May 20, 2016

DELAWARE INSIDER: Equitable Dissolution: The New (Old) Frontier

Aaron M. Nelson

An’ I’ve made up my mind, I ain’t wasting no more time
Here I go again on my own
 – Whitesnake, Here I Go Again (Geffen 1982)

In last summer’s decision, In re Carlisle Etcetera LLC, 114 A.3d 592, 601 (Del. Ch. 2015), the Delaware Court of Chancery made clear that judicial dissolution of a limited liability company (LLC) pursuant to Section 18-802 of the Delaware LLC Act “is [not] the exclusive, extra-contractual means of obtaining dissolution of an LLC.” Indeed, a party may petition the Court of Chancery to dissolve an LLC in equity. This equitable right cannot be waived by contract, i.e., in the operating agreement, or overridden by statute. Why? Because this equitable right imbues from the Court of Chancery’s constitutional authority itself. See Del. Const. art. IV, § 10. In this way, the much discussed amendment to the act in Section 18-1104 (“In any case not provided for in this chapter, the rules of law and equity, including the rules of law and equity relating to fiduciary duties and the law merchant, shall govern.”), merely validates that equity never left the dance – nor could it have.

We have been told that the act is an analog of the pure contractarian view (or the “nexus of contracts” theory) of corporations and that by structuring the rules of the game ex ante the parties’ business relationship can be adjudged fairly and consistently. The text of the act itself, as well as the case law applying it, show that that is indubitably true – LLCs are “creatures of contract” after all. But Carlisle Etcetera reminded us that such a view is incomplete (sorry, legal realism). Ultimately, what is “fair” is equally the province of equity and litigators would be loath to forget it.

This article seeks to explore equitable dissolution as a legal strategy post–Carlisle Etcetera. Specifically, this article posits that practitioners should consider utilizing equitable dissolution when a technical application of either (1) a default rule under the act, or (2) the express terms of the operating agreement, serves as an obstacle to the client’s petition for judicial dissolution and remaining in the status quo would harm the client.

“But I Sure Know Where I’ve Been”

Some background is in order. The policy of the act is “to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Section 18-1101(b). Thus, LLCs are viewed as “creatures of contract,” i.e., that which is created by contract. This provides individuals with tremendous freedom to organize their business and affairs in the way that they see fit. With this contractual freedom, the parties to an LLC agreement are permitted to fashion whatever provision they wish to govern the potential dissolution of the LLC.

If an operating agreement is silent on a particular matter (by omission or by express choice), then the LLC Act provides default rules to govern the situation at issue. If no provision governs dissolution, then Section 18-802 will apply by default:

On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.

Thus, in theory, the answers to all potential issues that may arise during the business relationship (including judicial dissolution) are either expressly addressed by the parties or the act will engraft a default rule onto the operating agreement.

Delaware law even allows the parties to proscribe the use of judicial dissolution altogether – just like any other non-mandatory, default rule. Huatuco v. Satellite Healthcare, 93 A.3d 654 (Del. 2014) (ORDER); R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318, *8 (Del. Ch.).

Therefore, as the Delaware Supreme Court recently reminded us: “[I]nvestors in these agreements [e.g., LLC agreements] must be careful to read those agreements and to understand the limitations on their rights.” The Haynes Family Trust v. Kinder Morgan G.P., Inc., 2016 WL 912184, *1 (Del.) (ORDER).

But the ability to both create and eliminate the right to seek judicial dissolution begs a fascinating question:

Whether the parties may, by contract, divest this Court [of Chancery] of its authority to order a dissolution in all circumstances, even where it appears manifest that equity so requires – leaving, for instance, irreconcilable members locked away together forever like some alternative entity version of Sartre’s Huis Clos.

Huatuco v. Satellite Healthcare, 2013 WL 6460898, *1 (Del. Ch.) (emphasis in original). The Huatuco court declined to answer the question because “considerations fundamental to equity [were] absent [t]here,” but certainly suggested that dissolution in equity may be available under certain factual scenarios.

