The derivative suit concept so familiar in the corporate context has been grafted onto the limited liability form. The contractual nature of limited liability companies and their often closely-held membership can pose significant pleading challenges, however, when a member feels aggrieved by the alleged misconduct of another LLC member or manager and must decide whether the asserted claims are derivative or direct. In the recent Court of Chancery decision in Clifford Paper, Inc. v. WPP Investors LLC, et al., C.A. No. 2020-0448-JRS (Del. Ch. 6/1/21), the court dismissed claims that a former LLC member attempted to bring directly because they were in fact derivative claims that the plaintiff lacked standing to assert. Applying the traditional Tooley analysis used to distinguish direct from derivative claims in the corporate context, the court concluded that claims alleging a breach of the plaintiff’s voting and other contract rights were not direct because the resulting injury allegedly damaged the entity directly and the plaintiff only indirectly.
Plaintiff Clifford Paper, Inc (CPI) and Defendants WPP Investors, LLC (Investors) and its owners Edgar Smith and Richard Baptiste formed a Delaware LLC, World Pac Paper (WPP) to provide paper, packaging, printing, warehousing and shipping services to commercial and retail clients. CPI owned 45%; Investors owned 55%. Under the Company’s operating agreement Smith, Baptiste, and CPI’s president John Clifford were designated as the Company’s managers.
The venture worked well for 13 years with CPI providing WPP under a services agreement the administration and management of WPP’s accounts receivable, invoicing, financing, and materials servicing and coordination. The relationship soured when Smith sought to add his wife to WPP’s payroll at a $185,000 annual salary to perform administrative services duplicative of those already provided by CPI. CPI objected but Smith proceeded with hiring her. Thereafter, WPP terminated its Service Agreement with CPI, replaced financing CPI had arranged for the Company with more expensive financing, and appointed Investors as WPP’s new administrative services and financial agent. Plaintiff alleged that the defendants conduct violated various provisions of the LLC Operating Agreement, including matters on which Clifford had been denied the right to vote, and diverted funds and profits in which CPI was entitled to share as a member of WPP. Eventually CPI and Investors entered into a Withdrawal Agreement to memorialize CPI’s election to withdraw as a member while preserving claims between CPI and Investors.
Thereafter, CPI filed a complaint against Investors, Smith and Baptiste alleging:
- violation of the Operating Agreement’s Section 8.1 by excluding Clifford from voting on the hiring of Smith’s wife;
- breach of Section 8.3 for Smith’s unilateral hiring of his wife;
- breach of Section 8.10 by preventing Clifford from voting on WPP’s new financing arrangement;
- breach of Section 14(a) by diverting payments from the Company to Investors; and
- breach of the fiduciary duty of loyalty by defendants for a variety of acts that benefitted themselves at the expense of WPP and CPI.
Arguing the claims were derivative and not direct, defendants moved to dismiss on the grounds that CPI lacked standing as a “former” member to maintain a derivative suit and had failed to plead demand futility in any event.
The court initially disposed of the contention that all claims in a two person LLC were effectively direct because the harm caused by one member flows directly to the other, permitting the Tooley direct/derivative analysis to be ignored.
The court reasoned that the LLC Act provides for the assertion of derivative claims by members and makes no exception for two person LLCs. The court distinguished precedent for allowing entity claims to be asserted directly as a case involving a dissolved entity that was no longer legally relevant for the purpose of resolving final claims between its two members.
Turning next to the application of the Tooley test, the Court focused its attention on
- whether the LLC or the suing member suffered the alleged harm, and
- whether the LLC or the members individually would receive the benefit of the recovery or remedy.
LLCs differ from corporations in that the fundamental LLC document is an Operating Agreement. This is a contract between the members of the LLC and is signed by each member and the Company. Ordinarily, when one party to a contract fails to perform in accordance with its terms the other parties have an individual direct claim for breach of contract.
In the LLC context, however, the Company is also a party to the Operating Agreement. The question becomes whether the breach claim is properly brought derivatively on behalf of the Company or directly by the injured member. The court followed the Tooley precedent by focusing not on the nature of the breach, but the harm flowing from the breach.
Thus, for Count IV alleging defendants’ breach of contract by diverting payments properly owed to the Company, the court said this was quintessentially derivative. The harm flowed directly to the Company in the form of depleted funds and only derivatively to its members.
The breach of the contractual right to vote alleged in Counts I-III presented a different analysis. Deprivation of a member’s right to vote can be a direct claim. In this case, however, the court again focused on the alleged harm flowing from the plaintiff’s right to vote; namely, the hiring of Smith’s wife at an excessive salary, causing the Company to pay for duplicative services and enriching Smith at the expense of the Company. Viewing the alleged harm as wasteful company expenditures, the harm and resulting recovery would flow to the Company, making it a derivative claim. The court applied the same reasoning with respect to the harm flowing from the Company’s assumption of new financing at a higher rate. Where all of the members are harmed and would recover pro rata in proportion with their ownership solely because they are members, the harm and the resulting claim are derivative in nature.
For practitioners, the court’s analysis, particularly its reasoning with respect to deprivation of the right to vote, provides valuable guidance. Given the fundamental and foundational nature of the member’s right to vote, one could conclude that any denial of that right is, standing alone, concrete harm, unique to that member which the member should be able to redress with his own direct claim. The court in Clifford Paper, however, concludes that when the voting deprivation allegedly causes monetary harm, the court will focus on whether the financial loss is the Company’s and only indirectly the member’s loss. When the loss is the Company’s, the special pleading and standing requirements applicable to derivative claims apply.