2009 Caiola Family Trust v. PWA, LLC: Chancery Court Confirms Limited Rights of Majority Non-managing Members | Practical Law

2009 Caiola Family Trust v. PWA, LLC: Chancery Court Confirms Limited Rights of Majority Non-managing Members | Practical Law

The Delaware Court of Chancery confirmed that the approval rights of an LLC's non-managing members, who held 90% of the company's membership interests, were to be read as veto rights, not as affirmative rights to require the managing member to take action.

2009 Caiola Family Trust v. PWA, LLC: Chancery Court Confirms Limited Rights of Majority Non-managing Members

by Practical Law Corporate & Securities
Published on 07 May 2014 • Delaware
The Delaware Court of Chancery confirmed that the approval rights of an LLC's non-managing members, who held 90% of the company's membership interests, were to be read as veto rights, not as affirmative rights to require the managing member to take action.
Operating agreements for LLCs formed to own and operate real estate investments frequently divide management and ownership between a managing member with a minority interest and majority-owning, non-managing members who have approval rights over major decisions. The Delaware Court of Chancery confirmed in 2009 Caiola Family Trust, et al. v. PWA, LLC, et al. that in the typical arrangement, the non-managing members cannot force the LLC to take action on a major decision, even if a majority of them has voted in favor of it, if the managing member has determined not to take that action (C.A. No. 8028-VCP (Del. Ch. Apr. 30, 2014)).

Background

Dunes Point West Associates, LLC was a Delaware LLC formed to own and operate a multifamily apartment complex in Kansas. The plaintiffs, a New Jersey trust named 2009 Caiola Family Trust and its trustee, were the non-managing members of Dunes Point and owned 90% of its total membership interests. The managing member of Dunes Point was a Kansas limited liability company named PWA, LLC that held the remaining 10% interest in Dunes Point. PWA's own managing member, an individual named Ward Katz, was also the sole owner of Dunes Residential Services, Inc., a Texas company (DRS). DRS managed the apartment complex under a property-management agreement with Dunes Point.
In July 2012, the non-managing members voted amongst themselves to terminate the management agreement and replace DRS as the property manager. PWA refused to terminate the agreement, which led the non-managing members to vote to replace PWA as managing member. After PWA declined to resign, the non-managing members brought claims for breach of contract against PWA and breach of fiduciary duty and waste against both PWA and Katz. The non-managing members also sought a declaratory judgment that their reading of the operating agreement was correct, entitling them to vote to terminate the management agreement, replace the property manager and remove PWA as managing member for its refusal to carry out those actions.
The Dunes Point operating agreement provided in Section 6.1 that the managing member had primary managerial authority. It stated that:
"Except as otherwise provided in this Agreement and subject to Section 8.4, the Managing Member shall have sole and exclusive control over the Company and the power and authority to take such actions from time to time as the Managing Member may deem to be necessary, appropriate or convenient in connection with the management and conduct of the business and affairs of the Company."
Section 6.1 added that the managing member had the authority to execute all agreements on behalf of the company, while Section 8.2 added that, except as otherwise provided in the agreement (such as under Section 8.4), the managing member had all of the rights and powers granted to a manager under the Delaware Limited Liability Company Act.
As for the non-managing members, Section 6.2 prohibited them from participating in the management of the company. Specifically, it stated that:
"Except as otherwise provided in this Agreement or under the Act, the Non-Managing Members shall not have the obligation or the right to take part, directly or indirectly, in the active management or control of the business of the Company, and the Non-Managing Members shall not have the right or authority to act for or bind the Company."
Section 3.8 repeated this restriction and added that "the intent of this Agreement that in no event shall any Non-Managing Member be exposed to liability as a manager under the Act."
The powers that were available to the non-managing members were contained in Section 8.4, which was the carve-out referenced in Section 6.1. Section 8.4(a) provided the non-managing members with certain approval rights, stating that:
"The prior written approval of a Majority Vote of the Non-Managing Members shall be required for the Company to take, or enter into any agreement to take, any of the following actions, and the Managing Member will use all commercially reasonable efforts to carry out and implement any of the following decisions approved by a Majority Vote of the Non-Managing Members. . . ."
The "following actions" included several customary actions that are reserved for majority approval, such as:
  • Approving the company's annual business plan.
  • Borrowing significant sums outside of the ordinary course of business.
  • Selling all or substantially all of the company's assets.
Also listed among those actions were the termination of the property-management agreement and the hiring of a new property manager.
The non-managing members placed great emphasis on the second clause in the lead-in provision to Section 8.4(a), which stated that the managing member must use commercially reasonable efforts to carry out any of the listed decisions approved by a majority vote of the non-managing members. According to them, this meant that whenever they voted for the company to take one of the actions enumerated in that section, PWA, as the managing member, would be required under the agreement to carry out that action.

