the court may assess attorneys’ fees and expert fees: (a) Against the limited liability company and in favor of any or all dissenters if the court finds the limited liability company did not substantially comply with the requirements of this article; or RCW 25.15.480(2). These provisions are similar to those in the Model Business Corporation Act and in many state corporate statutes. E.g., RCW 23B.13.310. Trial Court Ruling. The trial court found that the LLC had violated the Act by not paying Humphrey for its interest within 30 days of the merger as required by RCW 25.15.460(1). But, said the court, the LLC had “substantially complied” because it lacked the funds to pay, moved expeditiously to sell the real estate to generate funds to pay Humphrey, and paid interest on the delay period. Further, the trial court found that Humphrey acted arbitrarily, vexatiously, and not in good faith in pursuing its dissenters’ rights claim. It therefore awarded attorneys’ fees and expenses to the LLC. Humphrey appealed and the Court of Appeals affirmed. Supreme Court Weighs In. The Washington Supreme Court in Humphrey saw the 30-day payment requirement differently. The court characterized the purpose of the 30-day requirement as ensuring that dissenters have immediate use of the money which the LLC estimates to be the value of their member interests. Humphrey, 2010 Wash. LEXIS 1004, at *13-14. Humphrey should have received payment within 30 days of the merger date; instead the LLC sent the funds almost six months later. “A six-month deferral of payment is not ‘substantial compliance’ with a statute that unambiguously requires payment ‘within thirty days.’” Id. at *17. The court therefore reversed the Court of Appeals’ determination that the LLC had substantially complied with the LLC Act, and remanded to the trial court to determine whether Humphrey should be awarded attorneys’ fees based on the LLC’s noncompliance with the Act’s 30-day payment requirement. Id. at *20. The court also reversed the award of attorneys’ fees to the LLC. The trial court had concluded that Humphrey had acted arbitrarily, vexatiously, and not in good faith, based on its refusal to accept a settlement offer that would have provided more to Humphrey than it received from the trial court’s valuation award, and based on Humphrey’s conduct in other lawsuits against the LLC. The Supreme Court pointed out that evidence of conduct or statements in settlement negotiations is not admissible to prove the validity or invalidity of a claim or its amount. The court opined that even if the evidence was admitted for a permissible purpose, the record did not establish that Humphrey’s actions were arbitrary, vexatious, or in bad faith. Id. at *21. Ill-Motivated Merger. In a strange aside, the court stated: “If any acts were in bad faith, they were committed by the other members of Clay Street, who sought to bypass the dissenters’ rights statute and section 8.1 of their own LLC Agreement, which specifies that the property ‘shall not be sold, conveyed, and/or assigned without the mutual consent of each of the members.’” Id. at * 21-22 (ellipsis omitted). But after all, the members’ agreement did not require unanimous approval of a merger, and the LLC Act allows the surviving LLC to have different terms in its operating agreement. Where’s the bad faith in taking action allowed by the statute and the LLC agreement, in order to sell an asset and distribute the net proceeds to the members as their interests lie? Delaware’s doctrine of independent legal significance, DLLCA § 18-1101(h), would support the validity of using a merger to eliminate a unanimous voting requirement, but Washington’s LLC Act has no such provision. Holding. The court therefore reversed the trial court’s award of attorneys’ fees against Humphrey, and remanded for consideration of whether, in light of the LLC’s failure to substantially comply with the Act, Humphrey is entitled to attorneys’ fees. Dissent. The dissent contended that the legislature would have been well aware that in some cases 30 days is a short time to accomplish the accounting, appraisal, and other steps required to accomplish a merger and transfer property and assets, and that therefore the legislature must have intended the “substantial compliance” requirement to apply to the 30-day payment period as well as to the other provisions of the dissenters’ rights section. Humphrey, 2010 Wash. LEXIS 1004, at *26-27 (Chambers, dissenting). The majority riposted in a footnote that prudent planning is the answer: “It is likely that the legislature chose 30 days assuming that merging business entities would have the prudence and good faith to lay the groundwork for selling property well before a merger became effective, or seek other financing, so as to meet the statutory requirement.” Id. at * 18 n.11 (majority opinion). Lessons. The obvious lesson for any Washington LLC planning a merger is that if any members dissent, the LLC must be prepared to pay the dissenting members the fair value of their interests within 30 days of the later of the date the merger becomes effective or the date the member’s payment demand is received. The other lesson is a cautionary note for drafters of LLC agreements. A requirement that all members consent before specified actions are taken is not adequate unless mergers also require unanimous consent. The LLC agreement in Humphrey did not require unanimity for a merger, and the LLC was therefore able to merge and eliminate the unanimous voting requirement. A member resisting a unanimous vote will have dissenters’ rights if the LLC uses a merger to get around the voting requirement, but that may be small consolation to the dissenting member.
(b) Against either the limited liability company or a dissenter, in favor of any other party, if the court finds that the party against whom the fees and expenses are assessed acted arbitrarily, vexatiously, or not in good faith with respect to the rights provided by this article.
How Not to Draft an Attorneys' Fees Clause
Many LLC operating agreements include a fee-shifting provision, a clause that requires the losing party in litigation between members to pay the prevailing party’s reasonable attorneys’ fees. These fee provisions are usually relegated to the boilerplate sections near the end of the operating agreement, and often don’t get much attention when the agreement is being prepared. A ruling last month from the Idaho Supreme Court shows that if the attorneys’ fees clause is not carefully crafted, it may not work the way the parties intended.
