In re Carlisle Etcetera LLC: Delaware Court of Chancery Recognizes Theory of Equitable Dissolution of LLCs | Practical Law

In re Carlisle Etcetera LLC: Delaware Court of Chancery Recognizes Theory of Equitable Dissolution of LLCs | Practical Law

The Delaware Court of Chancery held in In re Carlisle Etcetera LLC that statutory dissolution under the Delaware Limited Liability Company Act is not the exclusive method for seeking dissolution of a Delaware LLC. The court held that it retains the authority to grant equitable dissolution, as in a case where the petitioner had not been formally admitted as a member of the LLC.

In re Carlisle Etcetera LLC: Delaware Court of Chancery Recognizes Theory of Equitable Dissolution of LLCs

by Practical Law Corporate & Securities
Published on 05 May 2015 • Delaware
The Delaware Court of Chancery held in In re Carlisle Etcetera LLC that statutory dissolution under the Delaware Limited Liability Company Act is not the exclusive method for seeking dissolution of a Delaware LLC. The court held that it retains the authority to grant equitable dissolution, as in a case where the petitioner had not been formally admitted as a member of the LLC.
On April 30, 2015, the Delaware Court of Chancery ruled that the Delaware Limited Liability Company Act's conditions for seeking judicial dissolution of a Delaware LLC are not exclusive and do not override the court's equitable authority to order dissolution of an LLC. As a result of its recognition of equitable dissolution, the Court denied a motion to dismiss a petition for dissolution despite the fact that the petitioner was not authorized to bring the petition under the statute (In re Carlisle Etcetera LLC, C.A. No. 10280-VCL, (Del. Ch. Apr. 30, 2015)).

Background

The case arose from a petition brought by a would-be member to dissolve a joint venture LLC. Carlisle Etcetera LLC was formed in 2012 by The Royal Spirit Group and Tom James Company for the purpose of acquiring a retailer business that was near bankruptcy. Royal Spirit, headquartered in Hong Kong, formed Well Union Capital Limited, also a Hong Kong entity ("WU Parent"), as the vehicle that would be the member of the LLC. At formation of the LLC, WU Parent and Tom James signed a rudimentary LLC agreement with the intention of replacing it with a more detailed version. The initial LLC agreement contemplated a manager-managed LLC in which a board of four non-member managers would manage the company. Each of WU Parent and Tom James appointed two individuals to the board, with the Tom James representative acting as the CEO of the company.
Soon after the formation of the LLC, Royal Spirit realized that it would be better served for tax purposes to have its interest held in a US-domiciled entity. Royal Spirit communicated its desire to switch holding companies to Tom James, which had no objections. On this understanding, WU Parent transferred its interest in the LLC to a wholly owned subsidiary called Well Union U.S. Holdings, Inc. ("WU Sub"). From then on, the LLC identified WU Sub as the holder of a 50% member interest in its tax filings, while the LLC's accountants identified WU Sub as "an equal member of the Company." The drafts of the more detailed LLC agreement also referred to WU Sub as a member.
Although the transfer was effective and the members and the LLC referred to WU Sub as a member, none of the parties ever took any formal action to admit WU Sub as a member. The members never voted on the admission, nor did WU Sub sign a joinder agreement. The draft LLC agreement stated that if an initial member were to transfer its membership interest to a wholly owned affiliate, the affiliate would be admitted automatically as a member. The draft, however, was never signed by the members, while the initial LLC agreement was silent on assignment of membership interests.
The relationship between Royal Spirit and Tom James eventually deteriorated to the point that it became impracticable to continue operating the company. The two members tried to work out a procedure for one member to buy out the interest of the other, but did not reach an agreement. At one point during the negotiations, Tom James told Royal Spirit that if a deal could not be worked out, Royal Spirit would be stuck because Tom James could perpetuate the deadlock and continue operating the company through the CEO.
In October 2014, WU Sub filed a petition seeking judicial dissolution of the company because of deadlock at the member and manager levels. Tom James moved to dismiss on the grounds that WU Sub was not a member of the LLC and therefore lacked standing to seek judicial dissolution under Section 18-802 of the Delaware LLC Act (6 Del. C. § 18-802). WU Sub amended its petition to add WU Parent as a co-petitioner, but Tom James renewed its motion to dismiss on the grounds that WU Parent was no longer a member in light of its transfer.

