LLCs — Read the Contract Before You Sign It
Miller v. HCP & Company (Del. Ch. Feb. 1, 2018)
By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C. © 2018 Herrick K. Lidstone, Jr.
The limited liability company is the entity du jour in Colorado and elsewhere. According to the Colorado Secretary of State’s office, more than 88,000 limited liability companies (“LLCs”) were formed in Colorado in 2017 as compared to fewer than 11,000 corporations. This continues the trend over the past several years. While a corporation is a statutory creature with some flexibility under the Colorado Business Corporation Act that can be included in the articles of incorporation, the LLC is a creature of contract and it is unlikely that the default provisions of the Colorado LLC Act would be acceptable to any LLC member who understood them.
Unlike Delaware law (see Del. Code Ann., title 6, § 18-201(d)), an LLC may be formed in Colorado without an operating agreement – whether written or oral. Oral agreements raise their own issues of substantiation and proof. As stated in Lidstone & Sparkman, Limited Liability Companies and Partnerships in Colorado (CLE in Colorado 2017) at § 3.2.5:
However, persons who enter into a business relationship with others without a written agreement risk future misunderstandings among the business owners and subject themselves to the default rules imposed by the applicable statutes. Sophisticated business people and the lawyers who advise them generally require that their understandings be documented in a written limited liability company operating agreement.
Scriven With Precision
Colorado statutes make clear that the members of an LLC can adapt the provisions of the LLC Act to their specific arrangement. C.R.S. § 7-80-108(4) states clearly: “It is the intent of this article to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” However, this freedom of contract can be risky.
Where properly drafted, the operating agreement can serve as a contract that waives various duties of the LLC members and managers, although in substantially all cases the contractual obligation of good faith and fair dealing remains, subject to the ability (in Colorado) to “prescribe the standards by which the performance of the obligation is to be measured, if such standards are not unreasonable.” (C.R.S. § 7-80-108(2)(d).)
Colorado LLCs are easy to form by filing a simple document with the Secretary of State online and paying $50. It is my experience that many business people make their own filing and move forward as statutory member-managed LLCs either without an operating agreement or with a form operating agreement the business people have downloaded and likely have only changed the names.
Off-the-shelf and on-line operating agreements do not reflect the special needs and expectations of the LLC members forming the LLC, or who may become members thereafter. Operating agreements are complex contracts that need to be drafted to fit the expectations of the parties, including to achieve desired tax and business results. Too many LLCs move forward without a carefully considered operating agreement drafted to meet their business, tax, and management goals – if they have any written understanding at all.
As then Vice Chancellor Strine of the Delaware Court of Chancery stated in a manner also applicable to Colorado operating agreements: “With the contractual freedom granted by the LLC Act comes the duty to scriven with precision.” (Willie Gary LLC v. James & Jackson, LLC, 2006 Del. Ch. LEXIS 3, at *5 (Del. Ch. Jan. 10, 2006), aff’d, 906 A.2d 76 (Del. 2006).)
Miller v. HCP & Company, C.A. No. 2017-0291-SG (Del. Ch. Feb. 1, 2018)
A recent case from the Delaware Chancery Court addressed issues where a group of members expected a different result from a sale of the LLC than the operating agreement (in Delaware the “limited liability company agreement” or “company agreement”) contemplated. One class of members thought that they had a priority to receive a 200 percent return before payment to the other members; the other members (the “complaining members”) thought that the approach taken by the first class was inconsistent with their duties. Unfortunately for the complaining members, the operating agreement was clear, and the Delaware Court applied the operating agreement as written.
This case also illustrates the difference between an LLC and a corporation, and the duties that the management (managers (in the case of the LLC) and directors (in the case of a corporation)) owe to the owners where, in the corporate context, common law fiduciary duties would apply and the stringent “entire fairness” standard of review would have to be considered. Where the parties elected to conduct business through an LLC and had a well-drafted waiver of duties, the complaining members had no avenues for relief in court.
