Chancellor Strine on LLC law

Larry Ribstein —  11 August 2011

We got our first LLC opinion from Chancellor Strine in his new position atop the Delaware Chancery Court.  It’s worth close attention in its own right as a case of first impression, and as an indication of the new Chancellor’s general approach to these cases.

The case is Achaian, Inc. v. Leemon Family LLC. Francis Pileggi does his usual good job on the basic analysis, so I’ll be brief on that.

The LLC was owned 50% by Leemon, 30% by Holland and 20% by plaintiff Achaian, a passive investor.  The Holland trust and Leemon managed the LLC together until Leemon took control over the other members’ objection.   The Holland trust purported to transfer its interest to Achaian.  Then Achaian sued for dissolution under Del. §18-802 claiming deadlock.  Leemon claims that Achaian only got an additional economic interest since Leemon didn’t consent to the assignment of ownership rights.

The Delaware statute, section 18-702(a), says an assignee of an LLC interest has no management rights except as provided in an LLC agreement. 18-704(a) says that an assignee is admitted as a member in compliance with the LLC agreement.

The agreement defines a member’s interest as “the entire ownership interest of the member.” Section 7.1 provides that “a member may transfer all or any portion of its interest in [the LLC] to any Person at any time. If at any time such transfer shall cause [the LLC] to have more than one Member, then this [LLC] Agreement shall be appropriately amended to reflect the fact that [the LLC] will then be treated as a partnership for purposes of the [Internal Revenue] Code. . .” Section 7.2 provides that “no person shall be admitted as a member of [the LLC] after the date of this [LLC] Agreement without the written consent of the Member . . . ”  The parties agree that “the Member” in 7.2 must be read as “Members,” so that all have a right to object to the admission of a new Member.

The Chancellor held that “entire” in the definition of “interest” refers to voting as well economic rights. The Chancellor reasoned that 7.1’s reference to a transfer adding a member suggests that a transfer includes ownership rights and section 7.2 deosn’t require a vote to confer additional voting rights on somebody who’s also a member.  Rather, he said, 7.2 is designed only “as a manifestation of the unremarkable idea that one gets to choose one’s own business partners.”  Requiring a vote for additional voting rights, said the Chancellor, “is a strained extension of the traditional idea underlying partnerships and limited liability companies, and is not supported rationally by the LLC Agreement’s text or by the context.”

Having decided that Achaian got additional ownership rights from Holland without Leemon’s consent, the Chancellor applied Delaware §18-802 as if this were a 50-50 joint venture, making applicable by analogy the reasoning under Delaware GCL §273: dissolution is justified where 50-50 holders can’t agree on continuation and the LLC agreement doesn’t provide a way to resolve the matter.  Hence he denied dismissal of the dissolution claim.

There is a lot to love in this case.  First, Chancellor Strine gives the matter the kind of close and sophisticated analysis he was renowned for as Vice Chancellor.  Second, he cited and quoted my LLC treatise.  Third, he continued Chancellor Chandler’s tradition of citing songs as authority — in this case the Commodores’ “Three Times a Lady” in n. 54, for the proposition that once somebody’s admitted as a member he doesn’t have to be admitted each time a member gets more shares.  Fourth, and best yet, the Chancellor says Leemon’s argument that the agreement contemplated a “serial admission scheme” lacks the critical support of “learned commentaries and treatises on alternative entities.” I very much like a requirement that parties’ positions in LLC cases require support from my or other treatises.

The only problem with the case is that it reaches the wrong result.

The big problem is that, as the Chancellor himself notes, the default rule in LLC statutes, including Delaware’s, is restricted transferability of management rights “given the closely held nature of most LLCs” (quoting §7:4 of Ribstein & Keatinge). The question here is whether the agreement varies the default rule.  It does not, because “entire” modifies “interest,” which, as already noted, the Act defines as including only economic rights.  No matter what modifier you put there, the basic thing being modified is economic rights.  To be sure, I can’t tell why “entire” is in there and the interpretation should try to make sense of every word.  But that’s not enough to reverse the statutory default.

Sections 7.1 and 7.2 of the agreement don’t expressly deal with the situation in which an existing member acquires additional voting rights.  That doesn’t render the agreement ambiguous.  Rather, the statute fills the gap by providing that a member can get shares with voting rights only by member consent.  Contrary to the Chancellor’s reading, the second sentence of §7.1 doesn’t assume that a transfer of a membership interest includes voting rights, but rather refers to the situation when the members create voting rights by consent under the statute.

