Unilateral Mistake Coupled With the Counter Party’s Knowing Silence Permits Reformation

Chief Justice Steele, writing for the Court En Banc, has clarified Delaware’s law on unilateral mistake. The Court held that in cases of unilateral mistake, where the counter party has knowledge of the mistake yet remains silent, a Delaware Court may reform the contract. The Court specifically adopted Restatement (Second) of Contacts, § 157 (1981). Neither exceptional circumstances, fraud nor trickery are required to reform a contract.

Scion Breckenridge Managing Member LLC v. ASB Allegiance Real Estate Fund, No. 437, 2012 (Del.)Scion v ASB is a case involving multiple real estate investments. Scion was the sponsor of the investments, it found and managed the properties, and ASB was the promoter which provided 99% of the capital. In their first transaction the joint venture agreement properly reflected the waterfall of funds from the project. In the second and subsequent investment the attorney who drafted the agreement, who admittedly lacked experience in such matters, copied the first agreement, made deal specific changes, but revered a significant term in the waterfall so that Scion would receive its “promote” return before ASB had received back its negotiated return and capital investment. The Court below found that Scion was aware of the mistake, but remained silent. In one of the transactions the parties amended their joint venture agreement and the amendment contained standard ratification language. Notwithstanding the ratification language the Court below found that Scion was not aware of the drafting mistake and ASB again remained silent.

Scion sought reformation. ASB defended on various grounds. ASB argued that Scion had not read the second and subsequent agreements, and was barred by its negligence in seeking reformation. Second they argued that the ratification barred reformation.

This case caused the Supreme Court to review, clarify and in some instances overrule existing Delaware precedent. The Court clarified its ruling in Cerberus International, Ltd. v. Apollo Management, L.P. 794 A.2d 1141 (Del. 2002) wherein it had taken “no position upon whether, under certain circumstances, a party’s misconduct could bar a reformation claim.” The Court went on to state “[i]t is unclear whether “misconduct” mean simple negligence, gross negligence, or something more. To resolve the confusion surrounding our use of the word ‘misconduct’ we now adopt the standard in Restatement (Second) of Contracts §157: for purposes of a reformation claim ‘[a] mistaken party’s fault in failing to know or discover the facts before making the contract’ does not bar a reformation claim ‘unless his fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.’ To the extent existing Delaware case law is inconsistent with this standard, we expressly overrule it.”

Later in the decision the Court held: “We hold that Cerberus accurately states Delaware law: reformation based on unilateral mistake is available where a party can ‘show that it was mistaken and that the other party knew of the mistake but remained silent.’ To the extent our case law otherwise or imposes additional requirements, we expressly overrule them.”

The Court went on to clarify the distinction between reformation and rescission. “This standard is limited to reformation claims and does not affect our existing rule in cases that a failure to read bars a party from seeking to avoid or rescind a contract. Avoidance and reformation are fundamentally different remedies. Avoiding or rescinding a contract essentially ‘results in [the] abrogation or ‘unmaking’ of an agreement, and attempts to return the parties to the status quo [ante].’ In contrast, reformation does not ‘unmake’ an agreement’ it corrects an enforceable agreement’s written embodiment to ‘reflect the parties’ true agreement.’ We adhere to our case law holding that a party cannot seek avoidance of a contract he never read. In contrast, we will permit a party to seek reformation of a written agreement that incorrectly transcribes the parties’ agreement, so long as the party’s conduct does not amount to a failure to act in good faith and in accordance with reasonable standards of fair dealing.”

Upon the issue of ratification the Court Stated:

“The Vice Chancellor appropriately noted that ‘[r]atification requires ‘[k]knowledge, actual or imputed, of all material facts’ and knowledge ‘may be implied from conduct, as well as expressed by words.’ He also correctly concluded that ratification of a document subject to reformation requires actual knowledge of the mistake. As we commented in Cerberus, a party seeking reformation by definition admits that had he read the document more carefully, he would have noticed and corrected the mistake. The Vice Chancellor reasoned that requiring actual knowledge ‘recognizes that a party otherwise entitled to equitable reformation based upon mistake nearly always could have discovered the erroneous provisions. The problem in these cases arise because ‘[t]he mistaken party unwillingly believes, however, that the provision is accurate. That is the point of the mistake. Accordingly, ratification does not preclude reformation unless the ratifying party actually knew of the error.'”

The Joint venture agreement contained a cost shifting provision with respect to attorneys’ fees. The provision used the term “incurred” in connection with reimbursement of attorney fees. In this case counsel for Scion was prosecuting the case with outcost to Scion based upon a malpractice claim. Consequently Scion had not “incurred” any attorneys fees. The Court did remand the case to determine whether under the Court of Chancery’s equitable powers Scion was entitled to an award of counsel fees.

sgoldberg@stevendgoldberg.com

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Delaware 2013 Amendments to the Limited Liability Company Act Confirm That Single Member LLC’s are Entitled to the Same Protections as Multi-Member LLC’s and that Default Fiduciary Duties Exist Under the Delaware Act

The 2013 Amendments to the Delaware Limited Liability Company Act have not yet been introduced in the General Assembly. The Delaware Bar Association traditionally proposes annual amendments to Delaware laws. This article is a preview of what is likely to be introduced. The amendments being proposed are modest, dealing primarily with single member LLC’s and confirming the existence of default fiduciary duties.

