By Jay McMillan
Managers of Delaware limited liability companies can be compelled to appear in Delaware courts if they are either formally named as managers under an LLC’s operating agreement (“formal managers”) or if they “participate materially in the management of the limited liability company” (“acting managers”). Under Section 18-109(a) of the Delaware LLC Act, serving as either a formal manager or an acting manager constitutes consent to service of process in a lawsuit and with it the exercise of personal jurisdiction by the Delaware courts. 6 Del. C. § 18-109(a).
LLCs can be either “member-managed,” where the vote of holders of a majority of the membership interests governs, or “manager-managed,” where the LLC agreement provides for a formal manager. In Metro Storage International LLC v. Harron, 2019 Del. Ch. LEXIS 272 (Del. Ch. July 19, 2019), the defendant, Harron, served as the acting manager of two Delaware LLCs. Although the LLCs were manager-managed, Harron was not the formal manager of either one. Based on the fact that Harron did manage the day-to-day operations of the two LLCs, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery found that Harron participated materially in their management and thus satisfied the plain language of the statute.
Harron argued, however, that to be an acting manager under the statute, a person must occupy a “control or decision-making role” and that any time an LLC agreement vests authority in a formal manager, another person cannot have a control or decision-making role and the LLC therefore cannot also have an acting manager. He also argued that a person who participates in management of an LLC as an agent for another cannot be an acting manager. The Court rejected those arguments.
The “Control Overlay” Argument
The Court referred to the first argument as the “control overlay” argument based on cases in which Delaware courts “added a layer to the material-participation test by holding that persons are not amenable to service as acting managers unless they occupy a ‘control or decision-making role.’” In the first such case, Florida R & D Fund Investors, LLC v. Florida BOCA/Deerfield R & D Investors, LLC, 2013 Del. Ch. LEXIS 216 (Del. Ch. Aug. 30, 2013), the Court of Chancery “mentioned the phrase ‘control or decision-making role’ once, in passing, without citing authority to support the formulation, and without providing any reason for departing from the statutory material-participation test.” The Court in Metro Storage found that “Later decisions have followed its language without testing the foundation’s footings.”
In the second case, Wakley Ltd. v. Ensotran, LLC, 2014 U.S. Dist. LEXIS 34918 (D. Del. Mar. 18, 2014), the United States District Court for the District of Delaware, following Florida R & D, “made the control overlay more onerous by interpreting a ‘control or decision-making role’ as requiring that the person named as a defendant be ‘effectively running [the entity’s] entire business.’” The District Court “elevated the control overlay from a passing phrase to an operative test, while further elevating the necessary level of involvement to require ‘effectively running [the LLC’s] entire business.’”
The Court in Metro Storage found that a more recent opinion of the Delaware Supreme Court, Hazout v. Tsang Mun Ting, 134 A.3d 274 (Del. 2016), “requires abandoning” the control overlay. Hazout addressed the analogous consent-to-service statute for directors and officers of Delaware corporations, 10 Del. C. § 3114. That statute provides for personal jurisdiction in two kinds of cases: (i) “all civil actions or proceedings brought in this State, by or on behalf of, or against such corporation, in which such officer is a necessary or proper party,” and (ii) “any action or proceeding against such officer for violation of a duty in such capacity.”
But in Hana Ranch, Inc. v. Lent, 424 A.2d 28 (Del. Ch. 1980), the Court of Chancery held that Section 3114 applied only to “claims asserting that the defendant had breached duties owed to the corporation or its stockholders,” abrogating the “necessary or proper party” portion of the statute. Hana Ranch was followed for 36 years, until the Delaware Supreme Court rejected it in Hazout, finding “it is our obligation to give effect to the plain language of statutes to the extent we can do so without offending any supervening constitutional limits.” The Delaware Supreme Court thus restored the Delaware courts’ full range of personal jurisdiction over corporate officers and directors in keeping with the plain language of the statute.
In Metro Storage, the Court of Chancery found that the same reasoning should apply to the consent statute for managers of LLCs; the control overlay violates the plain language of 6 Del. C. § 18-109(a), which provides for jurisdiction over persons who participate materially in the management of a Delaware LLC—the statute is not limited by its terms to persons in a control or decision-making role.
The “Formal Manager Designation” Argument
Next, Harron argued “that a defendant cannot serve as an acting manager if the operative LLC agreement contains a formal manager designation.” In Fisk Ventures, LLC v. Segal, 2008 Del. Ch. LEXIS 158 (Del. Ch. May 7, 2008), the defendant, Fisk Johnson, was a major investor who had the right to appoint two members to the LLC’s “Board of Member Representatives.” The plaintiff, Segal, argued that Johnson was an acting manager because he “(i) controlled his board appointees and (ii) participated in the management of [the LLC] through broad veto rights.” The Court of Chancery in Fisk Ventures rejected the first part of the argument, finding that Johnson did not materially participate in management.