Alas, the Chancellor’s reason is also not supported by the song he cites in support.  The Chancellor was implying that “one time a lady” was enough — three times would be redundant, just as you don’t need multiple membership votes for a member.  But Lionel Ritchie was saying in that song that he was a lost soul without purpose or direction until his lady came along and rescued him with “heart, soul and stone inspiration.”  The guy in the song needed all three — just love or soul wouldn’t have been enough without inspiration.  So, too, a member needs another vote to get additional membership interests.

Note that in addition to the quote from my treatise in the case, my treatise also says that “[r]estrictions on transfer of management authority may be appropriate for LLCs that are closely held firms” because, among other things, “transfers introduce potential new conflicts of interest.” Thus, contrary to the Chancellor’s reasoning, a veto on new ownership rights of an existing member does make sense in a very closely held firm.

That reasoning is particularly applicable to this case.  Holland’s transfer to Achaian completely changed the voting configuration in the LLC.  It stands to reason that any ambiguity in the agreement in this situation should be resolved against waiving the default rule requiring consent to the transfer.

So under my approach, Achaian would not get Holland’s 30%, there would not be a 50-50 split, and the §273 reasoning shouldn’t apply.  Leemon would still be in control. There would be no deadlock to resolve, and no dissolution, at least absent misconduct by Leemon.

Having said all this I don’t want to be too critical.  This was a case of first impression where there was at least an argument for the Chancellor’s result.  Moreover, the central problem was with the agreement, which failed to deal explicitly with an important situation and threw in an extra word (“entire”) as a spanner in the works.  But I would deal with such situations the way Chancellor Chandler did — with a tight reading of the agreement that forces the parties to be explicit when they vary the statute.  In this case, a tight reading would let stand the statutory default.

So the opinion was erudite (it cited and quoted my treatise) and funny (you don’t expect to see a Commodores’ song quoted in an LLC opinion, even if it didn’t support the holding).  Alas, it was not right.

But as another song said, “two out of three ain’t bad.”

Larry Ribstein

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Professor of Law, University of Illinois College of Law

4 responses to Chancellor Strine on LLC law

  1. 

    Well, I gave it a shot. I think the part that’s a little troubling is the legal presumption that people draft the transfer section of the LLC agreement with an awareness of what the statute defaults to. In other words, would there really be any ambiguity in the agreement at issue here but for the wording of 18-702? It just seems clear (to me) what the intention was.

    Maybe we’ll see 18-702 amended next year. IMO, the default should be the opposite: that a transfer is a transfer of economic and voting rights until the agreement says otherwise (though your point about closely held LLCs is taken).

    • 

      Well, you have to draft an agreement with some idea of how the courts are going to interpret it. The Delaware courts are pretty clear about the relationship between the agreement and the statutory default rules. If a lawyer drafted the agreement and didn’t know what the statutory default rules were, or their relevance to the court, you have to wonder what the lawyer was doing for his or her fee. That’s the part that bothers me. I could be persuaded that the default rule should be different, but if lawyers are going to ignore the default rules, you would just get different mistakes, not fewer.

  2. 

    You really read “A Member may transfer all or any portion of its Interest” as only referring to the economic interest, absent a specific explication that that includes the attendant voting rights? That strikes me as far too narrow. I think there are many, many LLC agreements that fail to go out of their way to emphasize that when they say “interest,” they really, truly mean the whole shebang, including the voting rights. I don’t think we even need the word “entire” to understand what the agreement here had in mind.

    As for the default rule, my take on 18-702 is that its purpose is to say that just because there’s been an assignment, it doesn’t mean the new member has managerial/voting rights — unless the LLC agreement specifically describes the managerial/voting rights of the members. Which practically all LLC agreements do. Not that 18-702 means that we should split economic from voting rights until the LLC agreement says not to do that when transferring interests, even though the rest of the agreement never makes that distinction. The totality of the agreement tells you that a member has economic and voting rights until the agreement explicitly splits them up.

    • 

      I have no doubt that my interpretation of the background legal rules is correct. It accords with generations of partnership law that form the basis of LLC law which I have discussed in my three treatises on unincorporated business law. In other words your interpretation of 18-702 is, frankly, wrong. Perhaps the LLC agreements you refer to actually mean to transfer voting rights, but that is not what they say when properly interpreted against this legal background. For the reasons discussed in my blog post, neither the totality of the agreement nor the use of the word “entire” changes this result. Even if you are right as to the bottom line result (and of course you have the Chancellor on your side in this case) the drafting is, in my opinion, horrible. This issue could be easily clarified in the agreement. And there is no guarantee that the next court that looks at this will agree with the Chancellor. More generally, the more LLC and partnership cases I read, the more depressed I get about the level of drafting in LLC and partnership agreements. I have done a lot of writing recently on the reasons for this, but that goes way beyond this response.