In Dawson v. Pittco Capital Partners, LLC, et al., C.A. No. 3148-VCN (April 30, 2012), the plaintiffs (who were investors and equity owners in LaneScan LLC)  complained that a merger improperly deprived them of their Notes and that a return of capital provision was inappropriately excised from LaneScan’s Amended and Restated Limited Liability Company Operating Agreement (the “LLC Agreement”) in conjunction with the merger.  Plaintiffs sought damages in the form of a return of their original investment in LaneScan (both the Notes and their equity investment) with pre- and post judgment interest, plus attorneys’ fees and expenses.  This lengthy opinion (98 pages and 350 footnotes) contains a complex set of facts set out in over 30 pages of the opinion in addition to a detailed legal analysis of a number of complicated legal issues.  Due to space limitations, this summary will focus on the main issue described below.

ISSUE:

Did the defendants have the power, through an LLC agreement or otherwise, to deprive shareholders of their interest in the Notes and excise a return on capital provision from the LLC Agreement in the merger?

Short Answer:  No.

BRIEF BACKGROUND

Plaintiffs invested in LaneScan, LLC, a small start-up company.  Almost from the beginning LaneScan was in financial difficulties. Eventually, LaneScan was faced with three options: (1) raise capital so that LaneScan could continue as an independent entity; (2) shut down and liquidate LaneScan; or (3) a merger.  The first option was attempted and failed.  Liquidation was not an attractive option because LaneScan’s assets had little liquidation value.  Ultimately, a majority of LaneScan’s directors and holders of a majority of its Preferred Interests agreed to a merger with Vehicle Safety and Compliance, LLC (“VSAC”) in which the holders of LaneScan’s preferred membership interests would be diluted and required to surrender certain LaneScan secured notes that they acquired when they initially invested in LaneScan (the “Notes”).

LaneScan and VSAC shared many of the same investors, directors, and key employees.  But, not all of LaneScan’s Preferred Members, such as the Plaintiffs, were also investors in VSAC. After the Merger, LaneScan’s former Preferred Members held very small stakes in the combined entity, as a result of an exchange ratio that assigned a value to VSAC about nine times that assigned to LaneScan.

The LLC Agreement created two types of membership interests: Preferred Interests and Common Interests.  Preferred Interests were received by investors who purchased Units, and Common Interests were awarded to employees and consultants.  Together, the Preferred Interests and Common Interests comprised LaneScan’s equity.  The Common Members were not entitled to vote, except as required by law.  The Preferred Members were entitled to vote on “Significant Transactions,” which included, among other possible events, any merger.  LaneScan could not enter into a Significant Transaction unless Preferred Members holding at least a majority of the Preferred Interests voted in favor of it; such a vote could be conducted at a meeting or by written consent.  In particular, Section 3.1(d) protected members from forced capital contributions.

The Merger

The merger was proposed to LaneScan’s members in a letter from Seamons, Chairman of the Board) dated March 28, 2006.  He also explained that the exchange ratio was set based upon the Southard Financial opinion, which was attached to the letter.  Furthermore, Seamons stated that “[i]n connection with the merger, and as additional consideration for the issuance of VSAC membership interests, each LaneScan member will be required to contribute such member’s [Notes] to VSAC.”

Interest holders who supported the Merger were asked to complete and return the Written Consent, which also contained an amendment to the LLC Agreement, whereby the Return of Capital Provision was deleted in its entirety (the “Amendment”).  The Plaintiffs did not support the Merger and did not sign the Written Consent.  The Amendment and the merger were approved on April 12, 2006, by means of the Written Consent.

 ANALYSIS

Defendants Did Not Have the Power to Effect the Purported Compelled Contribution

The plaintiffs argued that, although “parties to contracts are free to provide that contractual rights and obligations will not survive a merger, they must do so in clear and unambiguous terms” and in this instance, neither the LLC Agreement nor any other contract provided in “clear and unambiguous terms” for elimination of the Notes in connection with a merger.

The Court concluded that not only did the plaintiffs’ rights in the Notes not spring from their Preferred Member/LLC relationship with LaneScan, “no operable document, including the Notes and the LLC Agreement, stated as such in clear and unambiguous terms.”  The Court rejected the defendants argument noting that “[s]uch power simply cannot be found hiding within ‛the broad authority conveyed to the LaneScan Board.’”  The Court found that the plaintiffs never executed any documents pursuant to which they voluntarily contributed the Notes and as a result, the Notes have always remained outstanding.  Thus, the Court concluded that the appropriate remedy was to issue a declaratory judgment that the plaintiffs’ Notes have been valid, enforceable, and outstanding since the Notes’ issuance to the plaintiffs and remain valid, enforceable, and outstanding today.