Sections 1-5 of the Act are technical. They provide that in the case of a merger, consolidation, transfer, domestication or conversion of a limited liability company or the conversion of another entity to a limited liability company, the interests may remain outstanding or may be cancelled. The “remain outstanding” concept was added to the Act. Many people believe that this could have been accomplished before the amendment, however in certain EU and cross border transaction this has become important. In order to give clean opinions the “remain outstanding” language was added.

Some commentators who have written on asset protection have expressed the opinion that Section 18-703(d), which deals with charging orders, and which states that the charging order “is the exclusive remedy by which a judgment creditor of a member or a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest.” does not foreclose all other remedies where the company is a single member company, notwithstanding the fact that the Section uses the word “exclusive”. In response to the criticism Section 6 of the Act adds at the end of the Section 18-703(d) the phrase “and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member.”

The Act further focuses on the single member company in Section 7. There are few cases in the US, outside of the Bankruptcy Courts where corporations with a single stockholder are treated differently from corporations with multiple stockholders in the absence of the traditional basis of veil piercing, such as active fraud. In the LLC area, however, some courts have expressed the proposition that single member LLC’s are not entitled to the same protections. No Delaware court has ever expressed such a proposition, however Delaware LLC’s often find themselves in court rooms outside of the State of Delaware where the judges may not be entirely conversant with the Delaware Act. To clarify that a single member LLC is entitled to the same protections, the Act amends Section 18-1101 to add a new Subsection (j) which reads: “The provisions of this chapter shall apply whether the limited liability company has 1 member or more than 1 member.” This amendment should put the question to rest.

Within the Delaware Supreme Court, the Delaware Court of Chancery and the Delaware Bar the question as to whether there exist default fiduciary duties under the Delaware LLC Act has been an open question. The LP Act, through its integration with the GP Act provides for default fiduciary duties. The LLC Act does not contain a provision dealing with default fiduciary duties. That absence caused some commentators, including Delaware’s Chief Justice, to argue that as a contractual entity the duties of the members and managers should only be those contained in the company agreement and that the Act does not contain default fiduciary duties. The other side argued that the similarity between the LLC and LP acts and the fact that Section 18-1101(c) provides that “[t]o the extent that, at law or in equity, a member or manager … has duties (including fiduciary duties)… [those duties]… may be expanded or restricted or eliminated by provisions in the limited liability company agreement…”. Some have argued, including this commentator, that in order for these fiduciary duties to be expanded, restricted or eliminated, they must first exist within the Act.  In a recent Per Curium decision by the Delaware Supreme Court in the case of Gatz Properties, LLC v. Aruga Capital Corp., 2012 WL 5425227 (Del. Nov. 7, 2012), the Court invited the Delaware Bar to suggest legislation to the Delaware General Assembly if it believed that default fiduciary duties exist under the Delaware Act. Section 8 is the result of that invitation. Section 8 confirms that default traditional fiduciary duties exist within the Act by amending Section 18-1104 to add the highlighted language: In any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.”

If adopted by the Delaware General Assembly the amendment will become effective on August 1, 2013, and as is traditional with all Delaware amendments, unless otherwise provided in the legislation, the amendment are applicable to all Delaware limited liability company irrespective of when created.

I can be reached at sgoldberg@stevendgoldberg.com

 

Delay in Seeking Expedition Causes Court to Deny Motion to Expedite

Steven D. Goldberg, Esq. Wilmington, DE sgoldberg@stevendgoldberg.com http://www.stevendgoldberg.com Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law including Delaware Law opinions. Delaware Forms and Publications are available at http://www.delawarellclaw.com

The Delaware Court of Chancery almost routinely expedites cases where there is proof that a party will be prejudiced in the absence of expedition. The Delaware Courts are in fact renowned for their willingness to expedite complex and complicated cases. In Icahn Partners LP v. Amylin Pharm., Inc., 212 WL 1526814, (Del. Ch. Apr. 20, 2012) the Court stated:  “A plaintiff may earn expedited proceedings when she ‘has articulated a sufficiently colorable claim and shown a sufficient possibility of a threatened irreparable injury, as would justify imposing on the defendants and the public the extra (and sometimes substantial) cost of an expedited preliminary injunction proceeding.” The Court may however refuse to expedite a proceeding where the plaintiff’s delay “imposes additional burdens on the [C]ourt and could prejudice the [C]ourt’s ability to adjudicate the matter fairly.” Oliver Press Partners v. Decker 2005 WL 3441364 (Del. Ch. Dec 6, 2005).

In a recent decision by VC Noble, Brookstone Partners Acquisition XVI, LLC v. Tanus, CA No. 7533-VCN (Del. Ch. Aug. 10, 2012) the Court was faced with an action filed by the plaintiff on May  5, 2012, but did not seed to expedite the action until August 3, 2012 the Plaintiff sought to have the court enter a preliminary injunction before October 15, 2012 and a trial in January, 2013. Plaintiff knew when it filed the action that it faced an October 15, deadline to obtain a preliniary injunction as a contract was expiring on that date.