The HCP Operating Agreement Satisfied the New Investor’s Goals
According to the complaint, Christopher Miller (“Miller”) co-founded Trumpet Search, LLC (“Trumpet”) in 2008 and was a member and manager until its sale. HCP & Company, a private equity firm (“HCP”), first invested in Trumpet in 2014 when it acquired a majority of Trumpet’s Class D units, becoming Trumpet’s largest member. In 2016, HCP purchased nearly all of Trumpet’s newly created Class E units and, in connection with that purchase, Trumpet’s second amended and restated operating agreement (the “amended agreement”) was signed by all of the members, including Miller.
Under the amended agreement, HCP (as holder of most of the Class E units) was entitled to a first-priority return of 200% of its Class E capital contribution. The amended agreement also set out a distribution waterfall for determining members’ returns on capital investment in the event of a sale that effectively would give HCP, which also held 90% of the next-in-line Class D units, the first $30 million before any sale proceeds would go to other members (including Miller). The amended agreement waived all fiduciary duties of Trumpet’s members and managers and provided HCP the right to appoint a majority of Trumpet’s seven-person board of managers. The amended agreement also gave the HCP-controlled board the right to approve a sale of Trumpet to an independent third party and provided that the board could determine in its sole discretion the manner in which a third-party sale would occur (whether as a sale of assets, merger, transfer of membership interests or otherwise). If the board approved a sale, the amended agreement obligated every member to consent to it.
Seven months after the amended agreement was adopted in connection with its purchase of Class E units, HCP allegedly pushed for a sale of Trumpet to MTS Health Partners, L.P., an unaffiliated third party, which initially offered $31 million. The non-HCP managers objected to the lack of an open-market process and low price. In response, the HCP managers allowed Trumpet to undertake an abbreviated sale process and contacted two entities who had previously expressed interest in Trumpet. This outreach led to competing indications of interest (including one valued between $50 million and $60 million). HCP nevertheless continued to pursue a sale to MTS, which threatened to revoke its offer or file suit for breach of an alleged exclusivity agreement as a result of Trumpet’s outreach to other prospective buyers. The competitive pressure, however, moved MTS to increase its bid to $41 million and then again to $43 million. According to plaintiff, the HCP managers exploited the lack of other firm offers on the table at the time (as well as MTS’s threat of litigation) to “wear down” two of the non-HCP managers into accepting MTS’s offer. As a result, HCP received its contracted 200 percent return, and the other members of HCP (including Miller) received little or no consideration for their interests.
The Resulting Litigation
Miller, as a member, then brought legal action against HCP and its board designees for breach of the implied covenant of good faith and fair dealing – a covenant also existing under the Colorado LLC Act in C.R.S. § 7-80-404(3). Miller alleged that the covenant of good faith and fair dealing required HCP to conduct an open-market auction that would likely have returned funds to the other members. The defendants moved to dismiss the case based on Trumpet’s operating agreement, which Miller and the other minority members had signed, and the court granted the motion.
In granting the motion, the court noted that the implied covenant of good faith and fair dealing was (as in Colorado) intended to fill in gaps – not to create new obligations. The court found that Trumpet’s amended agreement did not contain any gap for the implied covenant to fill. The court observed that the amended agreement did not, by its terms, require the Trumpet board to conduct an auction but rather “explicitly vest[ed] the [b]oard with sole discretion as to the manner in which a sale is conducted, subject to the limitation that the company is ultimately sold to an unaffiliated third-party buyer.” According to the court, the Trumpet board had “unfettered discretion to determine both how the company will be marketed and how the sale will be structured, so long as the transaction does not involve insiders.”
The court next found inapplicable the principle that, when a contract confers discretion on one party, the implied covenant requires that the discretion be used reasonably and in good faith; the court reasoned that the amended agreement expressly defined the scope of the board’s discretion by requiring that any sale be to a third party and, thus, there was no gap in the contract or other reason for the court to look to the implied covenant to determine how the board’s discretion should be exercised. In the court’s view, the amended agreement indicated that the parties considered the implications of vesting discretion in a conflicted board, expressly addressed that situation with the third-party sale requirement, and thereby left no room for the implied covenant to operate.
