June 19, 2015 Top Story

Agreement to Arbitrate Upheld after LLC Converted to Corporation

Corporate charter does not supersede prior LLC agreemen''s arbitration requirement

Pamela Sakowicz Menaker

An arbitration clause in a limited liability company (LLC) agreement controls in a dispute involving a shareholder, despite the fact that the LLC had converted to a corporation that did not have a similar dispute resolution mechanism in its incorporation documents. 3850 & 3860 Colonial Blvd., LLC v. Griffin. Section leaders consider the Delaware case an interesting decision because of the court’s strict contractual reading of an LLC agreement requiring arbitration and ignoring a defendant’s alleged misconduct in unilaterally reorganizing the company, potentially to the plaintiff’s detriment.

Courts Favor Arbitration

The shareholder plaintiff was a seed investor in an LLC. When the company’s sole director pursued a recapitalization of the company that reduced the plaintiff’s interest, and then that director oversaw the LLC’s conversion to a corporation, the plaintiff alleged contractual claims and breach of fiduciary duty in an action against the director and the corporate successor.

Before the Delaware Court of Chancery were two contracts: the LLC operating agreement between the parties that contains an arbitration provision and an incorporation document that does not contain an arbitration provision. The defendant prepared the second document, without notice to the plaintiff, to convert the LLC into a corporation. The defendants moved to dismiss the suit for lack of subject matter jurisdiction under Rule 12(b)(1), arguing that arbitration is required and provides an adequate remedy. The court ruled that the corporate charter does not supersede the original operating agreement and thus the parties have an enforceable arbitration provision.

Defendant’s Conduct Not Considered

Despite the plaintiff asserting a breach of fiduciary claim because the defendant director acted unilaterally in deciding how to reorganize the company, perhaps even to the detriment of the plaintiff investor, the court, in reaching its decision, analyzed the issue strictly as a matter of contract law and did not address the defendant’s conduct.

“It makes sense to me,” says Bruce A. Rubin, Portland, OR, cochair of the ABA Section of Litigation’s Alternative Dispute Resolution Committee., “At the most fundamental level, the court was choosing which contract to examine, whether the organization documents of the LLC or the certificate of incorporation of the corporation. The case struck me as basic law analyzing contracts under Delaware law.”

“It is well-reasoned and consistent with what many other courts have done when determining whether the court or the arbitrator should decide if the parties previously agreed to submit their dispute to arbitration,” offers Neal M. Eiseman, New York, NY, chair of the Arbitration Subcommittee of the Section of Litigation’s Alternative Dispute Resolution Committee.

Precedent Supports Court’s Decision

The court followed precedent established in James & Jackson, LLC v. Willie Gary, LLC, where the Delaware Supreme Court adopted the view of a majority of jurisdictions and held as a matter of policy that “the reference to the AAA [American Arbitration Association] rules evidences a clear and unmistakable intent to submit arbitrability issues to an arbitrator.”

“The only agreement between the two parties [here] is that of the LLC,” notes Louis F. Burke, New York, NY, cochair of the Section’s Alternative Dispute Resolution Committee. “Therefore,” he explains, “the court distinguishes the previous case and holds that arbitration must control any and all disputes because that is the way the contract is written.”

“The court further noted that it concludes the parties agreed to arbitrate their dispute, because courts generally favor arbitration [and] any doubts are resolved in favor of arbitration,” notes Eiseman.

How Is an Investor to Protect Himself?

To avoid the fate of the plaintiff in the Griffin case, Section leaders emphasize that the method of dispute resolution needs to be clearly and specifically worded to effectuate the parties’ intent. “Given that the organization underwent a material change, an offer of rescission should have been made to the investors or the plaintiff should have demanded rescission,” Burke says.

“Had the arbitration clause not been as broad and instead given the parties the option of proceeding to court for injunctive or other relief, I believe the court would have ruled differently,” Eiseman explains. As a practical matter, “prudence dictates that the parties should amend their prior contract to delete the arbitration provision and/or specifically provide in any release between them that not only claims, but also the right to arbitration is being extinguished,” he continues.

“If the goal is to have everything decided by arbitration and giving the arbitrator the right to decide, you should state it again in a separate clause of the contract that all subsequent arbitrability is to be determined by an arbitration,” Rubin adds. “Specific wording protects the parties from any ambiguity as well as if the law should change,” he points out.


Pamela Sakowicz Menaker is a contributing editor for Litigation News.

Keywords: arbitration, LLC agreement, subject matter jurisdiction, substantive arbitrability, certificate of incorporation

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