The Court held tha “Had Brookstone moved for expedition when the case was filed (or shortly thereafter), this case might well be nearing a hearing on a preliniary injunction with a 2012 trial date. But Brookstone let this action … proceed on a normal basis for months, knowing that it wanted relief before October 15, 2012.” The Court finally stating “[E]quity aids the vigilant, not those who slumber on their rights” refused to expedite the proceedings.

Dlaware Court of Chancery Finds Personal Jurisdiction Over Party Acting As Manager Under 18-109

Steven D. Goldberg, Esq. Wilmington, DE sgoldberg@stevendgoldberg.com http://www.stevendgoldberg.com Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law including Delaware Law opinions. Delaware Forms and Publications are available at http://www.delawarellclaw.com

Feeley, et al. v. NHAOCG, LLC, et al. Vice Chancellor Laster

Ak-Feel, LLC was the sole “managing member” of Oculus Capital Group, LLC (“Oculus”) an a 50% member in Oculus. Feeley was the managing member of Ak-Feely and an employee of Oculus. NHAOCG, LLC (“NHA”), a NY LLC was the remaining 50% member in Oculus.

Under the LLC agreement of Ak-Feel the managing member had complete authority to act for the LLC and no member who was not acting as the managing member had any authority to act for the LLC.

The Oculus LLC agreement similarly gave the managing member complete authority. The managing member could only be removed with the consent of both members or by NAH if Feeley is no longer an employee of Oculus, if Andrea Aikel has been terminated for “Good Cause” or if Ak-Feel has defaulted un its obligation under the Oculus LLC agreement and has failed to cure the default.

After a dispute arose, NAH purported to act for Oculus and notified Feeley that Oculus would not renew his contract (an action which could only be taken by the managing member) but stated that his employment would continue after the termination of the contract. Later it gave Feeley notice that Oculus was terminating the employment contract of Feeley. NAH purported to remove Ak-Feely as the managing member and named itself as the managing member. Feeley promptly filed the subject action and sought a TRO against his removal as the managing member of Oculus and asserted 9 claims against NAH, the individual beneficial owners of NAH as well as Aikel, claims which involved the breach of the LLC agreement, the implied covenant of good faith and fair dealing, breach of fiduciary duties, tortious interference as well as other minor claims.

The Oculus LLC agreement did not contain a consent to jurisdiction provision and the defendants do not have any jurisdictional ties to Delaware other than their action with respect to Oculus in connection to the control dispute.

Section 18-110 of the Delaware LLC Act (the “Act”) gives the Delaware Court of Chancery in rem jurisdiction to determine who validly holds office as a manager of a Delaware LLC. The Court stated that “[b]ecause a Section 18-110 proceeding affects the Delaware LLC and the office of managing member, it is not necessary for all claimants to the office to be subject to the Court’s in personam jurisdiction in order for the court to make an authoritative determination.” The Court thus found that it had in rem jurisdiction over NAH.

Section 18-109(a) of the Act is an implied consent statute which grants the court personal jurisdiction over persons who serve as managers of a LLC for  the purpose of adjudicating claims for breach of duty in the capacity as manager involving or relating to the business of the LLC. The complaint alleges that NAH “participated materially in the management of Oculus by taking actions that fell within the exclusive authority of the Managing Member under the Oculus LLC Agreement.” The Court found that NAH had indeed participated beyond merely exercising a claimed right to remove Feeley and Ak-Feel.

The individual defendants moved to dismiss, the Court deferred decision on the motion to dismiss them pending further discovery and the scheduled one day hearing. The Court considered whether it had jurisdiction over the individuals by looking though the entities in a manner authorized in the USACafes case discussed in an earlier Blog. This case involves another layer of entities between the individuals and NAH which further caused the Court to defer a ruling.

The Court found pendent jurisdiction under 18-109 based in large measure by applying law developed under the DGCL and its application to corporate directors. “Once a defendant is subject to personal jurisdiction under Section 18-109 as to certain claims, the Court may over the defendant with respect to other sufficiently related claims. Asssist, 753 A.2d at 981; see Infinity Investors 2000 WL 130622, at *6 (‘[O]nce jurisdiction is properly obtained over a non-resident director defendant pursuant to Sec. 3114, such non-resident director is properly before the Court for any claims that are sufficiently related to the cause of action asserted against such directors in their capacity as directors.’)”.

I can be reached at sgoldberg@stevendgoldberg.com, my direct dial number is 302.351.4490

Delaware Chancery Court Rules On Default Fiduciary Duties Of The Manager Of A Delaware LLC

Steven D. Goldberg, Esq. Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law. Delaware Forms and Publications are available at http://www.delawarellclaw.com

The issue of whether a manager of a Delaware LLC has default fiduciary duties akin to a corporate director has been an unsettled area of Delaware law. Several members of the Delaware Court of Chancery have touched on the issue in written opinions, generally finding default duties to exist. The Delaware Supreme Court has not, however, ruled on the issue. Chief Justice Steele has written and spoken extensively on the issue positing that the Act does not create such duties and as the LLC is a creature of contract, the Court should not create duties where no such duties exist legislatively.

Many practitioners have expressed the belief that in the “public deal” where the structure is corporate in nature, there should be default duties as it would be against public policy in such cases that the manager’s conduct was not circumscribed by fiduciary duties. Section 18-1101(c) of the Delaware LLC Act provides:

To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.

