Delaware LLC derivative action; demand futility

StSteven D. Goldberg, Esq. Wilmington, DE
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TravelCenters of America, LLC is a publicly traded Delaware LLC, Alan R. Kahn is a “shareholder” in the LLC. Kahn filed a derivative action  against the LLC and its “directors” alleging that the directors breached their fiduciary duties to the LLC in connection with a transaction in which the dominant director had a direct and adverse financial interest to that of the LLC. The directors moved for summary judgment based upon exculpatory language in the LLC agreement and based upon a lack of a prior demand upon the directors as required under 18-1003. The decision by Chancellor Chandler of the Delaware Court of Chancery is on the motion for summary judgment, therefore at this stage of the proceedings the well plead factual allegations of the plaintiff are taken as true, the Court will make all reasonable inferences in favor of the plaintiff and only dismiss the complaint if the Court can determine with “reasonable certainty” that there is no set of facts that can be reasonably inferred from the well pleaded allegations in the complaint upon which the plaintiff could prevail. The Court will not on summary judgment choose between competing reasonable interpretations of ambiguous contract provisions. As I have pointed out in previous posts, the LLC agreement is a contract.

Copy of the decision in Kahn v. Portnory, et al., CA 3515-CC Kahn_v_Portnoy

The LLC agreement of TravelCenters is an example of the dangers of a poorly drafted agreement and the need for competent Delaware Counsel.

The LLC agreement provided that the “authority, powers, functions and duties (including fiduciary duties)’ of the board of directors will be identical to those of a board of directors of a business corporation organized under the Delaware General Corporation Law, unless otherwise specifically provided in the LLC agreement. The directors asserted that the LLC agreement (§ 7.5(a)) contained language which created a presumption in its favor when dealing with fiduciary duties and which created an enhanced presumption which the plaintiff must overcome. The Court found that there were two reasonable and conflicting interpretations of the paragraph in question and declined to choose which one was a more reasonable interpretation.

The Court noted that the LLC agreement explicitly imposed on the LLC corporate fiduciary duties which are the dual duties of due care and loyalty. The complaint implicates the duty of loyalty which requires that directors act in the best interest of the company and prohibits them from using their positions to further their own self-interest. The court found that the plaintiff properly plead a violation of the duty of loyalty and that the exception found in § 7.5(a) did not resolve the question as it is ambiguous.

Likewise the exculpatory provisions in the LLC agreement were found to be ambiguous and again as the exculpatory language relies on the exception found to be ambiguous, the Court declined to apply the exculpatory language.

The Court next focused on the question of demand futility. “In order to maintain a derivative suit on behalf of a LLC, a member must either (1) make a demand on the managers of the company to bring suit or (2) show that ‘an effort to cause those managers or members to bring the action is not likely to succeed'”. The complaint must allege with particularity the reasons why such demand would be futile. In evaluating futility the Court looked at corporate law. Under Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984) there are two tests which must be met. The complaint must allege particularised fact that establish a reasonable doubt that “(1) the directors are disinterested and independent [or] (2) that challenged transaction was otherwise the product of a valid exercise of business judgment.” The test is stated in the disjunctive.

The Court held:

“Turning to the first prong of the Aronson test, it is helpful to start by briefly reviewing what is meant by disinterested and independent.  A director is interested in a transaction when the director receives a personal benefit (or detriment) from a transaction that is not shared by the other shareholders of the corporation and the benefit is of subjective material significance to the director. A director can also be interested in a transaction where the director stands on both sides of the transaction. Thus, the first prong of  the Aronsontest requires inquiry into whether the director was interested in the underlying transaction. While a director has an interest, in some sense, in any decision that involves approving a derivative suit that names the director as a defendant, normally the threat of personal liability against a director is not enough, standing alone, to challenge the interestedness of a director. A director may be interested in the decision, however, if the challenged transaction is so egregious on its face that it gives rise to a ‘substantial likelihood’ of personal liability for the director.” [Citations omitted]

“Independence, on the other hand, does not necessarily involve an inquiry into whether the director will derive a benefit (or detriment) from a particular transaction or whether the director stood on both sides of the transaction. Rather inquiry into a director’s independence focuses on whether the director’s decision was impartial and based on the merits of the subject to be decided. In other words, independence inquiry focuses on whether the director’s loyalties where in any way divided such that the director will be unable to exercise business judgment in deciding whether the corporation should pursue a claim. A director, for example, is not independent if the director is ‘beholden’ to another such that the director’s decision would not be based on the merits of the subject before her. Thus, plaintiff can show lack of independence by creating ‘a reasonable doubt that a director is not so ‘beholden’ to an interested director … that his or her ‘decision would be sterilized.'” [Citations omitted]

The Court found that the plaintiff made sufficient well plead factual allegations of bad faith with regard to the dominant director to survive a motion for summary judgment.

Poorly drafted LLC agreements are an invitation to litigation. A LLC agreement is a Delaware contract which requires the skill and know how of an experienced Delaware attorney. I have an active Delaware business practice as well as a practice in Delaware’s State and Federal courts. If you or your client have a business matter or a matter which you wish to litigate in Delaware or has a matter pending in Delaware, we would appreciate the opportunity to consult with you regarding our representation. Please remember that we do not accept representation without a written engagement letter.

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