In Sanders v. Ohmite Holding, LLC, C. A. No. 5145-VCL (Del. Ch. Feb. 21, 2011), read opinion here, the Delaware Court of Chancery clarified the rights of a member of an LLC to demand certain books and records of an LLC.

Issue Addressed

 Whether the member was entitled to books and records, pursuant to Section 18-305 of the Delaware LLC Act ( 6 Del. C. Section 18-305), for a period prior to him becoming a member of the LLC? Answer: Yes.

Short Factual Background

Max Sanders loaned $2 million to a member of an LLC and received a security interest in the member’s units as collateral. That member later transferred his interests back to Sanders. In the interim, the member’s units were diluted and instead of having the 7.75% stake that he thought he had, the LLC told Sanders that he only had what the Court described as a "nigh microscopic"  stake of merely 0.000775%. Sanders made a formal demand for 8 categories of books and records relating to why his units were diluted and the value of his interest as well as the performance of the LLC’s management. The LLC denied the request in total. After this action was filed, the LLC did provide tax returns and financial statements but not all the documents requested. Based on that information, the Court found that Sanders had a reasonable basis to believe that additional units were issued to an affiliated party at a deep discount, and thus, questioned whether the LLC received proper consideration for the additional units that were issued.

Holding

The Court determined that Sanders had a proper purpose for inspecting the books and records and that the documents he requested were necessary for him to fulfill that purpose, regardless of whether they pre-date when he formally acquired member status. Thus, summary judgment was granted for Sanders.

Procedural Posture

Both parties filed cross motions for summary judgment which the Court treated as the equivalent of a stipulation for decision on the merits based on the record submitted with the motions, pursuant to Chancery Rule 56(h).

Brief Overview of Key Legal Principles Discussed

As the Court observed:

Section 18-305(a) of the LLC Act provides a member of an LLC with the right,
“upon reasonable demand for any purpose reasonably related to the member’s interest as
a member” of the LLC, to obtain the following records:

(1) True and full information regarding the status of the
business and financial condition of the limited liability
company;

(2) Promptly after becoming available, a copy of the
limited liability company’s federal, state and local income tax
returns for each year;
. . . .
(5) True and full information regarding the amount of cash
and a description and statement of the agreed value of any
other property or services contributed by each member and
which each member has agreed to contribute in the future,
and the date on which each became a member; and

(6) Other information regarding the affairs of the limited
liability company as is just and reasonable.

 6 Del. C. § 18-305(a). The inspection right is subject to “such reasonable standards(including standards governing what information and documents are to be furnished . . . ) as may be set forth in a limited liability company agreement or otherwise established by
the manager.” Id.

The rights of Sanders were co-extensive with Section 18-305 of the LLC Act because the LLC Agreement did not limit those rights. The Court observed that the extensive case law surrounding the rights of a shareholder to books and records of a corporation under DGCL Section 220 are often considered by analogy in the LLC context. Likewise, the following basic rules apply:

  • There must be a "proper purpose" for the inspection;
  • That proper purpose must be reasonably related to such person’s interest as a member;
  • The requested books and records must be reasonably required to fulfill the stated purpose.

Delaware cases have established several proper purposes in this context, including:

  • valuation of one’s ownership interest
  • investigation of potential wrongdoing and mismanagement. Note that in order to satisfy this proper purpose, one need not prove wrongdoing. Rather, it suffices in this context to merely present a "credible basis" to suspect wrongdoing and from which the court may "infer" wrongdoing that would warrant further investigation.

In this case, the Court explained that wrongful dilution that benefits a majority holder establishes a credible basis from which the Court can infer that further investigation is warranted.

The Court also remarked that the data received need not be used to file a derivative suit and that it may also be used, for example, to "communicate with … management" and to determine whether to retain or dispose of one’s interest.

A core inquiry in these types of cases is whether the documents requested are "essential and sufficient" to satisfy the party’s stated purpose. See footnote 2 and related text that comments on the lack of precision in these words that are used by the courts in these types of matters, and what the Court calls the "strange" choice of  "bi-partite phrasing".

Among the documents that the Court determined were reasonable to request in order to advance the stated purpose, were minutes of meetings that discussed the number and pricing of the units issued, and records relating to any opportunity that Sanders had to buy the units at the same price. The Court cited to cases in the Section 220 context to support its decision to allow the records requested for a period prior to the date that Sanders became a member because the records from that earlier period obviously had an impact, for example, on the value of the fully diluted units he currently owned.

Postscript

Although the result of this case may be a positive one for the member seeking the books and records, it may also be described in some ways as a Pyrrhic victory, for several reasons. First, the opinion describes the litigation that was initiated in Illinois by the member way back in November 2007 in his first attempt to address the issues involved. Now, over three (3) years later he obtains some judicial relief–but the story does not end there. The member still does not have the documents. I suspect that there is a good chance that the LLC will not be forthcoming in a prompt and complete manner with all the documents they are required to produce pursuant to this opinion. To the extent that the opinion requires "categories of documents" there is plenty of opportunity for the company to engage in Fabian tactics. I’m not in any way suggesting that the company in this case will do so. I’m simply commenting based on my experience that if the company did so, it would not be unprecedented.

The takeaway, in my view, about these cases, is that requests by members or shareholders for books and records are not for the faint-hearted and are not for those who do not have the financial stamina, or the financial tenacity to spend considerable sums in legal fees to pursue litigation if the company is determined to make the process as expensive as possible, especially in light of the American Rule pursuant to which each party pays its own fees, regardless of who wins the case.