Here the legislature expressed an intent that if a member or manager has duties, at law or in equity, including fiduciary duties, those duties may be “expanded, restricted or eliminated”. The “implied contractual covenant of good faith and fair dealing” may not be eliminated. The implied covenant, however, only comes into play where the parties have not addressed an issue which could not have been reasonably anticipated when the agreement was drafted and is not an opportunity for the court to “fix a wrong”. The question then is whether the legislature intended, without expressing, that there are default duties or was the legislature expressing the thought that there are not necessarily duties, but to the extent that they may exist, then they may be modified as provided. In the case of Auriga Capital Corporation, et al v. Gatz Properties, LLC, et al, CA 4390-CS Decided January 27, 2012 Auriga Capital Chancellor Strine held that the manager of this LLC had an equitable duty of care and loyalty to the LLC and its members which was not restricted or eliminated in the LLC company agreement. Generally when courts consider fiduciary duties in the corporate context they include a somewhat amorphous duty of “good faith”. In this case the Court inexplicably did not address good faith. The LLC which was the subject of this litigation was established as a blind investment where the investors put up their money and the manager created the investment from the funds raised. The Court found that the manager manipulated the LLC for the benefit of the manager and its affiliated family members to the detriment of the non-family members. [The manager was an entity with an individual as the sole member, in this context the Court ascribed the actions of the entity to its member and referred to the member as the “manager” of the subject LLC.] This is a case of very bad facts where the manager who took advantage of the minrity investors argued that there were no fiduciary duties owed to the members, and if any existed the exculpation provisions of the agreement absolved the manager from liability. In the manager’s defense it asserted that it had the voting power to cause a sale of the LLC’s property to itself, a matter at the core of the complaint, and the right to “exploit the minority”. The Court stated at p.5,

“The manager was free not to vote his membership interest for the sale. But he was not free to create a situation of distress by failing to cause the LLC to explore its market alternatives and then to buy the LLC for a nominal price. The purpose of the duty of loyalty is in large measure to prevent the exploitation by a fiduciary of his self-interest to the disadvantage of the minority.”

The Chancellor first concludes that fiduciary duties exist under the Act and then goes on to analyze their foundation.

The Delaware LLC Act starts with the explicit premise that “equity” governs any case not explicitly covered by the Act. [18-1104] But the Act lets contracting parties modify or even eliminate any equitable fiduciary duties, a more expansive constriction than is allowed in the case of corporations. For that reason, in the LLC context, it is typically the case that the evaluation of fiduciary duty claims cannot occur without a close examination of the LLC agreement itself, which often tailors the traditional fiduciary duties to address the specific relationship of the contracting parties.

. . . .

The Delaware LLC Act does not plainly state that the traditional fiduciary duties of loyalty and care apply by default as to managers or members of a limited liability company. In that respect, of course, the LLC Act is not different than the DGCL, which does not do that either. In fact, the absence of explicitness in the DGCL inspired the case of Schnell v. Chris-Craft. Arguing that the then newly-revised DGCL was a domain unto itself, and that compliance with its terms was sufficient to discharge any obligation owed by the directors to the stockholders, the defendant corporation in that case won on that theory at the Court of Chancery level. But our Supreme Court reversed and made emphatic that the new DGCL was to be read in concert with equitable fiduciary duties just as had always been the case, stating famously that “inequitable action does not become legally permissible simply because it is legally possible.”

The LLC Act is more explicit than the DGCL in making the equitable overlay mandatory. Specifically, § 18-1104 of the LLC Act provides that “[i]n any case not  provided for in this chapter, the rules of law and equityshall govern.” In this way, the LLC Act provides for a construct similar to that which is used in the corporate context. But unlike in the corporate context, the rules of equity apply in the LLC context by statutory mandate, creating an even stronger justification for application of fiduciary duties grounded in equity to managers of LLCs to the extent that such duties have not been altered or eliminated under the relevant LLC agreement.

It seems obvious that, under traditional principles of equity, a manager of an LLC would qualify as a fiduciary of that LLC and its members. Under Delaware law, “[a] fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.”  Corporate directors, general partners and trustees are  analogous examples of those who Delaware law has determined owe a “special duty.” Equity distinguishes fiduciary relationships from straightforward commercial arrangements where there is no expectation that one party will act in the interests of the other.

The manager of an LLC – which is in plain words a limited liability “company” having many of the features of a corporation – easily fits the definition of a fiduciary. The manager of an LLC has more than an arms-length, contractual relationship with the members of the LLC. Rather, the manager is vested with discretionary power to manage the business of the LLC.

Thus, because the LLC Act provides for principles of equity to apply, because LLC managers are clearly fiduciaries, and because fiduciaries owe the fiduciary duties of loyalty and care, the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties. [Citations omitted]

Looking for a legislative basis the Chancellor discussed the 2004 amendment to the LLC Act which added the “elimination” of duties in 18-1101(c). He concluded that if the duties he discussed did not apply to LLCs the legislation “would have been logically done differently.” He analyzes the use in the amendment of the term “eliminate” rather than the legislature stating that the manager and members “shall owe no duties of any kind to the LLC…” It is my opinion that this is a weak construct to bootstrap fiduciary duties. If indeed the legislature had believed there should be default fiduciary duties, the legislature knows how to say that and this reverse logic is inappropriate.

