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A Proposal to Permit Equitable Defenses to Noncompliant Acts That Are Described as 'Void' in an LLC Agreement

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October 26, 2022
By: Albert Manwaring

Albert Manwaring | Delaware LitigatorIn CompoSecure v. CardUX, 206 A.3d 808 (Del. 2018), the Delaware Supreme Court held that when parties use the word “void” to describe the consequences of a noncompliant act under an LLC agreement, the act is deemed void ab initio, which as a practical matter, means the act is incurably void. With certain limited exceptions, parties cannot later ratify or voluntary fix void acts, and they may not assert equitable defenses to bar a challenge to an alleged void act. This rule effectively allows parties to an LLC agreement to contract out of equity by describing an act as “void” in their agreement.

The consequences of this rule can be harsh and seemingly incompatible with the role of equity in our jurisprudence to ameliorate such results. Accordingly, in XRI Investment Holdings v. Holifield, No. 2021-0619-JTL, ___ A.3d ___ (Del. Ch. Sept. 19, 2022), faced with substantial evidence of the equitable defense of acquiescence to an alleged noncompliant act under an LLC agreement, the Delaware Court of Chancery could not consider this defense under the precepts of CompoSecure. In XRI Investment Holdings, the court held that a co-founder and LLC member’s transfer of his units to an entity that he owned was not a permitted transfer under the LLC agreement because he received consideration in the transfer as part of a larger financing transaction. Hence, the court found that the permitted transferee exception was not available, and violated the “No Transfer” provision under the LLC agreement, which in turn, provided that any transfer that violated the “No Transfer” provision was “void.” Bound by CompoSecure, the court declared that the transfer of the co-founder’s units was void, which left the units in his hands, instead of his transferee entity. Thus, the units were subject to foreclosure by the plaintiff XRI, which maintained an interest in the units as security for a defaulted loan to another entity owned by the co-founder.

The court explained, however, that if the defense of acquiescence was available, then it would have found that XRI acquiesced in the transfer of the co-founder’s units, and was barred from challenging the validity of the transfer. The court found that the co-founder satisfied all of the requirements to prove the defense of acquiescence by XRI. Indeed, XRI’s CEO worked with the co-founder to obtain the financing that disqualified the transfer under the permitted transferee exception in the LLC agreement. Hence, the XRI CEO knew about the transfer and related financing at the time that the transfer took place. Moreover, XRI’s attorneys subsequently reviewed the transfer, concluded that it violated the “No Transfer” provision, but the XRI board nevertheless made a business decision not to challenge the transfer because at the time, the transfer benefitted XRI in terms of priority of its interests in the units in the transferee entity over the co-founder’s general creditors. In short, if the defense of acquiescence was available, the units would have remained with the transferee entity, and the co-founder could have potentially avoided any foreclosure on the units, and the harsh result of allowing XRI to capitalize on his units, the value of which apparently far exceeded the amount due on the XRI loan.

In a respectful effort to advance Delaware law, and avoid such harsh results, the Court of Chancery suggested, however, that the Delaware Supreme Court reconsider its holding in CompoSecure, and allow consideration of equitable defenses invoked by parties to a contract claim when the parties have described the noncompliant act as “void” in their agreement. In this proposed regime, acts deemed void ab initio, and thus, incurably void, would be limited to those acts that contravene limitations imposed by the state, not agreements by private parties. The court explained, for example, that acts that violated the DGCL or LLC Act, or contravened limitations or exceeded authorizations in a certificate of incorporation would remain incurably void unless an exception under Sections 204 and 205 of the DGCL were applicable. Stay tuned for the Delaware Supreme Court to weigh in on this proposal.
Delaware Business Court Insider | October 26, 2022
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