Delaware Chancery Court decision points up risk of a “broad” purpose clause in a Delaware LLC agreement

Steven D. Goldberg, Esq. Wilmington, DE
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Section 18-802 of the Delaware LLC Act provides: “On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement. ”

In the case of In re Arrow Investment Advisors, LLC, Vice Chancellor Strine was presented with a case where one of the three founding members of the LLC sought an order to dissolve the LLC because it “was no longer practicable to carry out Arrow’s business.” arrow_investments_4091-vcs_opinion

Arrow’s purpose clause provided that it was formed “for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue” (emphasis in original) The Court determined that it must look to the LLC agreement to determine the purpose of the LLC and not to an initial business plan that any rational businessperson would expect to evolve over time”.

From the Court’s fact statement it appears that in 2008 the LLC suffered financial reverses and the Company’s management committee determined to explore additional, investment related business opportunities for the LLC rather than continuing to serve as the investment advisor to the funds as stated in the LLC agreement.

Arrow was formed by three individuals who became its initial “management committee”. The Petitioner was removed from management under the terms of the LLC agreement by the two remaining managers. Petitioner subsequently sued seeking dissolution under 18-801 and 18-802 of the Delaware LLC Act. According to the Petitioner, the new efforts were inconsistent with the initial business plan (which was not included in the LLC agreement). The Petitioner further alleged that the two other members of the management committee had breached their fiduciary duties to the LLC.

It is well established under Delaware law that the remedy of dissolution is an extraordinary remedy which the court is reluctant to invoke. The Court held:

Given its extreme nature, judicial dissolution is a limited remedy that this court grants sparingly. The court will not dissolve an LLC merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC’s owners originally envisioned; such events are, of course, common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures. In part because a hair-trigger dissolution standard would ignore this market reality and thwart the expectations of reasonable investors that entities will not be judicially terminated simply because of some market turbulence, dissolution is reserved for situations in which the LLC’s management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. (Footnotes omitted)

The Court pointed out that there are situations where a court even when faced with a broad purpose clause may order dissolution.

“Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue. In other words, a petitioner might obtain dissolution by making a convincing showing that the perpetuation of the entity, irrespective of its managers’ intentions to pursue a business line allowed by its governing instrument, was obviously futile and would not result in business success. One need not speculate on exactly what circumstances of that type might suffice to make that showing in order to confidently conclude that Hamman cannot state a claim for dissolution by simply alleging that a two-year-old LLC with a broad purpose clause has experienced some adversity and therefore ought to be dissolved. By that standard, investors could state a claim for dissolution against virtually all entities on a regular basis, especially in years of economic turbulence like this one.”
“Moreover, an important reason for parties to include a broad purpose clause in an entity’s governing instrument is to ensure that the entity has flexibility to adapt in the face of changing circumstances. Having agreed to such a clause in the Arrow LLC Agreement, and therefore having contemplated that Arrow may one day be something other than an investment advisor, Hamman cannot now seek to prematurely end Arrow’s existence because he is unhappy with how Arrow’s management chose to exercise its discretion.”

In footnotes to the decision the Court noted several cases where dissolution was mandated, in almost all of those cases there was misconduct involved on the part of the parties seeking the continuance of the LLC.

The Court pointed out that the Petitioner’s fiduciary duty claims are derivative in nature and the Petitioner was attempting to make an end around the demand requirements in 18-1003. Additionally as noted by the Court, the LLC agreement contained mandatory alternative dispute resolution provision which include claims for breach of fiduciary duties. Delaware law favors alternative dispute resolution and the Court determined that the Petitioner must pursue that remedy.

In Arrow the Petitioner conceded that the parties had contemplated that the LLC may, in the future, pursue additional avenues. Where the parties to the agreement anticipate the need for future flexibility it is not unusual for the drafter to have included a broad purpose clause. However, in those cases where the parties have formed the LLC for a specific purpose and do not intend that the company pursue any other activities you would expect that the purpose clause of the LLC agreement would be narrow. An example of a narrow purpose clause would state that the LLC was formed to “own, operate, lease, finance, refinance and sell or otherwise dispose of [the office building located at _____,] and to engage in such other activities which a Delaware Limited Liability Company may lawfully engage pursuant to the Delaware Limited Liability Company Act (the “Act”) which are incident thereto or connected therewith.” A broad purpose clause would state that  “the purpose of the company is to engage in such business or business as a Delaware Limited Liability Company may lawfully engage pursuant to the Delaware Limited Liability Company Act (the “Act”) and shall include the doing of any and all things incident thereto or connected therewith.” The decision as to the particular purpose clause in the LLC agreement is often the subject of much negotiation and is an issue which should be of concern to counsel for each of the parties to the agreement.

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