Lola Cars Int’l Limited v. Krohn Racing, LLC, No. 3379-VCN (Del. Ch. Nov. 12, 2009), read 31-page letter decision here. This decision of the Delaware Court of Chancery is chock full of substantive Delaware LLC law that is of practical usefulness for business lawyers and litigators.

Key Issues Addressed

• Dissolution requested by one member of an LLC pursuant to  Section 18-802 of the Delaware LLC Act;
• Breach of fiduciary duty of an LLC manager and whether pre-suit demand was excused (i.e., was a majority of the LLC’s governing body disinterested and independent);
• Breach of the implied duty of good faith and fair dealing;
• Rule 15 (aaa) regarding allowance of an amendment to a complaint despite filing of an Answering Brief to a Motion to Dismiss (yes, though unusual, Rule 15 (aaa) is the correct citation.)

Holding

The Court denied a motion to dismiss the claims for dissolution and appointment of a liquidating receiver, and also denied a motion to dismiss the claims for breach of fiduciary duty and the implied covenant of good faith and fair dealing. The Court’s analysis and reasoning in support of these conclusions makes this decision "must reading" for anyone who wants to know the latest in Delaware LLC law on these key issues.  In addition, the Court exercised its rarely used option to allow, in the interests of justice, an amendment of a complaint despite an Answering Brief having been filed in response to a motion to dismiss.

Background Facts

The Court carefully describes the copious background factual details, but I will only cursorily mention them here in order to focus on the legal analysis. The LLC in this case was formed by Lola Cars International, which owned 51% and Krohn Racing, which owned 49%. However, the governing structure they created allowed for only 2 directors, with each appointing one, despite Lola’s majority ownership. The deadlock that such an arrangement exposed the parties to, eventually came to pass. The LLC Agreement also provided for Krohn to provide the CEO. The provision about replacement of that CEO was one of the hotly contested issues in the case.

The parties’ LLC Agreement provided very specific descriptions of the responsibilities of each party in terms of monthly reports, operational duties, capital requirements and the like. There were two separate complaints filed in this case. The first sought dissolution and the appointment of a liquidating receiver based on a litany of reasons, including: (i)  the insolvency of the company; (ii) the failure so far, and inability going forward, of the company to achieve its objectives as stated in the LLC Agreement; (iii) and deadlock of the two person board, among other reasons. (The second complaint was dismissed without prejudice and was not a major part of the decision.)

The factual basis for the fiduciary duty claims was explained expansively, and included, for example, specific dollar amounts that were alleged to have represented lost profits because Krohn Racing and its appointed CEO were engaging in transactions with the LLC that did not provide for "market rates" for the benefit of the LLC–but which involved discounted rates that only benefited Krohn Racing (i.e., Krohn benefitted by "sweetheart transactions" at the expense of the LLC.)

The Second Complaint sought injunctive relief based in part on an alleged violation of the LLC Agreement that leads to termination of the agreement, and Section 18-402 of the Delaware LLC Act  which by default (unless otherwise agreed), gives control of an LLC to its members in proportion to their respective equity interests. Although a TRO and request for a receiver pendente lite was denied, the Court did enter a status quo order on the first complaint.

Legal Analysis

A.  Dissolution

 The Court provides a classic discussion of the prerequisites under Section 18-802 for a member of an LLC to seek judicial dissolution of an LLC based on an argument that it is no longer reasonably practicable to carry on the business of the LLC. The Court relied heavily of the prior Chancery Court decision in Fisk Ventures, LLC v. Segal, (Fisk I), reviewed on this blog here, and a separate decision that the Court referred to as Fisk II, summarized on this blog here.

In Fisk I, the Court gave three examples of situations that should be considered in determining if the "reasonably practicable" standard had been met (which is not an impossibility standard):

1. Whether the members’ vote is deadlocked at the board level;
2. Whether the operating agreement provides a procedure to break the deadlock;
3. Whether there is still a business to operate based on the company’s financial condition.

Moreover, Fisk I emphasized that none of these factors is individually determinative, "nor must each be found for a court to order dissolution. Rather they provide guidance to the ultimate inquiry of whether the company can continue to pursue its stated business purpose with reasonable practicability." See Fisk I, 2009 WL 73957, at *4.