The Court in Fisk Ventures also rejected the second part of the argument. The company’s LLC agreement provided that the members of the LLC “shall conduct, direct and exercise full control over all activities of the company through their representatives of the board.” The Court concluded that “the designation of the board as the formal manager precluded Johnson from qualifying as an acting manager.” The Court in Metro Storage found that, because the material participation test was not met in Fisk Ventures, “[t]he reference to the formal manager designation in the… LLC agreement did not add anything to the analysis.”
In support of the formal manager designation argument, Harron cited three cases, Wakley Ltd. v. Ensotran, LLC, 2014 U.S. Dist. LEXIS 34918 (D. Del. Mar. 18, 2014) (discussed above), In re Dissolution of Arctic Ease, 2016 Del. Ch. LEXIS 185 (Del. Ch. Dec. 9, 2016), and CelestialRX Investments, LLC v. Krivulka, 2019 Del. Ch. LEXIS 102 (Del. Ch. Mar. 27, 2019). The Court found that those cases were “not persuasive precedents.” In Wakley, the District Court found that although a defendant had “broad authority,” “her power was ‘subject to the decisions and instructions of the board.” The Court concluded that the defendant “is not a ‘manager’ under § 18-109(a)(ii) because she did not participate materially in the management of [the LLC].” The Court in Metro Storage found that “This brief reference does not appear to have played a meaningful role in the court’s analysis.”
In Arctic Ease, the LLC’s managing member argued that the Court of Chancery had personal jurisdiction over an investor because the investor participated materially in management. The Court found that because the LLC had a managing member who was empowered by the LLC agreement to manage the company, the investor “could not have served in the type of ‘control or decision-making role’ necessary to satisfy the control overlay.”
Similarly, in CelestialRX, the Court of Chancery found that a former board member “could not have participated materially in management because he no longer occupied a control or decision-making role.”
The Court in Metro Storage found that in all three cases the factual allegations did not support jurisdiction under the plain-language test, and that they all “reached outcomes for which the formal manager designation was unnecessary.” The Court also found that the formal manager designation argument derived from the control overlay argument that it had already rejected and that it originated from a misreading of case law. The Court concluded “Because LLCs have flexible governance structures and often operate with a relatively high degree of informality, the broader formulation enables Delaware courts to exercise personal jurisdiction over key individuals who take action on behalf of the entity.”
The “Agency Shield” Argument
Harron’s third and final argument was that “if a person participates materially in the management of an LLC while acting as an agent, then the person’s actions as agent cannot support a finding of material participation because the agent is acting on behalf of his principal.” In Wakley, the Court stated that the plaintiff failed to convince the Court that the defendants “were not acting at the direction of, and as representatives for” the investor who appointed them. The Court in Metro Storage rejected this “agency shield” argument, finding that it was a version of the “fiduciary shield” doctrine, “which holds that when an officer or other agent for an entity engages in acts within a jurisdiction in an official capacity, the agent is not subject to jurisdiction based on official acts, but only for acts committed in a personal capacity.”
The Court found that “Scholars have thoroughly critiqued the fiduciary shield and argued for its rejection,” that it conflicts with the Delaware long-arm statute, 10 Del. C. § 3104(c)(1), which authorizes service of process on a person who engages in forum-directed activity “in person or through an agent,” and the common-law agency theory of jurisdiction, which allows the exercise of jurisdiction over a non-resident principal by attributing the jurisdictional contacts of the agent to the principal.
The Court thus rejected the agency shield argument, and concluded that Section 18-109(a)(ii) can be used to serve a person with process “even if the person acted as an agent of the LLC or its formal manager.”
By rejecting Harron’s arguments and hewing to the plain language of the LLC Act, the Court of Chancery confirmed the full range of jurisdiction of Delaware courts over acting managers of Delaware LLCs in keeping with the statute. Acting managers of Delaware LLCs and their counsel should be aware that any person who participates materially in the management of a Delaware LLC can be haled into a Delaware court in any case “involving or relating to the business of the limited liability company or a violation by the manager . . . of a duty to the limited liability company or any member of the limited liability company….” 6 Del. C. § 18-109(a).
* This blog post is a reprint of an article to be published in the August 2019 edition of the newsletter of the ABA Business Section’s Middle Market and Small Business Committee.
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.