Can a Deadlock Resolution Provision Cause Deadlock? This One Did
May 20, 2019
This is the story of a deadlock resolution provision that backfired. It is a long story — 94 pages long to be exact. That is the length of Chancellor Bouchard’s characteristically detailed and thorough post-trial opinion issued last week in Acela Investments v DiFalco, C.A. No. 2018-0558-AGB [Del Ch May 17, 2019], in which he ordered the dissolution of a deadlocked start-up developer of abuse-deterrent opioid pain medications after finding that the LLC agreement’s deadlock resolution provision had planted the seeds of its own demise.
The Delaware limited liability company involved in Acela is named Inspirion Delivery Services (IDS) which owns two FDA-approved drugs. The venture was co-founded by a chemical engineer (DiFalco), a pharmaceutical industry scientist (Shah), and a pharmaceutical industry executive (Aigner). IDS attracted tens of millions of private equity dollars to fund drug development and the long and taxing drug-approval process. By the time of the lawsuit, only one of IDS’s two approved drugs was in production with limited commercial success.
IDS’s “Bespoke Governance Structure”
IDS’s LLC agreement contains what Chancellor Bouchard described as a “bespoke governance structure” in which Aigner as CEO and DiFalco as President performed their duties subject to each other’s “advice and consent,” and either Aigner alone or DiFalco and Shah together can veto any action of the IDS board of managers.
The agreement also has a provision — think of it as the tinder that lit the eventual fire — intended to resolve conflicts of interest by having an “Independent Representative” vote in place of a conflicted manager who has “a conflict of interest concerning an Affiliate Transaction.” Not only was the term “conflict of interest” left undefined, the provision also failed to specify who determined the existence of a conflict of interest.
The Unraveling
The relationship between Aigner on the one hand and DiFalco and Shah on the other, as Chancellor Bouchard put it, “devolved into one of distrust and animosity” leading to deadlock over certain “fundamental” issues. One concerned who IDS should partner with to manufacture its drugs and to develop new products. Another concerned the allocation of the company’s limited resources to R&D versus building an in-house sales force.
The unraveling took solid form in early 2017, when Aigner initially issued a series of written consents including approval of an “Infrastructure Resolution” and development agreement with a company called Cerovene that was co-owned by DiFalco and Shah, to build a pharmaceutical manufacturing facility financed by IDS. Aigner subsequently rescinded his consent to the Cerovene-related resolutions while implementing others including one that paid himself a $550,000 bonus, even though he had expressly presented his consents as a “package deal.”
Aigner followed with a series of other unilateral and/or inflammatory actions, including secretly exploring the use of a Puerto Rico-based pharmaceutical manufacturer; sending threatening letters to Shah at his home; appointing a new manager with voting rights to replace Shah after the latter’s resignation; confessing to a board observer his plan “to starve” DiFalco and Shah to make them “behave”; and obtaining DiFalco’s Independent Representative’s approval of certain resolutions before DiFalco even knew about it.
The Court Finds Deadlock
Chancellor Bouchard outlines at pages 66-67 of his opinion the by-now familiar standard adopted by the Delaware Chancery Court in applying § 18-802 of the Delaware LLC Act authorizing judicial dissolution “whenever it is not reasonably practicable to carry on the business [of the LLC] in conformity with a limited liability company agreement.” With respect to deadlock, the court explained,
when an LLC agreement requires that there be agreement between two managers for business decisions to be made, those two managers are deadlocked over serious issues, and the LLC agreement provides no alternative basis for resolving the deadlock, it is not reasonably practicable to continue to carry on the LLC business in conformity with its limited liability company agreement. Ultimately, if the deadlock cannot be remedied through a legal mechanism set forth within the four corners of the operating agreement, dissolution becomes the only remedy available as a matter of law. [Quotations omitted.]
Chancellor Bouchard found that “[u]nderlying the rupture in their relationship, Aigner, DiFalco, and Shah have been at loggerheads” over three “issues of fundamental importance to the Company and its future”: (1) who IDS should partner with to develop new products; (2) which pharmaceutical manufacturer to use; and (3) whether IDS should employ its own sales force to market its products.
The court concluded that, based on the parties’ “vehement” disagreement on issues “critical to the Company’s management and business strategy,” and the “Veto Rights that apply by default to any action of the Board and consent rights that apply to officer-level decisions,” dissolution is a “foregone conclusion” unless the deadlock resolution provision “provides a viable mechanism to make it reasonably practicable to carry on the business of the Company.”
A Flawed Deadlock Resolution Provision
As explained beginning at page 75 of the opinion, the ability to overcome the deadlock created by the veto power given the members as to board and officer action turned on the competing interpretations of the conflict of interest provision in Section 5.14(b) of the LLC agreement.
Chancellor Bouchard found “two aspects of Section 5.14(b) that appear to be the root cause of the problems with its application.”
First, the provision “does not specifically address who decides when the Independent Representative must step in to vote for an Interested Manager.” Second, “the scope of the provision is inherently vague and ambiguous.”