The Court  found that all three above factors were present in this case. There was a deadlock; the procedure in the agreement could not break the deadlock (e.g., about replacing the CEO); and the company was allegedly insolvent. The Court also recited several additional factors that supported dissolution and that related to the fiduciary duty claims of mismanagement, self-dealing and failure or inability of the company to achieve its stated purposes.

B.  Derivative Fiduciary Duty Claims and Demand Excusal

 The exemplary pre-suit demand analysis is notable for its application to the LLC context. See, e.g., footnote 33 for case supportinig application by analogy of the pre-suit demand analysis under Court of Chancery Rule 23.1 to the similar requirements of Section 18-1003 concerning whether demand is properly excused. The Court determined that it did not need to resolve whether both prongs of Aronson v. Lewis applied, or whether the second prong was eliminated based on the application of Rales v. Blasband. This was based on the Court’s conclusion that under the first prong of Aronson, one of the two directors was not disinterested. That is, the Court reasoned that there was a particularized showing that the director against whom the allegations were made, faces a "substantial likelihood of personal liability, and not simply the mere risk of damages." (citing Rales, 634 A.2d at 936.)

That finding made it unnecessary to determine if he was independent. The Court cited to a Court of Chancery decision from the year 2000 for the now well-settled principle that if one member of a two member board fails the test of disinterestedness or independence, then demand is excused due to a lack of a majority of disinterested, independent directors. See footnote 35.

For the convenience of the minority of readers who don’t have the seminal two-prong Aronson test committed to memory, it follows: Demand is considered futile and thus excused when particularized facts in the complaint create a reason to doubt that: (i) "the directors are disinterested and independent [or that] (ii) the challenged transaction was otherwise the product of a valid exercise of business judgment." (citing Wood v. Baum, 953 A.2d 136,140 (Del. 2008)(citing Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984)).

C. Implied Duty of Good Faith and Fair Dealing

This decision features the relatively rare case in which there is a finding that the elements of this somewhat amorphous cause of action survive a motion to dismiss. That distinction makes this opinion "must reading" for any litigator who  wants to understand the latest nuances of Delaware law on this non-waivable obligation implied in every Delaware contract. The Court relies on Fisk II, supra, for its discussion of the various aspects of this obligation that is imposed on every Delaware agreement but is not susceptible to mathematical precision in its definition or application. Among the many descriptions of its contours in this case, the Court observed that: "… it restrains a party from engaging in arbitrary or unreasonable conduct that has the effect of frustrating the contract’s overarching purpose and denying the other party the benefit of its bargain." (citing Fisk II, 2008 WL 1961156, at *10).

Many Delaware decisions have emphasized that they will not provide an "addendum" to the contract terms negotiated by sophisticated parties who "forgot to include a provision" that at least one party now wishes, in retrospect, was included, but that principle is balanced with the principle that: when the contract is silent on a topic, the court will imposed this obligation where "it is clear from the contract that the parties would have agreed to that term had they thought to negotiate the matter." (citing Fisk II, supra, at *10). Even if the agreement gave Krohn sole discretion to replace the CEO, or not,  and the parties could have included a provision to limit that discretion, the  Court was permitted on a motion to dismiss to make the reasonable inference that Krohn acted in bad faith by failing to consider Lola’s request to meet to discuss the CEO’ removal. Thus the claim survived a motion to dismiss.

D. Rule 15 (aaa) amendment

This is a rather technical, though important, procedural point that I will conclude with by simply saying that it is possible, though rare, that the Court of Chancery will allow an amendment to a complaint, or dismiss a complaint without prejudice to refile, even if contrary to the presumption in Rule 15 (aaa) that if one files an Answering Brief in reply to a motion to dismiss–instead of filing an amended complaint in reply to a motion to dismiss, that there will not be another opportunity to amend. This finding only applied to a separate, related second complaint that was filed by Lola against Krohn but did not impact the prior rulings mentioned in this synopsis.

UPDATE: Professor Ribstein provides scholarly insights on this case here.