Business Law Developments
Article Date: Tuesday, February 14, 2012
Written By: Thomas J. Molony
Voting Rights Still Aglow
The Delaware Chancery Court considered whether the transfer of an additional interest to a member of a Delaware limited liability company conferred upon the transferee the voting rights associated with the additional interest without readmission as a member. Achaian, Inc. v. Leemon Family LLC, 25 A.3d 800 (Del. Ch. 2011). The court concluded that, when a company’s LLC agreement defines a membership interest as a member’s entire ownership interest, freely allows transfers and merely requires consent for admission as a member, readmission is not required for a transferee member to obtain the voting rights associated with the additional interest.
Omniglow, LLC, a Delaware limited liability company, had a single member upon its formation in 2005. In 2006, Omniglow’s sole member divested completely, selling 50 percent of its interest to Leemon Family LLC, 30 percent to Randye Holland and the Stanley M. Holland Trust (collectively, “Holland”) and 20 percent to Achaian, Inc., all of whom became members. Under Omniglow’s LLC agreement, the members held management rights in the same proportions as their ownership percentages.
After a management dispute arose, Holland transferred its 30 percent interest to Achaian. Achaian then filed a lawsuit seeking dissolution, claiming that it held 50 percent of the management rights in the company and that it was deadlocked with Leemon. Leemon moved to dismiss and countered that Achaian had just 20 percent of the management rights because Holland’s transfer vested Achaian only with economic rights. According to Leemon, for Achaian to obtain the management rights associated with Holland’s interest, Achaian had to be readmitted as a member with respect to the interest. Under the LLC agreement, admission of a member required the consent of the existing members, and Leemon had not consented.
In considering Leemon’s motion, the Delaware Chancery Court noted that the Delaware Limited Liability Company Act (the “Delaware LLC Act”) provides as a default rule that a transferee of a membership interest only receives the economic rights with respect to the transferred interest and does not automatically become a member. According to the court, however, the default rule did not apply to Omniglow because its LLC agreement specifically addressed the transfer of interests.
Omniglow’s LLC agreement provided that “[a] Member may transfer all or any portion of its Interest in [the company] to any Person at any time” and that “[n]o Person shall be admitted as a Member of [the company] without the written consent of” the other members. In addition, the agreement defined a member’s interest as “the entire ownership interest of the Member.” Based on these and other related provisions, the court concluded that,
[r]ead in complete context, the LLC Agreement makes Interests in Omniglow freely transferable subject only to a limited proviso that requires the written consent of the existing Members in order for a transfer to confer the status of Member on a Person, who at the time of the transfer was not already a Member. Because Achaian was already a member at the time [it purchased Holland’s interest] and nothing in the LLC Agreement requires that it be readmitted as a Member with respect to each additional Interest it acquires in Omniglow, it was entitled to receive the “entire ownership interest” owned by Holland, including that Interest’s corresponding voting rights.
Indeed, the court noted, Del. Code tit. 6, § 18-704 seems to contemplate “singular admission governed by the specific terms of the LLC agreement.”
The court did not address whether, or to what extent, its decision might be different if Omniglow’s LLC Agreement had not overridden the default provisions of the Delaware LLC Act. Leemon argued that the decision would be different, and Achaian admitted that, if the default provisions applied, “it [was] possible that the Court might find that Achaian did not acquire Holland’s voting rights.” The court, however, avoided the question entirely, indicating equivocally that “the default provisions in the Act, if applicable, might lead to a different result.” Whatever the answer may be, Achaian underscores the importance of making sure that LLC agreements clearly and completely address what the parties intend regarding the transfer of interests.
A Derivative Suit Going Nowhere Fast
The Delaware Supreme Court considered whether a creditor of a Delaware limited liability company has standing to sue in right of the company. CML V, LLC v. Bax, 28 A.3d 1037 (Del. 2011). The court concluded that a creditor does not.
CML V, LLC loaned over $34 million to JetDirect Aviation Holdings, LLC, a Delaware limited liability company. In June 2007, JetDirect defaulted, and by January 2008, the company was insolvent. After its managers began liquidating JetDirect’s assets to reduce its debt, CML filed a derivative lawsuit against JetDirect’s present and former managers, claiming that they breached their fiduciary duties to the company and acted in bad faith. The defendants moved to dismiss the derivative claims, asserting that, because CML was merely a creditor of JetDirect, it lacked derivative standing.