The DGCL and corporate laws generally can trace their history back to English Common Law which existed prior to separation. The LLC Act to the contrary has no counterpart at Common Law and is wholly a legislative construct, notwithstanding the fact that much of the LLC Act is based on the Delaware Revised Uniform Limited Partnership Act, which did have a counterpart at Common Law. It is true that the DGCL does not specifically provide for default fiduciary duties, however there is a clear Common Law and historical basis for implying such duties. It is dangerous to apply corporate constructs to LLCs notwithstanding the fact that the LLC may have a corporate structure by agreement and may have been called by the legislature a limited liability “company”. The courts have made it clear that the LLC agreement is a matter of “private ordering” and based upon “…rules of law and equity, including the law merchant,…” (18-1104). This concept should not cause the Court to incorporate wholesale the corporate rules of governance. The parties in this case were very litigious, therefore there is the possibility that an appeal will be taken and the Supreme Court will have the opportunity to speak definatively on the issue.

I can be reached at sgoldberg@stevendgoldberg.com, my direct dial number is 302.351.4490

 

Creditors Of An Insolvent Delaware LLC Do Not Have Derivative Rights

Steven D. Goldberg, Esq.
Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law.
Delaware Forms and Publications are available at http://www.delawarellclaw.com

Previously decided Delaware cases had assumed, but did not analyze the Delaware LLC Act in reaching the assumption,  that the creditors of an insolvent Delaware LLC had the right to sue derivatively under §18-1002 of the Delaware Act. Only one treatise on the Delaware Act indicates that there is no derivative right for creditors.

In the context of the Delaware General corporation Law (DGCL), in Am. Catholic Educ. Program Found, Inc. v. Gheewalla, 930 A.2d, 101 (Del. 2007) the Delaware Supreme Court found that §327 of the DGCL does not limit the subset of parties which can sue derivatively to stockholders and that when a corporation is either insolvent or in “the zone of insolvency” the director’s constituencies shifts from the stockholders to the corporation’s creditors who then have the right to sue the directors derivatively for any breach of duty.  Section 327 creates a non-exclusive limitation on derivative standing.

In the November 3, 2010 decision in CML V, LLC v. Bax, C M L V LLC vs John Bax Vice Chancellor Laster concluded that in a derivative suit against the managers of an insolvent LLC, the Delaware Act only permits members and assignees to sue derivatively under §18-1002 and that creditors do not have standing to sue. “Under the plain meaning of Section 18-1002, standing to bring a derivative action is limited to ‘a member or an assignee.’ Read literally, Section 18-1002 denies derivative standing to creditors of an insolvent LLC.” (Slip at 7).

The Court observes  “As compelling as a literal reading of Section 18-1002 might seem, it encounters an awkward fact: Despite the ostensibly obvious implications of the statute, virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.” (Slip 8). The Court then makes an in depth analysis of the LLC Act, the LP Act and the DGCL to buttress its conclusion that there are no derivative rights for a creditor of an insolvent LLC or LP.

The Court observes that the creditor is not without a remedy. “Creditors generally are presumed to be ‘capable of protecting themselves through contractual agreements that govern their relationships with firms. .. Creditors are often protected by strong covenants, liens on assets, and other negotiated contractual provisions.'” (Slip at 22). The court again observed that under §18-101(7) the creditor may require the LLC to include in its company agreement protective provisions that could require creditor consent for specified actions by the LLC or include consequences or penalties for members upon the occurrence of specific events if a creditor’s rights are breached.”

Under §18-1101(c) the duties of a member or manager to creditors may be  expanded. “Although typically cited for authorizing the restriction or elimination of legal duties, this section likewise authorizes the expansion of legal duties. An LLC agreement conceivably could provide for duties triggered by insolvency that would include an obligation to preserve assets for creditors. If a creditor is willing to become a party to the LLC agreement, then it might be able to make creative use of Section 18-1101(c) of the LLC Act.”

“Third, Section 18-303(b) provides that notwithstanding the general protection of limited liability provided by the LLC Act, a member or manager may agree in the LLC agreement ‘or under another agreement’ to be ‘obligated personally for any or all of the debts, obligations and liability of the limited liability company.’ This provision could be used in lieu of or to supplement personal guarantees for a particular debt. The use of the series provisions under 18-215 could give the creditor an interest in specific property in lieu of or to supplement a security interest in the asset or assets.”

The court noted that “In each of these cases, a creditor can protect its enhanced rights through a provision conditioning the approval of any amendment to the LLC agreement on creditor consent or the satisfaction of conditions.

“Fourth,  a creditor of an LLC can protect itself by seeking the appointment of a receiver to enforce a member’s obligation to make a contribution to the LLC.  See §18-805.”

“Fifth, despite the lack of derivative standing, a creditor possesses a statutory right to enforce a member’s obligation to make a contribution to the LLC. Subject to statutory limitations, if a creditor extends credit to an LLC in reliance on a member’s obligation to make a contribution to the LLC or to return a distribution in violation of the LLC Act, then the creditor may enforce the obligation to the extent of the creditor’s reasonable reliance.”

