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Chancery Court Nullifies Cancellation of Certificate of Formation of Delaware LLCs

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Parties who form Delaware limited liability companies to organize their business affairs do so to structure their relationships contractually. This enables them to organize the governance and economic rights in a manner tailored to the enterprise they are establishing. They do so secure in the knowledge that the Delaware Limited Liability Company Act expressly provides that it is the policy of the Delaware act “to give maximum effect to the principle of freedom of contract and to the enforcement of limited liability company agreements.” If the parties ever have a dispute over their internal affairs, then a Delaware court will apply well-settled principles of contract interpretation to resolve it. The recent decision of Capone v. LDH Management Holdings, C.A. No. 11687-VCG (Del. Ch. Apr. 25, 2018), illustrates the court’s application of contract law principles to determine that two Delaware LLCs’ affairs were not wound up in compliance with the Delaware LLC Act resulting in the nullification of prior-filed certificates of cancellation.

Background

Plaintiffs in this action were employees of a Delaware LLC that had formed an employee equity incentive plan. Pursuant to that plan plaintiffs received membership interests (units) in a separate Delaware LLC (management holdings), which held a 15-percent profits interest in the company. Plaintiffs effectively held indirect profits interest in the company of 1.5 and 0.7 percent. The company created another Delaware LLC to manage management holdings (managing member) (together with management holdings, the Delaware LLCs). The company terminated each plaintiff without cause effective in the early part of 2011. The company’s LLC agreement entitled it to redeem the units of any employees so terminated at “the fair market value for such snit as of the last day of the last fiscal year preceding the fiscal year in which the call notice is given.” Since the redemptions occurred on April 12, 2011, Dec. 31, 2010, was the relevant “as of” date to determine fair market valueThe company on Dec. 23, 2010, finalized its valuation of its operating assets. Based on that valuation the company determined that as of Dec. 31, 2010, the operating assets had a value of $1.43 billion. Thereafter, pursuant to a sales process that had begun in the fall of 2010, the company sold its operating assets for $1.925 billion on March 22, 2011. On April 12, 2011, the company redeemed the plaintiffs’ units based on a valuation of the company as a whole of $1.744 billion and of the operating assets at $1.43 billion. The plaintiffs through written and oral communications to company management between April and June 2011 questioned how the company could have valued the company as a whole for approximately $200 MM less than the value that only a portion of its assets had sold for three weeks earlier.

Claims and Defenses

In 2015, the plaintiffs brought claims in New York state court against the Delaware LLCs for not determining in good faith the fair market value of the company and the plaintiffs’ units. The plaintiffs lacked the ability to sue the Delaware LLCs because, unbeknownst to the plaintiffs, the LLCs had been cancelled as part of an acquisition of the company by third-party investors in 2012. Incident to the dissolution of the Delaware LLCs, the defendants reserved no funds for the plaintiffs’ claims relating to breach of the LLC agreement. The plaintiffs filed the Capone action in the Delaware Court of Chancery to nullify the 2012 cancellations of the Delaware LLCs on the ground that their claims were both known to the Delaware LLCs and nonfrivolous such that the cancellation with a zero reserve was improper under the Delaware LLC Act. The defendants conceded that if the defendants were aware of a nonfrivolous claim at the time of dissolution, then the cancellation was improper. The defendants argued both that they were not on notice of the claims and that the LLC agreement did not allow consideration of events after Dec. 31, 2010.

Chancery Nullifies Cancellation of Delaware LLCs to Permit Plaintiff to Pursue Breach of Contract Claims in New York

After first finding that the plaintiffs’ communications with company management in 2011 and management’s contemporaneous responses reflected that the Delaware LLCs were on notice of the plaintiffs’ claims, the court sided with the plaintiffs in holding that the defendants did not act reasonably in setting a zero-dollar reserve for the plaintiffs’ claims that the company had undervalued their units. The court agreed with the defendants that language in the LLC agreement requiring that the fair market value as of Dec. 31, 2010, be “adjusted immediately prior to such deemed sale by [management holdings] board in good faith” could be read to prohibit information learned after Dec. 31, 2010. Nonetheless, it held that “it is not indisputably wrong to read the provision, as the plaintiffs do, as simply requiring a good-faith adjustment of the [company’s] gross asset value immediately before redeeming a terminated employee’s units.” The court also noted that plaintiffs contended that the defendants relied on a valuation performed a week before the LLC agreement contemplated that a valuation be performed. The court found that this fact supported an inference that the company rushed its valuation, knowing that bids would arrive a few weeks later for its operating assets, to enable the company to redeem the assets at below fair market value. The court thus held that the defendants were aware of the plaintiffs’ nonfrivolous claims against the Delaware LLCs for breach of contract at the time of the dissolution and that the failure to create a reserve to cover those claims violated the Delaware LLC Act. This finding caused the court to nullify the cancellations of the Delaware LLCs’ certificates of formation. With the revival of the Delaware LLCs, the plaintiffs can now proceed with their breach of contract claims in New York.

Lessons Learned

Delaware law requires that a dissolving Delaware LLC set aside sufficient reserves for known claims. A dissolving entity that fails to do so is at risk of having the court nullify the cancellation of its certificate of formation. If a terminated employee has nonfrivolous claims under the applicable LLC agreement for breach of contract at the time of dissolution, a failure to establish any reserve for his claim may, as here, put at risk the effectiveness of the cancellation of the certificate of formation. This could later result in the dissolved entity being revived and thus subject to suit. The court’s holding in Capone turned on its finding that the plaintiffs had presented a nonfrivolous interpretation of the parties’ LLC agreement that would have required the defendants in their valuation as of Dec. 31, 2010, to take account of the post Dec. 31, 2010, information indicating a higher value for the plaintiffs’ redeemed units. For transactional attorneys, one lesson is that to eliminate use of information learned after an “as of” valuation date, it is best to say so explicitly. Defendants may yet prove in New York that the language of the LLC agreement prohibits use of post-Dec. 31, 2010, information for the valuation of the units. The absence of any language forbidding the use of post-valuation date data and evidence that defendants may have rushed their valuation, however, means that the plaintiffs will have their day in court to prove that the defendants redeemed their units at too low a price.