Outcome

The court rejected the plaintiffs' reading of the operating agreement and granted summary judgment to the defendants. In so doing, the court interpreted both Section 8.4(a), the primary section addressing management of the company, and the agreement's overall approach to management in the defendants' favor.
In the court's reading, the second clause of Section 8.4(a) did not grant the non-managing members a unilateral right to compel the company to take any of the actions that they have voted on. Rather, the clause provided only that the managing member must use its efforts to implement those enumerated decisions that have been approved by a majority vote of the non-managing members. The court distinguished between a clause that requires a managing member to implement any decision made by the non-managing members and those that have been approved by them. The language of "approval" assumes that the managing member has first determined to take that action. It is then up to the non-managing members to either approve or reject taking that action. They cannot, however, force the managing member to take that action against its own judgment.
That it is the managing member who first initiates the decision-making process was implied by the other cited provisions of the operating agreement. Because Section 6.1 imbued the managing member with decision-making authority, while Section 6.2 prohibited the non-managing members from managing the company, the court read the authority granted in Section 8.4(a) as assuming that the managing member has first determined to take the action that the non-managing members have approved. The role of the non-managing members was only to approve or reject the managing member's decision.
The court found support for this interpretation in its reading of the operating agreement as a whole. The court noted that other provisions of the agreement explicitly provided the non-managing members with unilateral decision-making authority over given actions. For example, Section 8.4(e) granted the non-managing members the right to remove the managing member for cause. That section used the phrase "shall have the right to remove," as opposed to the language of "approval" in Section 8.4(a).
The court also held that the plaintiffs' interpretation of Section 8.4(a) conflicted with the general management scheme and division of authority between the managing and non-managing members. If, as the plaintiffs argued, Section 8.4(a) granted them a unilateral right to take all the enumerated actions, then in reality they would not be "non-managing" members at all. On the contrary, their authority to manage the company would exceed PWA's, because PWA would always require their approval to take the enumerated actions, while the non-managing members would not have the reciprocal restriction. The court also found it significant that in the many recent seminal Delaware decisions addressing LLC disputes (such as Feeley v. NHAOCG, LLC, Auriga Capital Corp. v. Gatz Props. and Kelly v. Blum), the LLC agreements frequently provided majority-owning non-managing members with veto rights over major decisions affecting the company, but not affirmative decision-making powers.
The court added that the plaintiffs' reading would also run afoul of Section 3.8, which provided that the non-managing members are not to have managerial authority in order to avoid liability for managers under the statute. Section 18-109 of the Delaware Limited Liability Company Act provides that a person who "participates materially in the management of the limited liability company" is considered a manager. The court stated that if the non-managing members had the authority under Section 8.4(a) that they asked for, they would "probably [be] expose[d] to liability under the Act."

Practical Implications

The 2009 Caiola Family Trust v. PWA decision squarely addresses a common negotiating point in member-managed LLC agreements. Managing and non-managing members frequently divide management responsibility along the lines described in this case. The non-managing members must understand that even though they may own a very large portion of the company's membership interests, the wording of the LLC agreement will govern their managerial rights. In particular, a right to approve certain major decisions will typically be read as a veto right, not as a unilateral right to initiate action. Although this arrangement has the immediate effect of weakening the majority-members' control, it provides the advantage of avoiding liability for managers under the Delaware LLC statute.
Practical Law's Standard Document, LLC Agreement (Two Member, Managing Member-Managed) largely avoids the issue by requiring unanimous approval for any of the enumerated major decisions (see Section 7.02). This way, neither side can fail to understand that it does not have a unilateral right to force the company to take action on a major decision. If, however, the parties wish to force action on a majority vote, they must draft the agreement to be clear that the non-managing members have more than a veto right, but a right to initiate action.