The court held that, even if the amended agreement contained a gap regarding how Trumpet could be sold, the plaintiff’s implied covenant claim would fail because nothing suggested his reasonable expectations were frustrated. On the contrary, the express terms of the amended operating agreement indicated that the parties actually contemplated that Trumpet might be sold through private negotiation rather than an open-market process. Moreover, while the complaint alleged a process that was tilted in favor of the defendants’ interests, the court found that the defendants’ putative conduct during the sale process was not arbitrary, unreasonable, or unanticipated based on the plain terms of the operating agreement.
Importantly (and consider “scriven with precision”), the court noted that the parties easily could have anticipated this situation given that the defendants’ interest in a quick exit, whether or not beneficial to the other owners, was clear from the distribution waterfall itself. The court also observed that HCP did not use its control to consummate MTS’s initial $31 million offer, but rather allowed for some process to play out over several months and successfully obtained a substantial increase in MTS’s offer – the only one on the table when the deal was approved by the Trumpet board.
The court further recognized that, had the plaintiff wanted to avoid this result, he could have sought explicit contractual protections when they were negotiating the amended operating agreement. These protections might have included a minimum sale price, a majority-of-the-minority condition, or a period in which a sale was prohibited. Plaintiff bargained for none of these terms, and the court stated that it would not give plaintiff what he failed to get at the bargaining table, explaining that the implied covenant “is not an equitable remedy for rebalancing economic interests.” Accordingly, the court dismissed plaintiff's complaint for failure to state a claim for breach of the implied covenant.
What if Trumpet Had Been a Corporation?
In a very interesting discussion, the Miller decision expressly contrasted the LLC result with the Delaware Chancery Court’s typical treatment of corporate cases involving similar facts. Under Delaware case law, a sale transaction such as the one described in Miller would have been subject to entire fairness review had Trumpet been a corporation. The entire fairness review (required because of the disproportionate interests of HCP as compared to the minority members) would have required that the defendants prove the fairness of the sale process and the price. Miller, in fact, is reminiscent of In re Trados Inc. Shareholder Litigation, Consol. C.A. No. 1512-VCL (Del. Ch. Aug. 16, 2013). In that case, a former common stockholder brought suit challenging a sale of the company wherein preferred stockholders received nearly all of the sale proceeds due to a liquidation preference and common stockholders received no consideration at all. Following trial, the Court of Chancery found that a disinterested and independent majority of the board did not approve the transaction because, among other conflicts, directors affiliated with the preferred stockholders were focused on their firms’ desire to exit their investments in the company and not on the best interests of the company in general. The court further found that the company’s board did not deal fairly with the common stockholders, reasoning in part that the preferred stockholder-affiliated directors:
“did not make this decision after evaluating [the company] from the perspective of the common stockholders, but rather as holders of preferred stock with contractual cash flow rights that diverged materially from those of the common stock.”
The court held in Trados that the defendants did not breach their fiduciary duties because it was entirely fair for the common stockholders to receive nothing for their shares, which the court found to have no economic value. There were no competing bids or even indications of interest.
The Trados court summarized the duty of the directors of a Delaware corporation as including a duty to enhance shareholder value. Citing Gantler v. Stephens, 965 A.2d 695, 706 (Del. 2009) and other cases, the Chancery Court described the directors’ duty of loyalty as mandating that directors maximize the value of the corporation over the long-term for the benefit of the providers of equity capital, as warranted for an entity with perpetual life in which the residual claimants have locked in their investment. The Chancery Court also noted the “Revlon doctrine” based on Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 182 (Del. 1986). Revlon held that once the directors determined to sell the company, the directors had an obligation to obtain the highest price possible.
Like Delaware General Corporation Law, the Colorado Business Corporation Act does not contemplate that the articles of incorporation or bylaws can waive the duties of directors to manage the business in the best interests of the shareholders. The directors’ duty of care is set forth in C.R.S. § 7-108-401(1) and their duty with respect to conflicting interest transactions in C.R.S. § 7-108-501. (Of course, directors of corporations that are formed as public benefit corporations under C.R.S. § 7-101-501 et seq. are not necessarily subject to the Revlon doctrine but also need to keep their public benefit purpose in mind.)