“Thus, in proper circumstances, [an LLC] creditor in effect may be placed in a position similar to that of the company itself in enforcing rights against members for contributions and returns. The right to enforce a contribution agreement under Section 18-502 has particular relevance to creditor derivative standing.”

The Delaware LLC Act is a contractual based Act. Given the freedom of contract which underpins the entire Act, creditors are able to protect themselves in the many ways indicated in the Court’s decision and this decision does not in any way interfere with the creditor’s rights.

Delaware Court of Chancery Confirms That The Implied Covenant of Good Faith and Fair Dealing is Not a Substitute For Fiduciary Duties

Steven D. Goldberg, Esq.
Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law.
Delaware Forms and Publications are available at http:www.delawarellclaw.com

On October 11, 2010, Vice Chancellor Laster of the Delaware Court of Chancery handed down an important case dealing with the Implied Covenant of Good Faith and Fair Dealing. Lonergan v. EPR Holdings LLC, et al.Opinion ].  The case involved a LP agreement which eliminated all fiduciary duties as permitted under 17-1101 of the Delaware Revised Uniform Limited Partnership Act (DRULPA).  Section 17-1101 is identical to 18-1101 of the Delaware Limited Liability Company Act so that this decision will have equal application for LLC’s. The Plaintiff recognizing that they had no claim for violating fiduciary duties attempted to characterize the claim as a breach if the implied covenant. The Court held that the implied covenant is not a substitute for fiduciary duties and declined to substitute the Court’s judgment for the parties to create a basis for a breach of implied duty claim.

The limited partnership is a publicly traded master limited partnership (mlp). Two sections of the agreement eliminate fiduciary duties (not just reduce or modify the duties).

Section 7.9(e) provides: 
Except as expressly set forth in this Agreement, neither [Holdings GP] nor any other Indemnitee shall have any duties or liabilities, including fiduciary duties, to the Partnership or any Limited Partner and the provisions of this Agreement, to the extent that they restrict or otherwise modify the duties and liabilities, including fiduciary duties, of [Holdings GP] or any other Indemnitee otherwise existing at law or in equity, are agreed by the Partners to replace such other duties and liabilities of [Holdings GP] or such other Indemnitee
Section 7.10(d) provides:
Any standard of care and duty imposed by this Agreement or under the Delaware Act or any applicable law, rule or regulation shall be modified, waived or limited, to the extent permitted by law, as required to permit [Holdings GP] to act under this Agreement and to make any decision pursuant to the authority prescribed in this Agreement, so long as such action is reasonably believed by [Holdings GP] to be in, or not inconsistent with, the best interests of [Holdings].

When Section 17-1101(d) [which is identical to 18-1101(d)] was drafted the drafting committee was careful to make sure that Delaware law was not subverted in a way that removed all protections from member but also in a way that does not create an alternative form of fiduciary duty. The drafting committee included in the section the phrase “provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” The use of the terms “contractual covenant” were carefully selected to differentiate the concept of good faith and fair dealing from any equitable concept of fiduciary duties. At the time that 1101(d) was being drafted the Court of Chancery was using corporate concepts to interpret LP and LLC law. The drafters wanted to clearly differentiate contractual terms from equitable concepts of fiduciary duties.

In defining the implied covenant the Court stated:

The implied covenant is not a substitute for fiduciary duty analysis. “The covenant is ‘best understood as a way of implying terms in the agreement’ . . . . Existing contract terms control, however, such that implied good faith cannot be used to circumvent the parties’ bargain, or to create a free-floating duty unattached to the underlying legal documents.”…The Court must focus on “what the parties likely would have done if they had considered the issues involved.” … It must be “clear from what was expressly agreed upon that the parties who negotiated the express
terms of the contract would have agreed to proscribe the act later complained of . . . had they thought to negotiate with respect to that matter.” “The doctrine thus operates only in that narrow
band of cases where the contract as a whole speaks sufficiently to suggest an obligation and point to a result, but does not speak directly enough to provide an explicit answer.” [Citations omitted].

The Court further stated:
Respecting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute. The nature of the implied covenant of good faith and fair dealing is “quite different from the congeries of duties that are assumed by a fiduciary.” … “Delaware’s implied duty of good faith and fair dealing is not an equitable remedy for rebalancing economic
interests after events that could have been anticipated, but were not . . . .”…To use the implied covenant to replicate fiduciary review “would vitiate the limited reach of the concept of the implied duty of good faith and fair dealing.” … To the extent the complaint seeks to re-introduce fiduciary review through the backdoor
of the implied covenant, it fails to state a colorable claim.

The Court declined to substitute its own analysis for the missing term thereby giving full effect to the elimination of fiduciary duties. This case has well defined the difference between fiduciary duties and the implied covenant. The result of this case is to provide additional certainty to the drafters of Delaware LLC and LP agreements. This certainty of outcome is a keystone of Delaware entity law.

In his decision Vice Chancellor Laster also reviewed the duties that a corporate officer has to the stockholders in a merger transaction. This case will also serve as a starting point for future analysis of corporate duties.

Steven Goldberg to Speak at NBI Teleconference on November 17

Steven Goldberg, the author of this blog,  will be the speaker at a NBI Teleconference on November 17, 3 PM to 4:30 PM Eastern time.

