Lewis H. Lazarus, Morris James

Delaware statutes enabling formation of unincorporated entities like limited liability companies (LLCs) and limited partnerships afford freedom for owners to structure business relationships as they see fit. This freedom carries with it the responsibility  to accurately and completely describe the parties' rights and duties. It also means that when disputes arise among owners or managers, a Delaware court will resolve the dispute through application of principles of contract interpretation. Moreover, if the parties in their foundational agreement do not address an issue, the court will apply default rules under the applicable business entity statute. The recent case of Domain Associates LLC v. Shah, C.A. No. 12921-VCL (Aug. 13, 2018), well illustrates these principles—the court applied default rules under the Limited Liability Company Act to hold that an expelled member of a Delaware LLC was entitled to the fair value of his interest and not simply to the value of his capital account.

Background

This dispute arose when principals of Domain Associates LLC exercised their rights to force the withdrawal of a member of the LLC. The operating agreement allowed for this expulsion upon a vote of all the other members. The LLC offered to pay the departing member the value of his capital account which was approximately $438,000. He refused to accept this payment and when a mediation failed, this action, initiated by the company, proceeded. A three-day trial ensued with Domain reflecting the court's post-trial decision.

Court Finds Parties' LLC Agreement Was Silent as to Compensation Due a Member Upon Forced Withdrawal

The court held that the LLC agreement was silent as to the payout due a member whose withdrawal was forced by the vote of the other members. It held that the provisions in the LLC agreement addressing payouts to retiring members did not address a forced withdrawal. Because the court held that the LLC agreement did not address payments due a member upon a forced withdrawal, it also rejected the plaintiff's invitation to consider extrinsic evidence. It did so because “principles of contract interpretation foreclose considerations of extrinsic evidence” when the scope of the provisions at issue are “plain and unambiguous.” Also, the court relied upon Delaware Supreme Court precedent that where, as here, “one side drafted the agreement and presented it on a take-it-or-leave-it basis,” extrinsic evidence yields only the views of one side. Therefore, the doctrine of contra proferentem applied such that the court would construe any ambiguities against plaintiff domain as the drafter. The court observed that even if it were to consider extrinsic evidence, the best evidence was the company's course of dealing which showed that the company always paid those who left the company millions more than the value of their capital accounts.

Court Rejects Plaintiff's Argument That Court's Interpretation Leads to Irrational Result

The plaintiff argued that the court's interpretation favored “derelict managing members or members whose areas of focus are uneconomic for the firm” by compensating them more than those who withdraw for more sympathetic reasons. The court noted that whether a person is derelict or underperforming is a question of judgment as to which humans can disagree. Therefore, “it is rational for sophisticated individuals to be worried about disputes and to want protection against being forced out following a legitimate disagreement over performance or due to a power struggle or personality conflict.” In the latter circumstances, limiting the payout to the value of the capital account would allow the remaining members who voted for a forced withdrawal to benefit by ganging up on a disfavored member. Protecting against this result by excluding the forced-withdrawal from the capital account payout scenario is therefore a rational result.

Court Applies Default Rule Under the LLC Act

The plaintiff argued that Section 18-604 supplies the default rule. That statute limits the payout to a resigning member to her capital account. The court relied upon authoritative commentary explaining that this provision uses the term “resignation” to connote “a person's autonomous withdrawal from the company.” Because Nimesh Shah did not resign voluntarily, this provision was inapplicable. Since no other section of the statute applied, the court relied upon Section 18-1104 of the LLC Act, which provides that when no other section of the LLC Act applies, “the rules of law and equity … shall govern.” Because Domain was member-managed, the court analogized to partnership law. Section 15-701 of the Revised Uniform Partnership Act provides that an expelled member is entitled to a payment in an amount equal to the fair value of the partner's economic interest in the enterprise. The court thus applied the same rule here.

Lessons Learned

Parties forming agreements to govern their rights and duties in unincorporated entities must be attentive to the words they choose to describe their governing structure. If they structure their entity like a corporation, with, for example, a board of directors and officers, they can expect that a court in a future dispute may analogize to corporate law precedent. Similarly, if they create a member-managed LLC, which courts have likened to a partnership, they should expect the court may apply precedent from partnership law. Better still, they should make their intentions clear and do their best to anticipate future circumstances and address them clearly in the governing documents. Among other lessons, Domain teaches that where the parties have omitted discussion of a topic, silence does not create ambiguity and well-settled principles of contract construction, rather than extrinsic evidence, will determine the result.

Lewis H. Lazarus ([email protected]) is a partner at Morris James in Wilmington and chair of the corporate and commercial litigation group. His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations.