Delaware Ruling Highlights Difference With New York Over Amending LLC Agreements
May 22, 2017
The common perception among practitioners familiar with the business entity laws of New York and Delaware is that Delaware law generally is friendlier to, and more protective of, majority ownership and management interests.
Two recent cases — one from each state — highlight at least one important area where the common perception does not apply: majority rights under the statutory default rules to adopt or amend an LLC operating agreement without the consent of all the members.
The difference between the two states can have critical consequences for both majority and minority members of the many LLCs that, for better or worse, are formed without a written operating agreement.
The New York case is one I previously wrote about on this blog. Last January, in Shapiro v Ettenson, the Appellate Division, First Department, in a case involving a three-member LLC that was formed without a written operating agreement, affirmed a lower court’s decision construing Section 402 (c) (3) of the New York LLC Law (“except as provided in the operating agreement . . . the vote of a majority in interest of the members entitled to vote thereon shall be required to . . . adopt, amend, restate or revoke the articles of organization or operating agreement”) to permit the two-member majority to adopt a written operating agreement almost two years after the LLC was formed and began operating, without the third member’s consent and notwithstanding certain provisions in the agreement that modified the statutory default rules adversely to the third member.
In my write-up of the Shapiro decision, I likened it to an “alarm bell” for minority members of New York LLCs that have no operating agreement and for anyone considering becoming a minority member of an LLC without first having in place an operating agreement. I also commented that Shapiro widens the prospects for encroachment upon minority member interests by negating the non-mandatory default protections in the New York LLC Law.
VC Laster’s Transcript Ruling in Gerlanc v Beatrice
A recent transcript ruling by Vice Chancellor Travis Laster of the Delaware Court of Chancery in Gerlanc v Beatrice, CA No. 2017-0211-JTL (Mar. 23, 2017), reaches the opposite result on similar facts due to key differences in Delaware’s LLC Act.
The transcript ruling makes for a fascinating read even if you’re not interested in the law of LLCs. VC Laster is known for his scholarship, his erudite and expertly-crafted legal opinions, his wit, his practical approach to dispute resolution, and, perhaps above all, for being a straight shooter. Read the full Gerlanc transcript and you’ll see his marksmanship on display in the course of a telephonic conference last March with the parties’ counsel, in which he deftly and relentlessly employs blunt logic with a touch of sarcasm to eviscerate the arguments of defense counsel who put up brave resistance but ultimately was forced to succumb.
As reported by Law360, Gerlanc is the second of two lawsuits among the three-members of Barrell Craft Spirits LLC which operates a distillery producing bourbon, whiskey, and rum. In the first lawsuit, the plaintiff minority member demanded access to the member-managed LLC’s books and records. The two majority members reportedly acquiesced to the demand but then, according to the complaint in the second lawsuit, improperly amended their “oral and implied” agreement to be governed by the LLC Act’s default rules, by adopting a new, written operating agreement without his knowledge or consent which appointed the 72.5% member as manager and authorized the issuance of additional membership interests, thereby threatening to dilute the plaintiff’s 7.5% interest. The additional LLC units, in the form of convertible notes, were intended to raise capital from outside investors.
The complaint’s reference to the alleged “oral and implied” LLC agreement may sound funny to New York practitioners familiar with Section 102 (u) of the New York LLC Law defining an operating agreement as “any written agreement of the members concerning the business of a limited liability company and the conduct of its affairs” (emphasis added). In the Shapiro case, New York’s requirement of a written LLC agreement doomed the plaintiff’s contention that the defendant majority members’ subsequent adoption of a written agreement without his consent improperly amended the members’ oral understandings reached at the LLC’s inception that guaranteed equal treatment of the LLC’s three members.
Not so under Section 18-101 (7) of the Delaware LLC Act which defines an LLC agreement as “any agreement . . . written, oral or implied, of the member or members as to the affairs of a limited liability company and the conduct of its business” (emphasis added). The section goes a step further, providing that an LLC member “is bound by the limited liability company agreement whether or not the member or manager or assignee executes the limited liability company agreement.”
