Lola Cars International Limited v. Krohn Racing, LLC, C.A. No. 6520-VCN (Del. Ch. Feb. 29, 2012). Prior decisions by the Court of Chancery in this long-running battle have been highlighted on these pages here, here and here.
The Delaware Court of Chancery addressed the issue of whether both members of a two-member LLC were responsible for their proportionate share of legal fees in a lawsuit in which they both contested issues.
This is the latest decision in a long-running series of decisions in this matter, some of which were previously highlighted on these pages at the links provided above, each of which also provided more background details about a two-member LLC with dysfunctional management. The first sentence of this letter decision from the Delaware Court of Chancery provides as follows: “This too-long running saga of a failed venture may be drawing to a close.”
In prior litigation among the parties, defendant/counterclaim-plaintiff Krohn generally prevailed after trial against the plaintiff/counterclaim-defendant Lola Cars. The Court declined to shift fees to the prevailing party as a bad faith exception to the American Rule. See 2010 WL 3314484, at *22. Krohn owns 49% of Proto-Auto and Lola owns 51% of Proto-Auto, which is an LLC organized under the laws of the state of Delaware. The legal fees incurred by Proto-Auto and the fees for the representation of Krohn , the representative on Proto-Auto’s two-person governing board, have been paid by Krohn. Krohn now seeks, in effect, to require Lola to pay its proportionate share of those legal fees.
The current dispute turns on what the 2010 audited balance sheet of Proto-Auto would reveal, but the balance sheet was never audited. It is not clear at this stage how the litigation expenses ended up being reflected on the unaudited balance sheet of Proto-Auto. Krohn relies on the operating agreement of Proto-Auto which required the preparation of an audited balance sheet, but no audited balance sheet had ever been prepared.
It was clear to the Court that Lola has not paid or even loaned its share of the deficit attributable to legal fees incurred for Proto-Auto.
According to the Court, Lola “scoffs” at the effort of Krohn to obtain reimbursement for part of its legal costs based on several reasons: (1) there is no advancement or indemnification provision for legal fees in the operating agreement that requires Lola to pay; (2) nothing would entitle the CEO to a reimbursement of his fees; (3) Lola asserted that the obligation in the operating agreement is based on an audited balance sheet which has never been prepared; and (4) the claims of Krohn are barred by res judicata and waiver.
The Court rejected in a prior opinion the argument that fees should be shifted as an exception to the American Rule, and also added that any other basis for seeking reimbursement of legal expenses should have been brought at the same time, including any rights under the operating agreement.
The Court emphasized, however, that this latest iteration of the parties’ imbroglio was not about litigation costs, but rather was about “the consequences of a Proto-Auto balance sheet with ‘negative assets’.” The claim of Krohn is about the share of Proto-Auto’s “negative assets” that Lola should be required to pay “or loan” to Proto-Auto under the operating agreement.
The Court began with the issue involving the claim by Krohn for a share of Proto-Auto’s “negative assets” that Lola may be required to pay, and stated that an inquiry was needed into “whether the litigation expenses were reasonably incurred by Proto-Auto.” Proto-Auto was named as a defendant in the original litigation filed by Lola. Proto-Auto was justified in retaining counsel. Whether those expenses were reasonable and necessary could not be determined from the present pleadings.
Importantly, at footnote 10, the Court recognized the “potential for conflict arising out of representation of Proto-Auto by the same law firms representing Krohn” and even though that potential for conflict was understood by the parties, because no one objected to it, at least for present purposes, the Court deemed Lola to have waived the objection to that potential conflict.
The foregoing note by the court acknowledges the potential for a conflict of interest when the same law firm represents a major shareholder who is a co-defendant along with the corporation being sued.
Lola argued that the CEO, who was also a defendant, Jeffrey Hazell, did not have a right to mandatory indemnification. However, the Court noted that this did not address the question of whether Proto-Auto could indemnify him. The Court observed, by citing to a case at footnote 13, that:
If there is no right to mandatory advancement or indemnification, the decision to provide an officer or a director with assistance in paying legal fees arising out of work-related matters is, as a matter of law, left to the governing board’s business judgment.
The Court underscored that just because the operating agreement could have provided for indemnification but did not, does not prevent the board of Proto-Auto from making such an award. However, the necessity for specific legal services for the benefit of Hazell and the reasonableness of their costs, cannot be resolved at the procedural stage of the case, which was cross-motions for judgment on the pleadings.
Equitable contribution was one of the doctrines invoked by Krohn as a basis for recovering litigation expenses paid for the benefit of both Proto-Auto and Kazell, as well as the doctrine of corporate benefit. See footnotes 14 and 15. The Court could not resolve those issues at this procedural stage of the case.
The Court observed that the duty of a member of Proto-Auto to put money into the company was premised on a “audited balance sheet” that showed “negative net assets.” However, it is not disputed that an audited balance sheet was never prepared for the relevant periods of time. The Court could not determine based on the early stages of the record whether or not Lola interfered with the ability of the company to prepare an audited balance sheet although that could prove to be the case eventually.
If Lola did interfere with the effort to obtain audited balance sheets, then the Court reasoned that “it would seem that Lola should not be able to benefit from the lack of an audit and avoid what otherwise would be an obligation to provide additional funding to the company.” In sum, the Court determined that there were disputed issues of fact that would preclude the grant of a judgment on the pleadings sought by Krohn.