Outcome

The Delaware Court of Chancery denied the motion to dismiss and allowed the petition for dissolution to survive. The court acknowledged that the Royal Spirit entities did not have standing to seek statutory dissolution under Section 18-802, but held that WU Sub did have standing to seek dissolution in equity.

WU Parent and WU Sub Could Not Seek Statutory Dissolution

As discussed in Standard Document, LLC Agreement (Multi-member, Board-Managed)(Private Equity Buyout): Drafting Note: Judicial Dissolution, Section 18-802 of the LLC Act authorizes members and managers to petition the Delaware Court of Chancery for judicial dissolution of the LLC. On this basis alone, Tom James would deserve to have its motion granted, because neither WU Sub nor WU Parent were members of the LLC when they brought the petition.
WU Parent was a member of the company, but was no longer a member once it assigned its interest to WU Sub. Under Section 18-702(a) of the LLC Act, a membership interest is assignable unless otherwise provided in the LLC agreement (6 Del. C. § 18-702(a)). The initial LLC Agreement was silent on assignability, which made WU Parent's interest freely assignable. WU Parent lost its status as a member of the LLC when it assigned its entire interest in the LLC to WU Sub, because under Section 18-702(b)(3) of the LLC Act, a member ceases to be a member (unless the LLC agreement provides otherwise) once it assigns its entire membership interest (6 Del. C. § 18-702(b)(3)).
Under the LLC Act, WU Sub was never a member of the company. Section 18-702(b)(1) of the LLC Act provides explicitly that, unless otherwise provided in the LLC agreement, an assignment of a membership interest does not entitle the assignee to automatically become a member (6 Del. C. § 18-702(b)(1)). Though the parties had intended for their eventual LLC agreement to provide for automatic admission, they never signed the more detailed agreement.
If the LLC agreement does not provide for automatic admission, the assignee can still be admitted as a member under Section 18-702(a) of the LLC Act on the affirmative vote or written consent of all of the members of the LLC (6 Del. C. § 18-702(a)). But no such vote or written consent ever took place at Carlisle Etcetera LLC.
WU Sub attempted to find an alternative statutory path to membership as a de facto member of the company. This argument was based on a reading of Section 18-301(b)(1) of the LLC Act, which speaks of "permitted admission [that] is reflected in the records of the limited liability company" (6 Del. C. § 18-301(b)(1)). However, the Court read that section of the statute as distinguishing between the act of admitting a member and the point when that admission becomes effective. The member must first be admitted through the vote or consent of the members and, after that, the admission becomes effective when it is reflected in the records of the company. The records of the company are not enough to establish admission with no prior formal acts of admission. The reason for this default rule (which can always be modified in the LLC agreement) is a notion that one is generally entitled to select his own business associates in a closely held enterprise like an LLC.

The Court of Chancery Can Order Equitable Dissolution

Although Tom James prevailed on its reading of the conditions for statutory dissolution, the Court held that Section 18-802 is not the exclusive extra-contractual means of obtaining dissolution of an LLC. Under the facts of this case, the Court held, WU Sub had standing to seek dissolution in equity.
To support its view that it has jurisdiction to grant a petition for dissolution in spite of the petitioners' lack of standing for statutory dissolution, the Court embarked on a detailed review of the common-law underpinnings for its equitable powers in general and over LLC dissolution in particular.
The Court began with a simple observation that Section 18-802 does not state that it establishes an exclusive means to obtain dissolution. However, the Court continued, if Section 18-802 did purport to provide the exclusive method of dissolving an LLC, it would be divesting the Court of a significant aspect of its traditional equitable jurisdiction. The Court stated that the validity of that aspect of the provision would raise serious Delaware constitutional questions. To buttress that contention, the Court went on to review the origins and extent of its powers in equity, which, it explained, are measured by the equity jurisdiction of the High Court of Chancery of Great Britain as it existed prior to the separation of the colonies from Britain.
The Court then addressed the argument that the recognized right of members to contractually waive their right to statutory dissolution (see R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, , at *4 (Del. Ch. Aug. 19, 2008)) must mean that equitable dissolution is unavailable. The Court held that the ability to waive dissolution under Section 18-802 does not extend to a party's standing to seek dissolution in equity. In the Court's view, the decision in R&R Capital relied heavily on arguments to the effect that Delaware LLCs should be viewed as purely contractual entities to which principles of equity (including fiduciary duties) do not apply. However, the Court here held that the amendments to the LLC Act passed in 2013, which confirmed that default fiduciary duties are owed in LLCs unless otherwise waived in the LLC agreement (see 6 Del. C. § 18-1104), amounted to a legislative declaration that Delaware law does not adhere to the purely contractarian view of LLCs.
The Court went on to describe this theory of equitable involvement in LLCs. The purely contractarian view, the Court explained, discounts core attributes of the LLC that only the state can authorize, such as its separate legal existence, potentially perpetual life and limited liability for its members. Once the state makes attributes available to an entity that contracting parties cannot grant themselves by agreement, the entity is not purely contractual. Furthermore, because the entity has taken advantage of benefits that the state has provided, the state retains an interest in that entity. That interest in turn calls for preserving the ability of the courts to oversee and, if necessary, dissolve the entity.

