Delaware Contractarian Principles Prevail in Appeal Over Deceased Ace Hotel Founder’s LLC Interest
December 26, 2017
The sudden death of Alexander Calderwood, the brilliant but troubled co-founder of the Ace brand of hotels, resulted in some fierce litigation between Calderwood’s estate and Calderwood’s LLC co-member over the nature of his estate’s membership interest in the company after his death. The litigation came to a head earlier this month, when Justice Barbara R. Kapnick issued a scholarly decision for a unanimous panel of the Appellate Division, First Department in Estate of Calderwood v ACE Group Int’l, LLC, 2017 NY Slip Op 08750 [1st Dept Dec. 14, 2017].
Boiled down, the question on appeal was whether, under Delaware law, Calderwood’s estate was a bona fide member of the LLC with all of a member’s associated rights and privileges, or instead, a mere assignee of Calderwood’s membership interest. As written about in a post last Spring (read here), New York County Commercial Division Justice Shirley Werner Kornreich issued a decision dismissing most of the Estate’s amended complaint, holding that the Estate lacked membership status in the LLC upon Calderwood’s death. Let’s see how the appeals court considered the issue.
The Basic Facts
Calderwood co-founded Ace Hotels in Portland, Oregon in 1999. In 2011, he bought out his then-business partner funded in part by a $10 million investment from Ecoplace LLC, a entity controlled by Stefanos Economou. Calderwood and Ecoplace then formed ACE Group International LLC (AGI), with Ecoplace owning 33.33% and Calderwood originally owning 66.66% (he later transferred 14.92% of his interest to certain AGI executives, still leaving him with a majority interest).
AGI had a comprehensive written operating agreement including a Delaware choice-of-law provision. The appeal turned primarily on Section 9.7 (b) of the operating agreement, which stated:
Upon the death or disability of a Member (in the case of a Member who is an individual) . . . (the “Withdrawing Member”), the Withdrawing Member shall cease to be a Member of the Company and the other Members and the Board shall . . . have the right to treat such successor(s)-in-interest as assignee(s) of the Interest of the Withdrawing Member, with only such rights of an assignee of a limited liability company interest under the Act as are consistent with the other terms and provisions of this Agreement and with no other rights under this Agreement. Without limiting the generality of the foregoing, the successor(s)-in-interest of the Withdrawing Member shall only have the rights to Distributions provided in Sections 4 and 10.3, unless otherwise waived by the other Members in their sole discretion.
In November 2013, Calderwood died in one of his hotels without a will. A few months later, Ecoplace offered to buy the Estate’s entire ownership interest – 51.74% of AGI – for $200,000. In its buyout offer, Ecoplace explained its low valuation as based on the “fact that Ecoplace is entitled to receive its initial investment amount of $10,000,000” under section 4.1 of the operating agreement “before the Estate receives any such distributions,” and “we do not believe that the Estate will realize any sort of financial benefit from its ownership interest in the foreseeable future (if ever).”
Predictably, the Estate rejected Ecoplace’s lowball offer, suing for, among other claims: (i) a declaratory judgment that the Estate was a member of AGI; (ii) a declaratory judgment that Ecoplace owed the Estate fiduciary duties; (iii) an order requiring production of AGI’s books and records; (iv) an accounting of AGI; and (v) imposition of a constructive trust on Ecoplace’s membership interest in the company. All of the Estate’s claims were premised upon the Estate’s position that it “stepped into Alex’s shoes upon his death, and that it possesses all of his rights and privileges as a Member under the LLC Agreement.”
In response, Ecoplace argued that under section 9.7 (b) of the operating agreement, once Calderwood died, he became a “Withdrawing Member,” “cease[d] to be a Member of the Company,” and as a result, “the Estate is considered the successor in interest of a Withdrawing Member (Alex) with rights only to potential distributions, and no rights to control or participate in the running of the company.”
In its appeal, the Estate relied heavily upon Section 18-705 of the Delaware Limited Liability Company Act, governing the powers of the estate of a deceased member, which provides, using the same language found in Section 608 of the New York LLC Law:
If a member who is an individual dies . . . the member’s personal representative may exercise all of the member’s rights for the purpose of settling the member’s estate or administering the member’s property, including any power under a limited liability company agreement of an assignee to become a member.
According to the Estate, the Act’s provision is a “mandatory provision pursuant to which the personal representative of a deceased member may exercise all of the member’s rights, notwithstanding the limitations contained in the LLC Agreement.” As the First Department noted, “to bolster its argument that section 18-705 controls here, the Estate relie[d] on the lack of the phrase ‘unless otherwise provided in a limited liability company agreement’ in section 18-705 as evidence of its mandatory status.”
The First Department’s Holdings
Relying on three interrelated strands of Delaware law, the First Department thoroughly rejected the Estate’s argument that the operating agreement did not (or could not) modify the default rule of Section 18-705.
“First,” the Court held, “under the Act, the parties to an LLC agreement have substantial authority to shape their own affairs and . . . in general, any conflict between the provisions of the Act and an LLC agreement will be resolved in favor of the LLC agreement” (quotation omitted).
“Second,” the Court held, “the LLC Act’s primary function is to fill gaps, if any, in a limited liability company agreement,” but a “gap-filling provision is not required here because the LLC Agreement specifically addresses the exact situation in which the parties currently find themselves” (quotation omitted).
Third, the Court held that the Estate’s heavy reliance upon section 18-705’s omission of the talismanic words, “unless otherwise provided in a limited liability company agreement,” as purported evidence of the default rule’s “mandatory status” has “already been considered and rejected by the Delaware courts” (citing, among other cases, Elf Atochem North America, Inc. v Jaffari, 727 A2d 286, 291 [Del 1999] [holding that the Delaware LLC Act “is replete with fundamental provisions made subject to modification in the Agreement (e.g. unless otherwise provided in a limited liability agreement . . .)”]).
Based upon these clear principles of Delaware law, the Court affirmed Justice Kornreich’s dismissal of the Estate’s amended complaint, including its claims for declaratory judgment, for an order compelling production of AGI’s books and records, for an accounting, and for the imposition of a constructive trust. At the conclusion of the opinion, the Court declared that the Estate was “not a member of AGI with all the rights that the decedent held under AGI’s LLC Agreement,” and further declared that defendants “do not owe fiduciary duties” to the Estate. In other words, the Estate was a mere assignee of Calderwood’s former membership interest in AGI.
Forewarned is Forearmed
In 2011, when the young Calderwood entered into AGI’s operating agreement with Ecoplace, he no doubt considered his death a remote prospect. Two years later, the unimaginable happened, triggering contract provisions he may never have carefully considered.
Calderwood is just another reminder that with LLCs in general, and Delaware-law-governed LLCs in particular, the express terms of the operating agreement almost invariably triumph over so-called “default rule” provisions of the LLC statutes, even when the outcome may, at least superficially, seem somewhat unfair. As Calderwood and countless other cases on this blog counsel, if you are considering entering into an operating agreement, best have that agreement carefully reviewed by a lawyer. Get to know your operating agreement before you sign it. Failure to do so will not be an excuse, for the general principle is that parties are free to enter into any contract they wish, and the courts will enforce the contract as written.