The subject is LLC Compliance and Dissolution:

  • The Dissolution Process
    Tax Considerations in the Operation and Dissolution of an LLC
    Annual Reports and Tax Returns
    Transfers of Membership Interests
    Sample Forms and Documents are included in materials

For further incormation or to register visit http://www.nbi-sems.com/Enbi/Email/55150T.htm or call 800.930.6184

Delaware Court of Chancery Has Inherent Equity Authority to Appoint a Receiver for a Delaware Limited Liability Company

Steven D. Goldberg, Esq.
Wilmington, DE
sgoldberg@stevendgoldberg.com http://www.stevendgoldberg.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law. Delaware Forms and Publications are available at http://www.delawarellclaw.com

The Delaware LLC Act in Section 18-805 provides that the Court of Chancery has the power and authority to appoint a receiver for a LLC which has had its certificate of formation cancelled. The Act is silent on the power of the Court to appoint a receiver for an LLC which has not had its certificate of formation cancelled.

Recently Vice Chancellor Noble decided the case of Ross Holdings and Management Company v. Advance Realty Group, LLC [Ross Holdings v. Advance Realty]. The plaintiffs in their moving papers asserted, among other claims, that Advance Realty Group (ARG) is insolvent as a result of the conduct of the individual defendants and that there is question as to whether ARG is able to continue as a going concern. Plaintiffs seek the appointment of a receiver to manage the company’s affairs in order to prevent the Board from further disposing of the company’s assets for personal gain.

Defendants counter that neither the LLC Act nor the Company Agreement permit the appointment of a receiver in the circumstances alleged.

The Plaintiffs took the position that as the Act is silent, the Court should borrow from the DGCL and look to the corporate case law as developed to determine when it has authority to appoint a receiver for a LLC which has not had its certificate of formation cancelled.

The Court stated at 14:
The LLC Act was written long after our corporate statutes and several of those provisions have been incorporated into the LLC Act. Notably, 6 Del. C. § 18-805 tracks closely 8 Del. C. § 279, the general provision establishing the process for appointing a receiver in the corporate context, with the notable difference being the circumstances in which a receiver may be appointed. This seems to suggest that the omission in the LLC Act of the provision for appointing a receiver in the case of insolvency was an intentional, not an inadvertent, act by the General Assembly.
The Plaintiffs point to case law where courts have borrowed from the
corporate law when the LLC Act was silent as to a particular provision. However, the example that they use, where the court looked to the corporate law to determine the default fiduciary duties that limited liability company members owe to one another duties. Moreover, the LLC Act refers to fiduciary duties, but is silent as to their contours. Our courts had developed standards for the appointment of a receiver long before the codification of 8 Del. C. § 279 and there was no obvious statutory gap in need of filling with respect to the appointment of a receiver on grounds of insolvency. Indeed, some courts have suggested that insolvency may be a
necessary condition for appointing a receiver under the court’s general equitable powers. That § 279 establishes a lesser basis for appointing a receiver does not mean that the rules of equity do not already account for insolvency in determining the appropriateness of appointing a receiver. There is no need to borrow from the corporate statute where a more general standard is well-established in our law, particularly with respect to questions of equity. As such, the Court accepts that a receiver may only be appointed in this case in accordance with its general equity powers.

The Court then considered whether a receiver should be appointed at the current stage of the proceedings. The Court concluded that because there were material facts in dispute that the Court would not at this stage appoint a receiver. (At 15)

Because a receiver is unavailable under either the LLC Act or any version of the Operating Agreement, the only basis for appointing a receiver is by way of the Court’s general equity powers. As a general matter, “the appointment of a receiver is an extraordinary, a drastic and . . . an ‘heroic’ remedy. It is not to be resorted to if milder measures will give the plaintiff, whether creditor or shareholder, adequate protection for his rights.” As such, courts of equity exercise this power “with great caution and only as exigencies of the case appear by proper proof. . . .” This is particularly the case where the entity continues to function actively. As this Court put it many years ago:
“[A] receiver pendente lite for a corporation actively functioning is
never to be justified except under circumstances that show an urgent
need for immediate protection against injury either in the course of
actual infliction or reasonably to be apprehended. As the remedy is a stringent one and fraught often times when asked for with the
possibilities of as much if not more harm than that which it seeks to
avoid, it should be applied with scrupulous care. Only emergent
situations can evoke its application.”
Consequently, a court may utilize its equitable powers to appoint a receiver only “when fraud and gross mismanagement by corporate officers, causing real imminent danger of great loss, clearly appears, and cannot be otherwise prevented.” Moreover, “a receiver will never be appointed except under special circumstances of great exigency and when some real beneficial purpose will be served thereby.” Nor will a court of equity appoint a receiver simply because of errors of judgment in business management.

The Court ordered a trial to determine the facts that are in dispute.

Olmstead v. FTC Charging Order Decision Will Not Affect Delaware LLC’s

Steven D. Goldberg, Esq.
Wilmington, DE
sgoldberg@stevendgoldberg.com
http://www.stevendgoldberg,com.com
Contact me if you need assistance in forming/organizing a Delaware business entity or any matter of Delaware law.

