Thursday, December 12, 2013

Delaware Chancery Court Addresses Status as a Member of LLC, “Corporate” Opportunity Doctrine and Breach of Fiduciary Duty

Delaware Chancery Court Addresses Status as a Member of LLC,
“Corporate” Opportunity Doctrine and Breach of Fiduciary Duty

      A Delaware Chancery Court decision from this summer addresses an all too common situation, namely the break down in an equally-owned LLC with each of the opposing sides then seeking to protect what they think to be their rights.  Grove v. Brown, 2013 WL 4040495 (Del. Ch. Aug. 8, 2013).
      Marlene and Larry Grove entered into an operating agreement with Melba and Hubert Brown for Heartfelt Home Health, LLC, a Delaware limited liability company.  The operating agreement provided that each would be a 25% member and that each was obligated to make a $10,000 contribution to the LLC.  While the business was initially successful, at the end of the first year, in the course of working on the tax returns, a dispute arose because neither Larry Grove nor Melba Brown had yet satisfied the full $10,000 capital contribution.  Ultimately, Melba would contribute the full $10,000 while Larry would contribute an additional $3,657, asserting that the balance was satisfied by furniture and equipment he contributed to the LLC.  The Browns contested that valuation.  As this dispute was simmering, Marlene Grove, even as she continued her employment with the LLC, formed a new Maryland LLC for the purpose of engaging in that jurisdiction in a similar line of business as that of Heartfelt.  The place of business of this new LLC was less than ten miles from that of Heartfelt, the original LLC.  Ultimately the Groves would form as well another Delaware LLC, it engaging in a similar line of work in Delaware as that undertake by Heartfelt.

      Ultimately, the Groves decided to sever their relationship from the Browns, requesting a buyout in the amount of $941,000.  In addition, they stated an intention, presumably in the alternative, to move for the dissolution and liquidation of Heartfelt.  In response, the Browns first suggested an independent appraisal of the company, which offer was rejected.  Thereafter, the Browns sought to merge the Heartfelt Home Health LLC into another company, freezing out the Groves, this action taken on the purported basis that they held a 63% interest in the company based upon the capital contributions actually made.  Under Delaware law, the merger of an LLC may be approved by the members holding more than 50% of the current interest in the profits of the LLC.  See Del. Code Ann. tit. 6, § 18-209(b).
      The first question analyzed by the Chancery Court was whether or not the Groves and the Browns were equal owners of the company or, as asserted by the Browns, they had a majority position based upon the capital contributions made.  The Court directed that “the ownership of Heartfelt is governed by the Operating Agreement, which identifies Hubert Brown, Melba Brown, Larry Grove and Marlene Grove as the sole members of the LLC.”  2013 WL 4041495, *5.  The Court went on to note that the Operating Agreement provided that each of the four members had a capital interest of $10,000, and that “the Operating Agreement further provides that the profits and losses shall be divided among the members ‘in proportion to each Member [sic] relative capital interest in the company’.”  Id.  From there, the Court found that:
Nothing in the Operating Agreement indicates that the allocation of relative ownership interests was contingent on the Member’s actions post-signing.  Though the Operating Agreement imposes an obligation on the Members to provide capital to Heartfelt, the Operating Agreement does not provided that one member’s failure to do so divests that Member of his or her share of the company.  2013 WL 4041495, *5.   

      In that the Operating Agreement said that each of the four was an equal 25% member of the company, the Browns were 50% owners of Heartfelt, not 63% owners based upon a greater capital contribution to the company.  As such, “the purported merger transaction, in which Heartfelt merged into a company wholly owned by the Browns was a legal nullity” in that the Browns “never owned more that 50% of Heartfelt.”  2013 WL 4041495, *7.  
      Although obviously in dicta, with respect to the suggestion that  the supposed threat from the Groves to dissolve Heartfelt justified the Brown’s action in effecting the merger, the Court noted that “tit for tat is not a justification for breach for fiduciary duty under Delaware law,” and that there was no threat of dissolution in that the Groves, as 50% members, had no authority to unilaterally dissolve the company. 
      The Court then turned its attention to the breach of fiduciary duty and the usurpation of business opportunities, by Marlene and Larry Grove in setting up the LLCs that were engaged in the same line of business as Heartfelt.  Finding that both Marlene and Larry owed fiduciary duties to the LLC and the other members {note that the Delaware LLC Act, unlike the Kentucky LLC Act, does not define either what are the fiduciary duties owed by the members or to whom they are owed; rather, those duties have been developed primarily through case law and only in 2013 enacted, in at best skeletal form, into the Delaware LLC Act.  This is in contrast to the Kentucky LLC Act, which at KRS § 275.170 defines who owes fiduciary duties, to whom the duties are owed and what those duties are}, the Court reviewed Delaware law on business opportunity and determined that the companies set up by Marlene and Larry Grove in competition with Heartfelt constituted a breach of fiduciary duty.  With respect to that issue, the Court found much of the testimony to be not credible and focused on the fact that there was no “express grant of permission” from the LLC for Marlene Grove to open those other companies.  Highlighting as well the legal separation between an LLC and its members, the Court wrote:
It is unclear to what extent Marlene’s testimony, even if I accepted it as true, supports a finding that Heartfelt waived a corporate opportunity.  Marlene did not testify she presented the opportunity to expand to nearby markets to Heartfelt; she avers that she invited the Browns in their individual capacity to join her in creating new, competing entities.  Presenting an opportunity to the Browns is not the same as presenting an opportunity to Heartfelt….  In any event, as mentioned above, the Groves had the burden of proving that they had the right to pursue the opportunities which would otherwise belong to Heartfelt.  I find that they failed to meet that burden.  2013 WL 40414945, *10.
      Finding that all of the parties had engaged in some inappropriate conduct, the Court ordered that all of them account to the Heartfelt LLC for any profits they have derived that should have been earned by and paid to it, and invited the parties to come to an agreement with respect to dissolution of the company.

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