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The Risk of Self-Help Inconsistent With an LLC Agreement

August 21, 2013
Morris James LLP
Delaware Business Court Insider

While limited liability company agreements offer members the opportunity to  anticipate and address potential issues that may arise in the future,  particularly when ownership is equally split, members often fail to take  advantage of those opportunities. If things do go wrong, engaging in self-help  that does not comply with the terms of a limited liability company agreement can  just lead to more problems, as illustrated by the recent decision in Grove v.  Brown, C.A. No. 6793-VCG (Del. Ch. Aug. 8, 2013).

Grove arose from a successful business relationship that soured.  Plaintiffs Mary and Larry Grove started a home health care agency with  defendants Melba and Hubert Brown. In December 2009, the Browns and Groves  entered into a limited liability company operating agreement that named the  Browns and Groves as the four members of Heartfelt Home Health LLC. The  operating agreement required that each member make an initial capital  contribution of $10,000 and provided that each member owned an equal portion of  Heartfelt. Heartfelt was successful and earned a respectable operating profit in  its first year. In January 2011, Mary Grove had discussions with the Browns  about possibly expanding into Maryland and Southern Delaware. There was  conflicting testimony about expansion, with the Browns testifying that they had  wanted to focus on the existing business in Delaware but had not outright  rejected the possibility of expansion and Mary Grove testifying that the Browns  were not interested in expanding the business. The Groves went ahead and formed  new home health care agencies in Maryland and Delaware.

A dispute concerning the parties' membership interests arose in April 2011  as an accountant prepared Heartfelt's 2010 tax return. Larry Grove and Melba  Brown had not made the required $10,000 capital contributions. Hubert Brown gave  Melba Brown $6,500 to bring her cash contribution to $10,000 and Mary Grove gave  Larry Grove $3,657. The Groves argued that the remaining $6,343 owed by Larry  Grove was satisfied by his donation of furniture and equipment to Heartfelt, but  the Browns disputed the value of the donations. Relations between the Groves and  Browns became increasingly tense.

The Groves began operating the Maryland home health care agency business and  proposed that the Browns buy them out of Heartfelt for $941,000. The Groves  later notified the Browns of their intent to liquidate Heartfelt. In response,  the Browns purported to merge Heartfelt with Heartfelt Home Health II LLC. The  Browns claimed they could cause such a merger because they owned 63 percent of  Heartfelt as a result of Larry Grove's failure to make a $10,000 cash  contribution to Heartfelt. The Groves and Browns then sued each other for breach  of fiduciary duty.

The court first addressed the Groves' claim that the Browns lacked authority  to merge Heartfelt with Heartfelt II. Analyzing the operating agreement, the  court found it unambiguously provided that each of the four members owned 25  percent of Heartfelt. Although the operating agreement required members to  provide capital, the court found it did not provide that one member's failure to  do so divested that member of his or her interest in the company. According to  the court, extrinsic evidence would not change this conclusion. The Groves and  Browns signed membership certificates indicating each owned 25 percent of  Heartfelt, their conduct reflected that they believed they each owned 25 percent  of Heartfelt, the Browns did not initially take the position that Larry Grove  was not a member when the shortfall in his contribution was discovered and Melba  Brown was also late in making her required contribution, according to the  opinion. Because the Browns were 50 percent members of Heartfelt and not 63  percent members, they lacked the legal authority to effectuate the merger and it  was a nullity.

The court next addressed the Browns' claim that the Groves had usurped a  corporate opportunity of Heartfelt by operating a home health care agency  business in Maryland. A fiduciary may not take a business opportunity for itself  if: (1) the entity is financially able to exploit the opportunity; (2) the  opportunity is within the entity's line of business; (3) the entity has an  interest in the opportunity; and (4) the fiduciary will be placed in a position  inimical to its duties. A fiduciary may take an opportunity if: (1) the  opportunity is presented to the fiduciary in an individual capacity; (2) the  opportunity is not essential to the entity; (3) the entity holds no interest in  the opportunity; and (4) the fiduciary has not wrongfully used the resources of  the entity in pursuing the opportunity. The fiduciary bears the burden of  showing he or she did not usurp a business opportunity. While recognizing that  much of the parties' testimony was self-serving, the court concluded that the  Groves had failed to prove that they had the right to exploit opportunities  otherwise belonging to Heartfelt.

As far as the appropriate remedy, the court exercised its equitable powers  to order each side to account to Heartfelt for the profits they wrongfully kept  to themselves. The Browns had to account for profits earned by Heartfelt II  since the nullified merger and the Groves had to account for profits earned by  the other home health care agencies they operated. While there was presently no  application for dissolution on the grounds that it was "not reasonably  practicable to carry on the business in conformation with the limited liability  company agreement" under Section 18-802 of the Limited Liability Company Act,  the court encouraged the filing of a petition for petition dissolution in light  of the animosity between the parties.

As this case illustrates, it is wise for parties to anticipate potential  issues when they own equal interests in a business. It was foreseeable that all  of the members would not necessarily make the required capital contributions. If  the parties had wished to change ownership interests when a member failed to  make a required capital contribution, then they needed to make that clear in the  operating agreement. It was also foreseeable that the parties might have  different goals for the business. The parties could have included language in  the operating agreement that would have allowed some members to pursue an  opportunity of Heartfelt if the other members of Heartfelt were not interested  in having Heartfelt pursue that opportunity. In the absence of language along  the lines described above, both the Browns and Groves violated their fiduciary  duties by taking actions that were not in compliance with the operating  agreement and incurred higher and perhaps unnecessary litigation burdens and  costs.