In June, 2010 the Florida Supreme Court decided the case of Olmstead, et al. v. FTC, a case certified to the Florida Supreme Court by the United States Court of Appeals for the the 11th Circuit. This is a case of bad facts making bad law. The decision of the Court of Appeals indicates a massive fraud had occurred and the assets of the defendants were to be found in several single-member Florida LLC’s. The FTC sought to require that the defendants hand over ownership of the LLC’s by way of execution process, the defendants countered that the sole remedy was a charging order and that the court could not require them to surrender ownership.
The question certified to the Florida Court was “Whether, pursuant to Fla. Stat. Sec. 608.433(4) a court may order a judgment-debtor to surrender all ‘right, title, and interest’ in the debtor’s single member limited liability company to satisfy an outstanding judgment.”

Florida Section 608.433 reads in part as follows:
608.433  Right of assignee to become member.
(1)  Unless otherwise provided in the articles of organization or operating agreement, an assignee of a limited liability company interest may become a member only if all members other than the member assigning the interest consent.
(4)  On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company membership interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of such interest. This chapter does not deprive any member of the benefit of any exemption laws applicable to the member’s interest.

The Court held in part that “…we conclude that the statutory charging order provision does not preclude application of the creditor’s remedy of execution on an interest in a single-member LLC. In line with our analysis, we rephrase the certified question as follows: ‘Whether Florida law permits a court to order a judgment debtor to surrender  all right, title and interest in the debtor’s single-member limited liability company to satisfy an outstanding  judgment.’ We answer the rephrased question in the affirmative.”

The Florida Court examined the “Generally Available Creditor’s Remedy of Levy and Sale under Execution” under Section 56.061 of the Florida Statutes. The Court recites that the remedy against a judgment debtor’s “interest in a corporation has been part of the law of Florida since 1889.” but then goes on to observe, incorrectly I would suggest, that [a]n LLC is a type of corporate entity, and an ownership interest in an LLC is personal property that is reasonably understood to fall within the scope of ‘corporate stock'”. The Florida Court bootstrapped this unusual conclusion by citing to a 1940 and to a 1911 Florida decisions. Most commentators would take strenuous exception to this conclusion. Much bad LLC law is based upon judges who went to law school when LLC’s did not exist and who fall back incorrectly upon their knowledge of corporate law to decide LLC cases.

The Florida Court next looked at the interplay between 608.433(1)&(4) and concluded first that in the case of a single-member LLC the interest in the LLC is freely assignable by the single member as there is no third party whose consent is required for the transfer an no third party whose interet needs to be protected. More significantly the Court looked at the specific language of (4) and compared it to the language found in Florida’s Limited Partnership Act and its Uniform Partnership Act. The LP Act states in Sec 620.1703(3) that it “provides the exclusive remedy which a judgment creditor of a partner or transferee may use to satisfy a judgment out of the judgment debtor’s interest in the limited partnership or transferable interest.”  The language in the GP Act was similar to the LP language. The court then concludes that as (4) does not specifically state that a charging order is the sole remedy available to the judgment creditor of the member of the LLC, then execution process is available.

Turning now to the Delaware LLC Act, Section 18-703
§ 18-703. Member’s limited liability company interest subject to charging order.
(a) On application by a judgment creditor of a member or of a member’s assignee, a court having jurisdiction may charge the limited liability company interest of the judgment debtor to satisfy the judgment. To the extent so charged, the judgment creditor has only the right to receive any distribution or distributions to which the judgment debtor would otherwise have been entitled in respect of such limited liability company interest.
(b) A charging order constitutes a lien on the judgment debtor’s limited liability company interest.
(c) This chapter does not deprive a member or member’s assignee of a right under exemption laws with respect to the judgment debtor’s limited liability company interest.
(d) The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or of a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest.
(e) No creditor of a member or of a member’s assignee shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of the limited liability company.
(f) The Court of Chancery shall have jurisdiction to hear and determine any matter relating to any such charging order.

The Delaware language in 18-703(d) is similar to the language found in both the Florida LP and GP Acts.  (The identical language is found in 17-703(d) of the Delaware LP Act.) The Florida Court held “The legislature has shown-in both the partnership statute and the limited partnership statute-that it knows how to make clear that a charging order remedy is an exclusive remedy.” Likewise the Delaware legislature has made clear in 18-703(d) that a charging order is the “exclusive” remedy available to the judgment creditor. An added protection afforded to Delaware LLC’s is 18-703(f) which grants jurisdiction to the Delaware Court of Chancery to hear and determine any matter relating to a charging order. While 18-703(f) does not provide exclusive jurisdiction in the Court of Chancery, the judgment debtor could commence a case in Delaware Chancery which would create a logical basis for a motion in the non-Delaware court to transfer jurisdiction.

We believe that the Delaware Act provides the best asset protection available to the member of a single-member LLC. Histroically Delaware courts have pierced the corpoate veil to allow judgment creditors to reach the assets of the stockholders of corporations in cases involving the use of the corporation to commit actual fraud by the cstockholder and other limited bad acts. The courts have applied the same reasoning to LLC’s. Bad facts will continue to result in courts looking to “do justice” and an attempt to fashion a remedy to prevent the bad actor from keeping his or her assets to the detriment of an innocent creditor. The dissent in the Florida case is illustrative and is well reasoned.

We continue to believe that the Delaware LLC Act provides the most flexible LLC law in the nation and a framework that best protects the interests of the members of the LLC.