Those provisions, together with Section 18-302 (f) of the Delaware LLC Act which, in contrast to Section 402 (c) (3) of the New York LLC Law as construed in Shapiro, requires “the approval of all of the members” to amend the LLC agreement unless otherwise provided in an existing agreement, created an insuperable barrier for the defendants in Gerlanc when their counsel attempted to defend the written operating agreement adopted without the plaintiff’s consent.
Defense counsel’s arguments initially concentrated on challenging the plaintiff’s motives in bringing suit, the resultant expense to the LLC, and the LLC’s need to raise capital to grow its operations. VC Laster pushed back hard, for instance at page 13 of the transcript where he admonished defense counsel, “Look, as long as you’re impugning the guy, why not impugn him as many ways as possible,” and “you haven’t actually gotten to anything relevant to this application yet. All you’ve done is given me three or four reasons why this guy is supposedly a bad guy.”
Defense counsel’s argument on the merits fared no better. Essentially, the argument went, since the complaint didn’t explicitly allege an oral or implied agreement giving each member a veto right over future financing transactions, the majority members could adopt a new agreement providing a mechanism for attracting outside investors involving the issuance of new membership units. In response, VC Laster forcefully deconstructed counsel’s cramped reading of the complaint which, he noted, plainly alleged an oral or implied agreement to be governed by the LLC Act’s default rules, and he reframed the issue simply as whether, in a member-managed LLC, “where all of the units have been allocated, the dominant member can just create new units and issue them without an amendment to the agreement?” In answer to his own question, VC Laster explained:
You have to do an amendment to do something major like shift people’s ownership percentage or pump out new units, which has the same effect, because that’s the default rule under the statute. And you need unanimous consent to do that because that’s the default rule under the statute. . . . [¶] The point is they agreed to the default provisions of the Act, either consciously or by not doing this, but just sort of going forward with the LLC, which, again, like, start-up ventures, I think it’s highly likely. And that was — that may well have been a sensible risk-adjusted decision at the time not to spend money for a fully worked agreement that would contemplate all these things, because everybody’s in a start-up mode and everybody’s getting along and everybody’s trying to work together. But when the risk actually comes home, you don’t get to go back and pretend that you did something different. And none of the things that you and your clients have pointed to as suggesting that they did something different actually support the inference that they did something different.
In the end, VC Laster granted the plaintiff’s motion to expedite and directed counsel to prepare and submit a status quo order. But speaking of straight shooting, he didn’t stop there. First, he made it plain that, based on the defendants’ “minimal showing,” if asked he would grant summary judgment on plaintiff’s claim for a mandatory injunction prohibiting new membership units from being issued without plaintiff’s consent.
Second, he warned both sides that continuing to litigate would only intensify the parties’ dislike for each other “[s]o none of this ends up being good for anybody in this setting” including the plaintiff whom, the judge noted, “ought to think about what he can really get out of a small start-up entity and whether there’s really any value for him in fighting this litigation . . ..” He also counseled that the litigation “gives you a concrete lens through which to focus on resolving these people’s relationship” and that,
if that means that you guys do negotiate an agreement that has some protections for minority shareholders like [plaintiff] and his friends who invested, great. Do it. That’s the path out of this. If this means [defendants] buy out [plaintiff] and his friends so that they can do whatever they want, great. That’s another path out of this. [¶] What is unlikely to be the path out of this is [for defendants] to claim, unless you have really good contemporaneous documents to back yourself up, that really when you started this entity, you effectively had in your mind the equivalent of 39 pages of LLC agreement legalese.
VC Laster also endorsed as another possible factor in negotiating a solution — albeit a “heavy handed” one — defense counsel’s mention of his clients having default rights under the statute to cash-out the plaintiff by merger, commenting:
So maybe when you’re negotiating, [plaintiff] gets to have the high hand in terms of his ability to potentially win the current case, and [defendants] get to have the threat of potentially doing a merger to convert this into a money damages litigation. And maybe what people ought to do is say, “Wow, there’s mutual risk here, and what we really want to do is make good bourbon. So let’s figure out some protective provisions for the minority that lets us go forward and make good bourbon.” And that, I think, would actually be a good outcome and a better use of people’s time than litigation.
Like the judge said, “Wow.”