More on Corporification

More on Corporification

      “Corporification” is the term, invented I believe by Steve Frost, to describe the incorporation (pun intended) into limited liability companies of concepts and principles that have arisen in the context of corporations. Oftentimes the utilization of concepts developed initially in corporate law into an LLC leads to either confusing or unintended consequences as there exist ambiguity as to the degree to which corporate law is intended to be incorporated. A recent case out of Delaware provides a clear illustration of these problems. Obeid v. Hogan, No. 11900-V CL, 2016 BL 185285 (Del. Ch. June 10, 2016).

       This dispute arose out of a pair of limited liability companies, Gemini Equity Partners, LLC and Gemini Real Estate Advisors, LLC. Each of these LLC was owned one third by plaintiff William T. Obeid, one-third by Christopher S. La Mack and one-third by Dante Massaro. Between the two LLCs, they held in excess of 1 billion in real estate assets, including 11 hotels and 22 commercial properties. Prior to the disputes addressed in this litigation, Obeid managed the hotel properties while the La Mack and Massaro managed the commercial properties. The defendant Hogan is a retired federal judge who was retained to serve as the special litigation committee on behalf of each of the LLCs; La Mack and Massaro were not parties to this action. The court throughout referred to Gemini Equity Partners, LLC as the “Corporate LLC” while referring to Gemini Real Estate Advisors, LLC as the "Manager-Managed LLC."

      The Corporate LLC, organized in Delaware, utilized a board of directors comprised of a Obeid, La Mack and Massaro through July, 2014, at which time the La Mack and Massaro removed Obeid. With respect to the Manager-Managed LLC, also organized in Delaware, each of Obeid, La Mack and Massaro served as a manager.

      On July 1, 2014, La Mack and Massaro voted to remove Obeid as the president of the Manager-Managed LLC, installing Massaro in his place. In effect, while Obeid remained a manager, Massaro took on day-to-day control of the Manager-Managed LLC. After a flurry of litigation ranging from North Carolina to federal and state courts in New York, the Corporate LLC and the Manager-Managed LLC, under the control of the La Mack and Massaro, hired the Brewer firm to serve as outside counsel. One of its recommendations was that a retired federal judge be hired to serve as a special litigation counsel to respond to a derivative action filed with respect to each of the LLCs in New York. After a meeting at which no formal resolutions were adopted, the Brewer firm circulated the names of two retired federal judges it had identified as being appropriate to serve as the special litigation committee. Hogan, one of those judges, was ultimately retained pursuant to an engagement letter signed by La Mack and Massaro to serve in that role. Crucially for the outcome of this decision, Hogan was not appointed a director of the Corporate LLC nor appointed a manager of the Manager-Managed LLC. Upon learning that Hogan had been so retained, Obeid filed this action in Delaware seeking a determination that Hogan could not act as special litigation committee on behalf of either LLC or otherwise take any action with respect to the derivative suit. In addition, Obeid sought a declaratory judgment that his removal as a director of the Corporate LLC was invalid.

      With respect to Hogan’s service as the special litigation committee for the Corporate LLC, after setting forth its ultimate conclusion that he could not do so, the court began its analysis with a telling section heading, namely “The Implications Of Mimicking A Corporation's Governance Structure.” From there it observed that LLCs may design their inter-see management structure as they see fit, citing Robert L. Symonds, Jr. & Matthew J. O’Toole, Delaware Limited Liability Companies § 9.01[B] at 9-9 (2015) for the principle that “Virtually any management structure may be implemented through the company’s governing instrument.” From there the Court wrote:

Using the contractual freedom that the LLC Act bestows, the drafters of an LLC agreement can create an LLC with bespoke governance features or design an LLC that mimics the governance features of another familiar type of entity. The choices that the drafters make have consequences. If the drafters have embraced the statutory default rule of a member-managed governance arrangement, which has strong functional and historical ties to the general partnership (albeit with limited liability for the members), the parties should expect the court to draw analogies to partnership law. If the drafters have opted for a single managing member with other generally passive, non-managing members, a structure closely resembling and often used as an alternative to a limited partnership, then the parties should expect a court to draw analogies to limited partnership law. If the drafters have opted for a manager-managed entity, created a board of directors, and adopted other corporate features, then the parties to the agreement should expect a court to draw on analogies to corporate law. Depending on the terms of the agreement, analogies to other legal relationships may also be informative. (citation and footnotes omitted).

      While going on to recognize that there are limitations in drawing analogies between LLCs and other organizational forms, the Court, citing Elf Autochem, 727A.2d at 293, observed that “the derivative suit is a corporate concept grafted onto the limited liability company form.”, leading the conclusion that “absent other convincing considerations, case law governing corporate derivative suits is generally applicable to suits on behalf of an LLC.” (footnote omitted).

      Having determined that the corporate law governing special litigation committees in derivative actions would be applicable to the corporate LLC, the Chancery Court turned its attention to the Zapata Corp. v Maldonado, 43 A.2d 779 (Del. 1981) decision.

      After an extensive review of the Zapata decision and the role of the special litigation committee, the Court noted an absence of situations in which the special litigation committee was comprised of non-directors, observing that as derivative litigation does not fall into the ordinary course, these matters would, in the corporate context, need to be resolved by the board. It was observed that:

A board may not make a similarly complete delegation to an officer or a non-director. Doing so would risk an improper abdication of authority. Hence the requirement exists that a Zapata committee be made up of directors.

From there was ultimately concluded:

Judge Hogan is not a director of the Corporate LLC. Consequently, under the Corporate LLC Agreement, he cannot function as a one-man special litigation committee on behalf of the Corporate LLC.

      Turning to the Manager-Managed LLC, even as the Court acknowledged it was not utilizing a board of director management model, it was concluded that the manager-managed system employed was sufficiently analogous to a board structure to justify the application of Zapata and the ultimate determination that Hogan could not, with respect to that LLC, serve as a special litigation committee. “In my view, the resulting structure is sufficient to cause the reasoning that governed the Corporate LLC to apply equally to the Manager-Managed LLC.”

      The court had little problem, applying the operating agreement and the Delaware LLC Act, to find that Obeid's removal as a director was permissible.

      Which brings us back to Corporification. The drafter of the limited liability company agreement for the Corporate LLC wrote into the document significant aspects of the laws of corporate derivative actions. From that utilization, the Chancery Court assumed that the entire body of law governing derivative actions, including that developed exclusively through court decisions, was intended to be applied in the context of this LLC. In effect, the Court read into the express terms of the LLC agreement the common-law penumbra of derivative actions. Whether that is what was actually intended by the drafter is unknown. Were they intending that the common law of derivative actions be incorporated by a deemed incorporation by reference, or rather where they intending that only so much of that law as was set forth in the agreement would apply? Curiously, the Court did not reference the terms of the merger clause of either LLC agreement.

      Regardless, this decision well highlight the perils of utilizing in an LLC agreement principles developed under corporate law. Absent particularly careful drafting, concepts not intended to be applied with respect to that LLC may be found applicable.