Del. Code tit. 6, § 18-1002 provides that, “[i]n a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action” and must have been either a member or assignee at the time of the disputed transaction or have received his or her interest by operation of law from someone who was a member or an assignee at that time. CML offered two arguments as to why this clear statutory language does not preclude derivative standing for creditors. First, CML claimed that the limitations in Del. Code tit. 6, § 18-1002 apply only in the context of Del. Code tit. 6, § 18-1001, which grants derivative standing to members and assignees, but does not limit standing to them. According to CML, when read together, the two sections indicate that the Delaware General Assembly intended to adapt for the Delaware LLC Act language from the Delaware General Corporation Law that the Delaware Supreme Court previously determined did not prohibit derivative standing for creditors of insolvent corporations. Second, CML asserted that, if Section 18-1002 limits derivative standing to members and assignees, it is unconstitutional because it prevents the Delaware Chancery Court from “extending standing to sue derivatively in cases where derivative standing is necessary to prevent a complete failure of justice.”
The Delaware Supreme Court rejected both of CML’s arguments. It concluded that Section 18-1002 is unambiguous and, therefore, its plain meaning applies. CML had claimed that the statutory language is ambiguous because applying its plain meaning would treat creditors of insolvent LLCs differently from those of insolvent corporations. The court responded that the General Assembly was free to establish different limits on derivative standing for LLCs. According to the court, it is reasonable that the General Assembly would not extend derivative standing to creditors of LLCs because, by giving maximum effect to freedom to contract, the Delaware LLC Act offers creditors substantial flexibility to protect themselves.
As to CML’s constitutional argument, the Supreme Court concluded that the Chancery Court’s equitable power to extend derivative standing exists only in the corporate context. The court explained that a corporate derivative action existed at common law and that nothing in the Delaware Constitution prohibits the General Assembly from limiting derivative standing with respect to LLCs, which did not exist at common law. The court noted that the Delaware LLC Act was enacted “in derogation of the common law,” and therefore, “when adjudicating rights, remedies and obligations associated with Delaware LLCs, courts must look to the LLC Act because it is the only statute that creates those rights, remedies and obligations.” According to the court, although the Delaware LLC Act allows the common law to supplement provisions of the Act, those principles are not to override the statutory provisions “under the guise of” equity.
CML is important because it emphasizes that, when dealing with LLCs, creditors must protect themselves contractually. If they fail to do so, they may be left in the cold.
No Need to Put Two and Two Together
The Delaware Supreme Court considered when, under New York law, separate asset dispositions must be aggregated for purposes of determining whether a borrower has disposed of “substantially all” of its assets in violation of an indenture covenant. Bank of New York Mellon Trust Co., N.A. v. Liberty Media Corp., 29 A.3d 225 (Del. 2011). Looking to the decision of the United States Court of Appeals for the Second Circuit in Sharon Steel Corp. v. Chase Manhattan Bank, N.A., 691 F.2d 1039 (2d Cir. 1982), the court concluded that “aggregation is appropriate only when a series of transactions [is] part of a ‘plan of piecemeal liquidation’ and ‘an overall scheme to liquidate’ and not where each transaction stands on its own merits without reference to the others.”
Liberty Media Corporation and its wholly-owned subsidiary Liberty Media LLC (collectively, “Liberty”) were parties to an indenture under which Liberty issued over $13 billion of debt from 1999 to 2003. The indenture included a successor obligor provision that prohibited Liberty from transferring “all or substantially all” of its assets unless the transferee assumed the obligations under the indenture and, after giving effect to the transaction or series of transactions, no event of default under the indenture would result. After Liberty announced in 2010 that it planned to split off the assets of its Capital Group and Starz Group (the “Capital Splitoff”), a Liberty bondholder asserted in a letter to Liberty that the Capital Splitoff “might violate the Successor Obligor Provision.” Thereafter, Liberty filed a lawsuit against the indenture trustee, seeking a declaration that the Capital Splitoff would not result in a transfer of “substantially all” of Liberty’s assets.