WU Sub Could Seek Equitable Dissolution

Having explained why the Court of Chancery retains an equitable interest in LLCs, the Court here held that this case presented the type of situation where equity should intervene. If the opportunities for dissolution were to be limited to Section 18-802 and the specific terms of the initial LLC agreement, then dissolution would not be an option. This would result in the company continuing under Tom James's management, with Royal Spirit locked in as a powerless passive investor. That situation would be contrary to the bargain the parties struck. WU Parent and Tom James formed the company as equal business partners who contributed equal amounts of capital and brought comparable expertise. Desiring to move quickly, they agreed to start with a basic operating agreement in which they committed to negotiate a more detailed replacement agreement. As reflected in the more detailed draft LLC agreement, the parties contemplated that an affiliate transfer from WU Parent to WU Sub would result in the automatic admission of WU Sub as a substitute member. Had the parties finalized the proposed agreement, or acted in accordance with their agreement with a formal vote, then WU Sub would have been a member and had standing to seek dissolution under Section 18-802.
WU Parent engaged in the affiliate transfer with Tom James's knowledge and participation, and Tom James subsequently treated WU Sub as a member. The real relationship between the parties was a joint venture in which they were equal participants. Neither party intended to be a passive investor subject to the other member's unilateral dominion. "In good conscience," the Court said, "WU Sub should be regarded as a member with the power to seek dissolution." The Court therefore denied Tom James's motion to dismiss.

Practical Implications

By recognizing the theory of equitable dissolution of LLCs under Delaware law, the Court of Chancery has provided a method for members to seek dissolution when their failure to adhere to the technical requirements of the statute would otherwise make dissolution impossible.
Ideally, this state of affairs, in which the LLC agreement leaves the membership of the company unclear, should never arise. For example, Practical Law's form LLC agreement for a joint venture makes clear that a new member is not admitted to the company, even after a transfer of LLC units to it, until it signs a joinder agreement (see Standard Document, LLC Agreement (Two Member, Managing Member-Managed): Section 4.01(b)). Even Practical Law's simple form for a single-member LLC agreement states explicitly that a new member is only admitted with the consent of the initial member, the amendment of the LLC agreement and the execution of a counterpart to the agreement by the new member (see Standard Document, LLC Agreement (Single Member): Section 4(b)). By contrast, the situation in Carlisle Etcetera arose because the parties' initial LLC agreement did not contain even the most basic provisions for admission of new members.
However, in real-life business settings, parties sometimes fail to follow up with legal formalities until it is too late. For these situations, the Carlisle Etcetera decision confirms that the parties have a safety valve in equity and will not remain bound to each other just because statutory dissolution is unavailable.
Beyond dissolution of LLCs, the Court's detailed analysis of its powers in equity ought to apply to other areas of LLC and corporate law as well. In any situation in which a party acted by mistake or failed to adhere to a statute's technical requirements, the Court could find an avenue to forgive the error as a matter of equity. This opening will not always be available—certain statutes (for example, the appraisal statute) are quite clear about their technical procedures, and the Court has been adamant that it will not ignore explicit statutory requirements. However, if the statute can be read as providing a non-exclusive means to accomplish an action, the Court can hold that its equitable powers are reserved for it to exercise when appropriate.