The plaintiffs did argue that their Notes were in default, and, as a result, they were entitled to immediate payment of the entire face value of their Notes, with interest.  The plaintiffs relied on § 2.1(b)(v) under which an event of default has occurred “[i]f, pursuant to or within the meaning of the United States bankruptcy code or any other federal or state law relating to insolvency or relief of debtors . . . [LaneScan] shall . . .(v) admit in writing its inability to pay its debts as they become due.”  However, the Court rejected the argument.  Under § 2.1(b)(v), an event of default occurred if LaneScan “admit[ted] in writing its inability to pay its debts as they become due.” While the plaintiffs referenced various statements by Seamons that the company was days away from bankruptcy, these statements described a state of affairs that precedes the point when LaneScan would have been unable to pay its debts as they become due and that LaneScan entered into the Merger to avoid reaching this point.  Apparently that point was near at the time of the Merger, but no evidence was presented that LaneScan had reached that point.

Remedy for the Notes Claims

The plaintiffs claimed that they were entitled to reimbursement of their attorneys’ fees and expenses related to the Notes Claims on the basis of § 2.3 of the Notes and under the bad faith exception to the American Rule.

Section 2.3 of the Notes provides in pertinent part: “[LaneScan] shall pay all reasonable costs and expenses incurred by or on behalf of [a Note holder] in connection with [a Note holder’s] exercise of any or all of its rights and remedies under this Note, including, without limitation, reasonable attorneys’ fees.” The Plaintiffs’ argument for contractual fee shifting pursuant to § 2.3 is based upon the premise that “LaneScan breached the Notes and the remaining defendants converted and tortiously interfered with [the] Plaintiffs’ rights in those Notes when they caused the Notes to be contributed and cancelled.”  As discussed above, the Court has granted the Plaintiffs a declaratory judgment, but it has held that the Plaintiffs’ Notes-related breach of contract, conversion, and tortious interference claims failed.  Therefore, the Plaintiffs’ argument for contractual fee shifting fails.

The Court also looked at whether the director defendants and investor defendants had contractual duties or fiduciary duties to abstain from intentional misconduct and gross negligence.

 Section 7.1 of the LLC Agreement states in pertinent part:

 No Member, Director or Officer shall have any duty to any Member or the Company, except as expressly set forth herein or in other written Contracts. Except as expressly set forth herein or in any other written Contract, no Member, Director or Officer of the Company shall be liable to the Company or to any Member for any loss or damage sustained by the Company or any Member, unless the loss or damage shall have been the result of gross negligence, fraud or intentional misconduct of such Member, Director or Officer, or in the case of an Officer, breach of such Person’s duties pursuant to Section 4.6.

The Court concluded “an LLC agreement may limit or eliminate any and all liability for breaches of fiduciary duties, although it may not eliminate liability for breaches of the implied covenant.  Indeed, “parties to [an LLC] agreement can contractually expand, restrict, modify, or fully eliminate the fiduciary duties owed by the company or its members, subject to certain limitations.”  Defendants also argued that  § 7.1 eliminated all of their fiduciary duties. The Court concluded:

Section 7.1 may be interpreted as such: (1) the first sentence ‛eliminate[d] fiduciary duties to the maximum extent permitted by law by flatly stating that [M]embers [and directors] have no duties other than those expressly articulated in the [a]greement’; and (2) in an abundance of caution, the second sentence states that, if any duties are ever found in any agreement, unless such agreement expressly states otherwise, the directors, officers, and Members can only be liable as a result of those duties if the damage suffered was a result of gross negligence, fraud, or intentional misconduct. In essence, the second sentence is a ‛just in case’ measure meant to ensure that any duty established (inadvertently or otherwise) is limited (at least in terms of liability) to gross negligence, fraud, and intentional misconduct.

Court Rejects Claim of Intentional Misconduct

Plaintiffs alleged that the Director Defendants engaged in intentional misconduct by approving of the Merger, including the terms by which the Preferred Members were purportedly compelled to contribute their Notes, and their consent to the Amendment.

In rejecting those claims, the Court stated:

The Court finds that the Director Defendants’ overriding motivation with regard to the Merger, in general, and the Amendment and purported Compelled Contribution, specifically, was to salvage whatever value they could from LaneScan. Without the Amendment and the Compelled Contribution, VSAC would not have merged with LaneScan, and, without the Merger, LaneScan would have soon become insolvent.  Because LaneScan had little liquidation value, the Merger was LaneScan’s only chance to salvage some value for its owners.  Since the Court finds that the Director Defendants’ motivation with regard to the challenged actions was to salvage whatever value they could for LaneScan’s Members, not to enrich VSAC at the expense of LaneScan’s Members, the Plaintiffs intentional misconduct claims fail.