Liberty split off from AT&T in 2001. At the time of the splitoff, Liberty’s assets consisted primarily of small minority interests in large public companies and large minority interests in private companies. Unfortunately, the assets produced little cash flow. To remedy that problem, Liberty implemented a strategy of using its minority interests to acquire control of “mutually supporting operating businesses.” When Liberty’s management determined that it could not reasonably achieve control of a business, however, it pursued alternatives, including spinoff and splitoff transactions that management believed would benefit Liberty’s shareholders. Accordingly, in 2004, Liberty spun off its international cable business, which represented 19 percent of Liberty’s book value as of March 31, 2004. In 2005, it spun off assets, including a substantial minority interest in the cable channel Discovery, that collectively represented 10 percent of Liberty’s book value as of March 31, 2004. In 2009, Liberty split off businesses, including an interest in DirecTV, that represented 23 percent of Liberty’s assets as of March 31, 2004. The Capital Splitoff represented 15 percent of Liberty’s total assets as of March 2004.
Liberty and the indenture trustee agreed that the Capital Splitoff, standing alone, did not represent a sale of “substantially all” of Liberty’s assets. The trustee claimed, however, that the previous spinoff and splitoff transactions and the Capital Splitoff should be considered together and that, when considered together, the transactions constituted a transfer of “substantially all” of Liberty’s assets in violation of the successor obligor provision in the indenture.
The case involved an appeal from the Delaware Chancery Court’s decision in Liberty Media Corp. v. Bank of New York Mellon Trust Co., N.A., No. 5702-VCL, 2011 WL 1632333 (Del. Ch. Apr. 29, 2011), which was discussed in the November 2011 edition of this column. Applying New York law, the governing law for the indenture, the Chancery Court had determined that the Capital Splitoff did not need to be aggregated with the earlier transactions. Consequently, because the trustee agreed that, alone, the assets subject to the Capital Splitoff did not constitute “substantially all” of Liberty’s assets, the court concluded that the Capital Splitoff would not violate the successor obligor clause under the indenture. In reaching its decision, the Chancery Court applied Sharon Steel and found that “aggregating the four transactions is not warranted because each transaction was the result of a discrete, context-based decision and not as part of an overall plan to deplete Liberty’s asset base over time.” Focusing on the phrase “series of transactions” in the successor obligor provision and not satisfied that Sharon Steel alone offered a sufficient basis for its opinion, however, the Chancery Court analyzed the transactions under the step-transaction doctrine, a doctrine under which separate, but related transactions are treated as a single transaction. The court determined that none of the doctrine’s three tests required aggregation of the Liberty transactions.
On appeal to the Delaware Supreme Court, the trustee argued that the phrase “series of transactions” does not mean “step-transaction” and that Sharon Steel allows for aggregation even if the step-transaction doctrine does not apply. Moreover, the trustee cited language from the American Bar Foundation’s Commentaries on Model Indenture Provisions that indicates that “the evolution of the Successor Obligor Provision in th[e] case does not incorporate the step-transaction doctrine.”
The Delaware Supreme Court, affirming the Chancery Court’s decision, concluded that the Chancery Court had applied Sharon Steel correctly and that the step-transaction doctrine was inapposite. The court noted that the parties agreed that the phrase “series of transactions” was included in the successor obligor provision based on a comment to the American Bar Association’s Model Simplified Indenture. According to the court, the comment appeared shortly after Sharon Steel and warned “that ‘serious consideration must be given to the possibility of accomplishing piecemeal, in a series of transactions, what is specifically precluded if attempted in a single transaction.’” The court agreed with Liberty that, in light of the comment, when a post-Sharon Steel successor obligor provision includes the phrase “series of transactions,” the “only fair conclusion” is that it means an “integrated series of transactions” such as those that occurred in Sharon Steel. The Supreme Court determined this interpretation applied to the Liberty successor obligor provision because the provision represented boilerplate language and not language subject to specific negotiation.
The Liberty opinion offers valuable guidance as to when separate asset transactions will be combined for purposes of determining whether “substantially all” of a company’s assets have been transferred. In addition, it highlights the importance of understanding the common meaning of boilerplate language and of making appropriate modifications when parties intend something different.