In Henderson v. Henderson Investment Properties, L.L.C., No. 35138, 2010 WL 569890 (Idaho Feb. 19, 2010), the Supreme Court reversed the trial court’s award of $21,552 in attorneys’ fees. The LLC in the case was formed by a husband and wife and their son and daughter-in-law to operate a sandwich shop. Acrimony later developed between the generations, and the father brought suit to dissolve the LLC. The Idaho LLC Act allows a court to order dissolution if actual or threatened irreparable harm results either from member deadlock or from illegal, oppressive or fraudulent acts of the controlling members. Idaho Code Ann. § 53-643.
Mr. Henderson alleged both deadlock and illegal, oppressive or fraudulent acts, with resulting irreparable harm. The trial court dismissed the complaint, holding that although there had been a deadlock it had not resulted in actual or threatened irreparable injury, and that there had been no illegal, oppressive or fraudulent acts. The trial court also awarded attorneys’ fees to the son and daughter-in-law, based on this provision in the LLC’s operating agreement:
In any action or proceeding brought to enforce any provision of this Agreement, or where any provision is validly asserted as a defense, the successful party is entitled to recover reasonable attorneys’ fees in addition to any other available remedy.
The Supreme Court analyzed that language and reversed the award of attorneys’ fees because it found that the plaintiff did not seek “to enforce any provision of the Agreement,” as required by the clause. The plaintiff instead sought dissolution, which is a statutory remedy.
If the parties had been asked about this clause when they signed their operating agreement, they probably would have interpreted it to mean that in any litigation about their rights and duties as members, the winner would have been entitled to recover its reasonable attorneys’ fees.
This clause did not work that way because it applied only to contractual disputes, i.e., disputes over the terms of the operating agreement. The clause did not apply to any of the rights of members that are defined by the statutory provisions of Idaho’s LLC Act. In this case the dispute was over dissolution, a purely statutory remedy. The irony is that if the operating agreement had simply parroted the language of the statute’s dissolution remedy, Idaho Code Ann. § 53-643, then under the court’s reasoning the defendants would have been entitled to attorneys’ fees.
Many important rights of LLC members, such as sharing of profits, rights to distributions, and rights to certain records of the LLC, are controlled by provisions in Idaho’s LLC Act. The Act allows some of those provisions to be waived or modified in the operating agreement, while others are non-waivable. That approach is typical of other states’ LLC statutes.
Under an attorneys’ fees clause like that in Henderson, and under that court’s reasoning, the right of the winning party to get a judgment for attorneys’ fees will depend on whether the dispute was governed by the LLC statute or by specific terms in the operating agreement. That does not seem like the result most business people would intend when they put an attorneys’ fees clause in their operating agreement.
A better solution, of course, is to use a broader attorneys’ fees clause. One example I’ve seen is:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement or to interpret or enforce any rights under this Agreement, [the prevailing party may recover.]
The language “any controversy arising out of this Agreement” may be broad enough to cover both contractual and statutory claims, although it is perhaps susceptible to the argument that statutory rights not referred to in the operating agreement do not “arise out of” the agreement.
I've also seen another approach that would have changed the result in Henderson, but it may be too broad for some situations:
In the event that any dispute between the Company and the Members or among the Members should result in litigation, [the prevailing party may recover.]
This language literally applies to “any dispute” between members, which could cover a dispute between members that has nothing to do with the LLC. A more natural interpretation would limit the scope of the clause to member disputes that have something to do with the LLC, i.e., with their status as members of the LLC. But to be safe, something like the following might be best:
If a suit, action, arbitration or other proceeding of any nature whatsoever is instituted in connection with any controversy arising out of this Agreement, or to interpret or enforce any rights under this Agreement or the [name of State] Limited Liability Company Act, [the prevailing party may recover.]
Some LLC operating agreements require that disputes be settled by binding arbitration instead of litigation. A recently-published treatise on drafting operating agreements for Delaware LLCs has a nice treatment of arbitration and attorneys’ fees, among other things. John M. Cunningham & Vernon R. Proctor, Drafting Delaware Limited Liability Company Agreements: Forms and Practice Manual (2009).
In the model operating agreements provided by Cunningham and Proctor, arbitrable matters include “material matters: (1) That arise under or relate to this Agreement or that relate to the LLC…” Cunningham & Proctor, supra, at Form 6.1, § 30.3. Their model agreement then goes on to assign attorneys’ fees to the nonprevailing party:
To the extent that an arbitrator determines that a party to an arbitration has failed to prevail in that arbitration, the arbitrator shall allocate to that party the costs of the arbitration, including reasonable attorneys’ fees and fees payable to the arbitrator.
Cunningham & Proctor, supra, at Form 6.1, § 30.11(c). This approach allows the arbitration to cover any dispute related to the operating agreement or the LLC, and applies the “loser pays” rule to the entire arbitration. This approach would avoid the type of problem dealt with in the Henderson case.
The clause at issue in Henderson, and the court’s ruling, show in microcosm why contract drafting is difficult. The unexpected scenario can rise up to swat the drafter. I’ll wager that when the parties put together their operating agreement in the Henderson case, they paid little or no attention to the exact words of the clause. Before any disputes arose I’m sure they would have said that any dispute directly related to the LLC was intended to be covered by the “loser pays” rule of the clause. But yet it wasn’t.
It was not a case of the language being unclear (although some might argue that); it was primarily a case of the language not reaching far enough in its scope. The Henderson case is an object lesson in vignette form for lawyers who draft contracts. The lesson? Know the underlying law and the context in which you’re drafting, and don’t rely too quickly on language taken from other contracts.