Who Decides? Section 5.14(b)(i) provides that a manager “with a conflict of interest concerning an Affiliate Transaction . . . shall disclose the conflict of interest to the Board . . ..” Section 5.14(b)(ii) names the Independent Representatives for each of Aigner, DiFalco and Shah and empowers them to vote when there’s a conflict of interest concerning an Affiliate Transaction. DiFalco, who never disclosed any such conflict and claimed there was none, argued that the provision is not triggered “unless a manager steps forward to acknowledge” that he has a conflict, and that such disclosure is a precondition to bringing in the Independent Representative to vote in the member-manager’s place. Aigner argued that the provision requires an objective standard not dependent on whether the manager discloses a conflict of interest.
Chancellor Bouchard wrestled with shortcomings in both interpretations — DiFalco’s, because “its utility depends on the good faith of the manager to identify a conflict of interest”; Aigner’s, because it reads the disclosure requirement out of Section 5.14(b)(i) “by letting any manager unilaterally invoke the Independent Representative provision in Section 5.14(b)(ii)” — but ultimately sided with DiFalco’s interpretation as “the only textually reasonable one.” In short, no disclosure by the manager of a conflict of interest → no appointment of an Independent Representative to vote in lieu of the manager → no opportunity to break deadlock.
Scope of the Provision. Section 15.4(b)(i) does not define “conflict of interest.” As described in the opinion, it does define “Affiliate Transaction” in four subparts, “two of which appear to encompass potential conflicts of interest, i.e., those that ‘could impact’ certain arrangements or other transactions.” The question for Chancellor Bouchard was whether “conflict of interest” was limited to actual conflicts of interest or also includes potential conflicts. After noting that the drafting history of the provision “shows that Aigner sought to broaden the provision to cover potential conflicts” but that the broader definition ultimately was dropped, Chancellor Bouchard concluded that he
cannot discern from the plain language of Section 5.14(b) or its drafting history whether the shared intention of the parties was that a manager would be an “Interested Manager” only if he had an actual conflict of interest or if he had either an actual or potential conflict of interest. Equally problematic, the court cannot discern what the outer boundary of the latter concept would be even if that was the shared intention given the inherent vagueness of the term “could impact.”
“The bottom line,” the court added, “is that the scope of Section 5.14(b) is inherently vague and ambiguous,” thereby further enervating the LLC agreement’s deadlock resolution mechanism. Chancellor Bouchard then summed up:
[T]he past two years of their relationship demonstrates that Aigner and DiFalco do not trust each other, do not get along, and are deadlocked on issues critical to the Company. And, for the reasons discussed above, Section 5.14(b) provides no workable solution to these problems. To the contrary, by acting unilaterally to invoke the Independent Representative provision, and by exploiting the inherently ambiguous and vague scope of that provision in the process, Aigner has arrogated to himself virtually unfettered control over the Company’s management in contravention of the governance structure contemplated in the IDS Agreement. Given this reality, the court concludes that it is not reasonably practicable to carry on the business of the Company in conformity with the IDS Agreement.
Lowering the Boom on IDS
Having found deadlock, and having found no mechanism in the LLC agreement to resolve the deadlock, Chancellor Bouchard proceeded to order dissolution of IDS. In so doing, he rejected Aigner’s request for a court-appointed custodian with the power to vote as a tie-breaking manager in lieu of dissolution, for three reasons.
First, IDS’s LLC agreement contains no buy-sell provision or any other provision resolving deadlock when the mechanism in Section 5.14(b) fails to do so. Quoting from Chancery Court precedent, Chancellor Bouchard observed that LLCs are “creatures of contract” and the court “is in no position to redraft the LLC Agreement for these sophisticated and well-represented parties.”
Second, all attempts extending back more than two years to solve IDS’s governance problems had failed. Aigner had “single-handedly defeated one of those attempts” when he vetoed a resolution to drop veto rights and to enlarge the board from four to five managers. “The court has no confidence,” the Chancellor wrote, “that a reprise of that proposal in the form of a custodian with the power to vote as a tie-breaking manager would work now.”
Third, the “window of opportunity for the Company is rapidly closing because,” among other reasons, its patents are expiring, IDS has not entered into a product development agreement, and it has no “obvious source of financing for the $10 to $15 million necessary to obtain FDA approval for a new drug.” Under these circumstances, the Chancellor finished,
the court concludes that dissolution of the Company is the best and only realistic option to force the parties to find a solution where they have failed before, or, if they cannot, to yield value for them by selling the Company’s assets.
The Deadlock Conundrum. There’s a legitimate school of thought that business partners with co-equal authority are better off without a deadlock or tie-breaker mechanism; it forces them to reach a compromise solution without bringing in a third party who will side with one over the other, creating a “winner” and a “loser.” But when the company’s capital investment, financial stakes, and risk profile are high as with IDS, experienced transactional lawyers recognize the wisdom of including a deadlock-breaking mechanism when drafting a shareholders or operating agreement for a closely held entity with an evenly divided managing board. The failure of IDS’s deadlock mechanism may or may not ultimately bring about the company’s demise, but, as with every case involving a flawed agreement, the flaws exposed by Chancellor Bouchard will enable the masses of other transactional lawyers to avoid the same pitfalls when drafting agreements for their clients.