Let’s Be Candid
The North Carolina Court of Appeals considered the standard for measuring when deal protection measures undertaken by a North Carolina corporation are coercive and the disclosure obligations of directors of a North Carolina corporation when they seek shareholder action. Ehrenhaus v. Baker, __ N.C. App. __, 717 S.E.2d 9 (2011). The court concluded that a deal protection measure is impermissibly coercive if it does not allow shareholders a meaningful exercise of their voting rights and that, when seeking shareholder action, directors have a duty to disclose “fully and fairly” material information under their control.
In 2008, a shareholder of Wachovia Corporation, a North Carolina corporation, filed a class action lawsuit in the North Carolina Business Court seeking equitable relief and damages with respect to Wachovia’s merger with Wells Fargo & Company. In a motion for a preliminary injunction, the plaintiff argued that Wachovia’s board breached its fiduciary duties by, among other things, approving measures designed to protect the transaction. One of the challenged measures was Wachovia’s agreement to exchange shares of a new series of its Class A preferred stock for Wells Fargo common stock. Through the preferred shares Wells Fargo obtained 39.9 percent of the aggregate voting rights of Wachovia’s shareholders, and the terms of the shares barred redemption for 18 months after Wachovia’s shareholders voted on the merger. The other challenged measure was a “fiduciary out” provision that required Wachovia’s board to submit the merger to a shareholder vote even if the board later determined that it could not recommend the merger. The Business Court considered the plaintiff’s preliminary injunction motion in Ehrenhaus v. Baker, 2008 NCBC 20 (Dec. 5, 2008), which was discussed in the January 2009 edition of Notes Bearing Interest. In that case, the court enjoined the 18-month prohibition against redemption of the new Wachovia preferred shares, but otherwise denied the plaintiff’s motion.
After the Business Court issued its injunction, the plaintiff amended his complaint to allege that Wachovia’s directors also had breached their fiduciary duties by using a proxy statement with respect to the merger that contained “materially misleading statements” and material omissions. Less than two weeks later, the parties to the lawsuit agreed in principle to settle. The terms of the proposed settlement required Wachovia to disclose additional information about the merger, which Wachovia did before its shareholders approved the merger. The Business Court approved the settlement in early 2010. Two Wachovia shareholders objected to the settlement and appealed the Business Court’s approval, claiming, among other things, that the court erred when it did not grant in full the plaintiff’s request for a preliminary injunction.
In support of their claim, the objectors argued that the board breached its fiduciary duties by failing to obtain necessary shareholder approval with respect to the exchange of Wachovia’s preferred shares for Wells Fargo common stock. They asserted that shareholder approval was required under N.C. Gen. Stat. § 55-10-03(b) for the amendment to Wachovia’s articles of incorporation establishing the rights and preferences for the new series of preferred stock and that shareholder approval was required under N.C. Gen. Stat. § 55-11-03(a) for the exchange itself. The North Carolina Court of Appeals concluded that Wachovia shareholder approval was not required in either case. According to the court, approval was not required under N.C. Gen. Stat. § 55-10-03(b) because Wachovia’s articles previously had been amended to allow the board to issue one or more series of Class A preferred stock and to establish the voting rights with respect to each series. Likewise, the court determined that the exchange was not a statutory share exchange requiring Wachovia shareholder approval under N.C. Gen. Stat. 55-11-03 because the exchange was not a compulsory exchange of Wachovia stock already outstanding, but instead was a new issuance of Wachovia stock for which the Wells Fargo common stock served as consideration.
Consistent with the Business Court’s 2008 decision, the Court of Appeals also determined that it was “highly unlikely” that the plaintiff would have been successful with a claim that Wachovia’s directors breached their fiduciary duties by approving a share exchange that was impermissibly coercive. Looking to Delaware law for guidance, the court stated that, “in North Carolina, a deal protection measure . . . cannot be so coercive that it deprives the pre-exchange shareholders of the opportunity to exercise their voting rights in a meaningful way.” The court then concluded that granting Wells Fargo 39.9 percent of the aggregate voting rights of Wachovia’s shareholders was not improperly coercive because independent shareholders (who held approximately 60 percent of the aggregate voting rights) could defeat the merger. In addition, the court noted, Wachovia had no viable alternative for a merger partner. The court further concluded that the plaintiff had no viable claim with respect to the 18-month prohibition against redeeming the preferred stock because that term was eliminated after the Business Court enjoined it.