In Carlisle Etcetera, the Court of Chancery asserted what Huatuco implied: the appropriate factual showing will open the door for equitable dissolution. There, the Court of Chancery held that an assignee of an LLC membership interest, who is not a manager or member, has standing to seek dissolution in equity. 114 A.3d at 607. The court observed that “[i]f the opportunities for dissolution are limited to [Section 18-802] and the specific terms of the [operating agreement], then dissolution is not an option.”

Next, the court emphasized that an LLC is not “purely contractual,” because an “LLC has powers that only the State of Delaware can confer.” Thus, “[b]ecause an LLC takes advantage of benefits that the State of Delaware provides . . . the State of Delaware retains an interest in having the Court of Chancery available, when equity demands, to hear a petition to dissolve an LLC.” Any other interpretation, the court said, would be inconsistent with the court’s constitutional authority, as well as its past practices. See Haley v. Talcott, 864 A.2d 86, 98 (Del. Ch. 2004) (dissolving corporation and declining to enforce the terms of an unreasonable exit mechanism on equitable grounds); Meyer Natural Foods LLC, v. Duff, 2015 WL 3746283, *4 (Del. Ch.) (refusing to limit its dissolution analysis to the express purpose clause in the operating agreement because it would “resolve the dispute on a technicality”). In this way, Carlisle Etcetera was not novel at all, but it did provide guidance on what other factual scenarios may trigger equitable dissolution in the future.

“Just Another Heart In Need Of Rescue”

Establishing equitable dissolution (of course) will require a strong factual showing and will be (and should be) reserved for the rare case. But that does not mean that litigators should be chary of keeping equitable dissolution in their arsenal of potential claims. Indeed, Carlisle Etcetera opens the gate to a new (old) frontier.

Specifically, practitioners should think about the availability of equitable dissolution in situations where the technical application of either a default rule supplied by the act or a provision of the operating agreement is an obstacle to judicial dissolution and remaining in the status quo will harm the client. If a literal application of a default rule supplied by the act works an injustice on the client, equity may step in. See Carlisle Ectetera, 114 A.2d at 607. Or if the literal application of a provision in the operating agreement has worked (or is working) an injustice on the client, then equitable dissolution may be available. Cf. Haley, 864 A.2d at 98; Meyer, 2015 WL 3746283, *4; Carlisle Etcetera, 114 A.2d at 607. If the client is prevented from exiting a stagnating business venture under the operating agreement, for whatever reason, then equitable dissolution may be an option. Huatuco, 2013 WL 640898, *6; Carlisle Etcetera, 114 A.2d at 607.

This can be a particularly useful tool if deadlock cannot be established, the members’ relationship is severely acrimonious (but the business is technically operational), or the business has never operated consistently with a default rule under the act or a particular provision of the operating agreement. This list is not intended to be exhaustive, but only serves to highlight some of the factual scenarios where equitable dissolution may be utilized going forward.

“Tho’ I Keep Searching For An Answer”

In conclusion, Carlisle Etcetera demonstrates that equity and pure contractarian theory are not enemies – “they ironically call each other into question, and thus leave us with an area of free play otherwise unavailable.” Boyle, Is Subjectivity Possible? The Post-Modern Subject In Legal Theory, 62 U. Colo. L. Rev. 489, 523 (1991).

For the practitioner, this new (old) frontier or “area of free play” leads to factual circumstances where asserting equitable dissolution may be the client’s best – or only – option.

Aaron M. Nelson

Aaron M. Nelson is an associate at Proctor Heyman Enerio LLP in Wilmington, Delaware, where he practices corporate, alternative entity, and complex commercial litigation, including business divorce cases involving the dissolution of privately held business entities. The author’s firm, Proctor Heyman Enerio LLP, represented the successful petitioner in Carlisle Etcetera.