In summary, though, had Trumpet been organized as a corporation under Delaware law or Colorado law, waivers of fiduciary duties of care and loyalty would not have been enforceable and the court’s decision on the motion to dismiss likely would have been different.
Implied Covenant of Good Faith and Fair Dealing: Ever-present, But Weak
The Miller decision describes the Delaware courts’ unwillingness to use the contractual obligation of good faith and fair dealing where it would contradict otherwise clear contractual language and where the court found no arbitrary, unreasonable or unanticipated conduct. Where there is a clear waiver of fiduciary duties in an LLC operating agreement in a manner permitted by statute, a court will be “all the more hesitant to resort to the implied covenant.” A waiver of fiduciary duties “implies an agreement that losses should remain where they fall.” While the implied covenant inheres in every contract and cannot be eliminated by provisions of an LLC agreement, Delaware courts apply it “cautious[ly]” and it is “rarely invoked successfully.” Importantly, the implied covenant will not “override the express terms of the contract,” nor is it a “free-floating requirement that a party act in some morally commendable sense.” The implied covenant is not intended to be “an equitable remedy for rebalancing economic interests after events that could have been anticipated, but were not, that later adversely affected one party to a contract.”
As the Chancery Court stated, the contractual obligation of good faith and fair dealing is intended to be a narrow gap-filler that applies only when one party “proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected” at the time of contracting, or where the contract actually contains “gaps” – that is, unaddressed issues.
The implied covenant is also intended to address circumstances where one party acts in an arbitrary, unreasonable, or unanticipated manner. This was the case in New Design Constr. Co. v. Hamon Contractors, Inc., 215 P.3d 1172, 1182 (Colo. App. 2008), where Hamon attempted to control New Design’s work under a contract in what the court found to be an unreasonable manner. “As NDCC pointed out, if the implied covenant of good faith and fair dealing were not incorporated into the contract documents, Hamon could have required it ‘to perform its paving work at midnight using teaspoons.’” In response, the Court of Appeals said that the contractual obligation of good faith and fair dealing requires that “a party vested with contractual discretion exercise that discretion reasonably, not arbitrarily, capriciously, or in a manner inconsistent with the reasonable expectations of the parties.” In Hamon, the court of appeals accepted evidence as to the custom in the industry for defining performance obligations.
The implied covenant is not intended to save a disappointed party from a bad deal. Where, as in Miller, the operating agreement provided the board the sole discretion to determine the manner of the company’s sale and addressed any risk of abuse of that discretion by restricting it solely to transactions with an unaffiliated third party, the court concluded that the parties “did consider the conditions under which a contractually permissible sale could take place” and left to the controlled board “the ability to structure a deal favorable to their interests.” This left no gap in the contract and no room for the implied covenant to work.
Conclusion
The stated statutory policy of the Delaware LLC Act, like the Colorado LLC Act, is to give maximum effect to the principle of freedom of contract and the enforceability of LLC contractual provisions as written – even though certain provisions may favor one party or another. This affords contracting parties great flexibility to privately order the affairs of the LLC and their respective rights and responsibilities. It also means that careful negotiation and drafting are essential to ensure that foreseeable scenarios are addressed and that the parties’ bargain is expressed in clear and unambiguous terms in the agreement.
Given the latitude provided by Colorado and Delaware law to organize LLCs, no two LLCs will be exactly alike.
- Founders and their attorneys should carefully organize the LLC as a manager-managed entity, and carefully draft the operating agreement to address the management, business, and tax goals expressed by the founder.
- Prospective LLC investors should review closely the operating agreement so that they are fully aware of the risks, rights, and remedies associated with an investment in the particular LLC.
- Equal attention and care should be paid to any material amendment to the operating agreement – which Miller and the other founders failed to do in the Miller case.
As the Miller court reminds us all by quoting Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010), “[p]arties have a right to enter into good and bad contracts[;] the law enforces both.”
|