Regarding the claim that the proxy statement contained materially misleading statements and material omissions, the Court of Appeals, quoting Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992), held that “North Carolina directors ‘are under a fiduciary duty to disclose fully and fairly all material information within the board’s control when it seeks shareholder action.’” Although the court determined that the plaintiff had a viable claim that the directors had breached this duty of candor, it concluded that the additional disclosures the plaintiff secured through the settlement made the claim moot.
Ehrenaus is an important case because it articulates North Carolina’s standard for determining whether deal protection measures are impermissibly coercive and recognizes, apparently for the first time, that directors of a North Carolina corporation owe a duty of candor when seeking shareholder action.
Leaving the Competition Behind
The North Carolina Business Court considered whether a manager of a North Carolina limited liability company breached her fiduciary duty by taking actions in preparation for later competition with the company. Lake House Academy for Girls LLC v. Jennings, 2011 NCBC 40 (Oct. 13, 2011). The court concluded that a manager who, while serving in that capacity, takes actions that further a plan to compete later breaches her fiduciary duty.
Roy Cook and Catherine Jennings are the sole members of Lake House Academy for Girls LLC (“LHAG”), a North Carolina limited liability company. Cook owns 75 percent of the membership interests, and Jennings owns the remaining 25 percent. LHAG’s operating agreement provides that each member, by virtue of being a member, also is a manager.
LHAG was formed in 2010 to acquire Lake House Academy for Girls (the “Academy”), a residential therapeutic program for girls ages 10 to 14. Jennings served as executive director of the Academy prior to the acquisition, and to encourage Cook to invest in LHAG, she represented that the Academy would be the only program of its kind on the east coast. After the acquisition, in addition to serving as a manager of LHAG, Jennings continued as executive director of the Academy.
The relationship between Cook and Jennings quickly declined, and in June 2011, Jennings began to take steps to establish a new program that was comparable to the Academy. She emailed confidential LHAG documents to her husband. She told other LHAG employees that she planned to leave the Academy and to solicit key employees to terminate their positions with LHAG. She attempted to convince LHAG’s clinical director to leave LHAG and join her in her new venture. She asked a real estate broker to assist her in securing a lease for space in which to operate her new program.
After Jennings’s term as executive director ended in late July 2011, her efforts continued. She took further steps to find space for her new program, and in late August 2011, a lease was executed. She directed parents of Academy students to a website that disparaged LHAG’s staff. She encouraged the Academy’s academic director to resign and executed an employment contract with him for her new program. She deleted LHAG documents from a laptop that was given to her for her use as the Academy’s executive director.
LHAG filed a lawsuit against Jennings alleging, among other things, breach of fiduciary duty and seeking injunctive relief. After considering the evidence, the North Carolina Business Court granted LHAG’s motion for a preliminary injunction and enjoined Jennings from taking further steps to compete with LHAG. The court noted that, under N.C. Gen. Stat. § 57C-3-22, as a manager, “Jennings owed [LHAG] a duty of good faith to act in the best interest of the company and a duty to account as trustee for any benefit derived without the informed consent of the other members” and that LHAG’s operating agreement had not modified this duty. Based on the evidence presented, the court determined that, because Jennings “set in motion” a plan to compete with LHAG while she was a manager of the company, LHAG was likely to succeed on its claim that Jennings breached her fiduciary duties.
In early October 2011, Jennings had attempted to resign as a manager of LHAG while retaining her 25 percent membership interest in the company. Because the court found that Jennings’s plan to compete with LHAG started before her attempted resignation, it declined to address whether her resignation was effective notwithstanding the fact that the operating agreement provides that all members, by virtue of being members, are managers.
The Business Court’s decision in Lake House Academy is noteworthy less for its ultimate conclusion and more for the question it left unanswered. The unanswered question highlights the importance of drafting operating agreement provisions that clearly address when members and managers may resign and what happens if they do. •
Molony is assistant professor of law at Elon University School of Law.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.