By: Lori Smith and Patrick Devine
Shareholder agreements and operating agreements contain a variety of knobs and levers, many of which a company’s founders hope never to invoke. Chief among them are the provisions for resolving disputes or deadlocks in decision-making on fundamental matters and the dissolution provisions. The former sets forth the roadmap for dealing with situations where there is disagreement among the decision-makers regarding actions fundamental to the business and operations of the company, and the latter sets forth the means and methods for disbanding the company and winding up its affairs (generally based on a vote of the stakeholders). Under ordinary circumstances, when a company’s end is near, its constituents amicably initiate the dissolution process without court intervention. However, on rare occasions, they may find themselves in an intractable deadlock as to whether dissolution is necessary or appropriate. Thus, one faction may ask a court to dissolve the company by judicial decree, while another faction may oppose that request. The Delaware Chancery Court visited upon one such occasion in the case of Acela Investments, LLC v. DiFalco. On May 17, 2019, the court issued its Acela decision, which offers a rare example of the circumstances under which the court may invoke its judicial dissolution powers.
In Acela, the company in question owned two FDA-approved drugs designed to deter opioid abuse. For the first several years of the company’s existence, the managers worked in tandem to bring their drugs to market and curb the opioid epidemic. However, in 2016, the Chief Executive Officer and the President, both of whom were managers, began to quarrel about fundamental issues relating to the company’s management and business strategy. The CEO complained that the President engaged in self-dealing and other unscrupulous practices when choosing the company’s contractors, suppliers and drug manufacturers; meanwhile, the President accused the CEO of manipulating the corporate governance mechanisms set forth in the company’s operating agreement to usurp power and control. The rift came to a head in July 2018 when the CEO filed suit seeking various forms of declaratory relief that, if granted, would solidify his control over the company. The President filed a counterclaim seeking judicial dissolution of the company.
Pursuant to 6 Del. C. § 18-802, the Delaware Chancery Court has discretion to enter a dissolution decree if it is not “reasonably practicable to carry on the business” in conformity with the company’s operating agreement. If the company is the subject of a deadlock that “cannot be remedied through a legal mechanism set forth within the four corners of the operating agreement, dissolution becomes the only remedy available as a matter of law.”
As noted in previous blog posts, limited liability companies are often referred to as “creatures of contract,” as they are largely governed by the operating agreement among the members. Therefore, the issues in Acela turned upon the contractual interpretation of the provisions of the company’s operating agreement, which contained several provisions that were critical to governance of board actions. In particular, provisions relating to board actions taken at meetings and by written consent expressly provided that no action was effective unless it was approved by both the CEO and either the President or a third manager who had resigned before the CEO filed suit. Although the operating agreement allowed for an independent representative to exercise voting or consent rights as a board member with respect to a transaction in which a particular manager had an interest, it did not provide any other method for resolving a deadlock in the absence of an interested party “affiliate” transaction. In fact, the operating agreement included language that further complicated matters, as the CEO and the President not only were subject to board control, but also had to supervise and control the business and affairs of the company subject to the advice and consent of each other.
The company’s operating agreement in Acela expressly incorporated 6 Del. C. § 18-802 and the President relied upon this clause to advocate for judicial dissolution. Arguing against the President’s proposed judicial dissolution, the CEO pointed to Section 5.14(b) of the operating agreement, which provided for the independent representative voting in place of the CEO on any action pertaining to transactions that could lead to self-dealing. Thus, the CEO averred that the previously appointed independent representative – who unconditionally resigned several months before the CEO commenced his action – was free to revoke his resignation, return to his position and side with either the CEO or the President to clear the logjam.
Scrutinizing the language in Section 5.14(b), the court determined that the independent representative could not revoke his resignation and return to his position. The court noted that the language clearly contemplated only a binary situation such that the independent representative could occupy the position and be available to vote for an interested manager when necessary, or, if he became unwilling or unable to serve, then he was out of his position, and a replacement needed to be put in place. The court further observed that, pursuant to Section 5.14(b), it was unequivocal that board action was required to replace the independent representative upon his resignation. However, the deadlock stymied the board as much as it stymied the managers individually, so the appointment of a new independent representative proved an untenable solution. In fact, the court noted that both the CEO and the President recognized, before and after the litigation began, that the company’s operating agreement was intended to require board action, as they both attempted to fill the independent representative position through board action. Thus, the court concluded that no mechanism existed within the four corners of the agreement to remedy the deadlock, and it dissolved the company by judicial decree. The court noted that “if a contract is unambiguous, extrinsic evidence may not be used to interpret the intent of the parties to vary the terms of the contract or to create ambiguity.” Therefore, the court was unwilling to look beyond the express provisions of the agreement. However, the court did go on to opine that, even if Section 5.14(b) was ambiguous, the parties’ courses of conduct demonstrated their mutual understanding that board action was necessary to fill the vacancy.
Acela is another example of why business owners should be precise and thoughtful in drafting agreements relating to the governance of their business, particularly in the context of limited liability company agreements, which are largely governed by contract. Further, when entering into any partnership, regardless of entity form (or the absence of an entity, for example, in a contractual strategic alliance), the parties should focus carefully on provisions that govern deadlock and “business divorce,” as tensions are likely to be heightened when these provisions need to be implemented and interpreted. It is crucial to make sure that the intent of the parties is properly reflected and to consider appropriate language that will provide a clear roadmap for either dispute resolution or objective grounds for dissolution or exit from the partnership.
Acela should be a warning: when presented with a request for judicial dissolution, courts will scrutinize the company’s governing agreements in search of a less austere alternative, but they will not look outside the four corners of those agreements, absent ambiguity. It may prove difficult to forecast whether judicial dissolution will be a positive or negative result several years in the future; nevertheless, it behooves every business owner to contemplate the question before signing any governing agreement.
If you have any questions or would like additional information, please contact Lori Smith (firstname.lastname@example.org; 212.714.3075) or Patrick Devine (email@example.com; 215.864.6272).