The Risk of Self-Help Inconsistent With an LLC Agreement
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.