By Jay McMillan
Members of a Delaware limited liability company (LLC) are protected from liability for debts and obligations of the LLC to third parties. 6 Del. C. §18-303. However, in a recent case, Domain Associates, L.L.C. v. Shah, C.A. No. 12921-VCL (Del. Ch. Aug. 13, 2018), Vice Chancellor Laster of the Delaware Court of Chancery held that members of an LLC who voted to terminate the membership of another member (Shah) were jointly and severally liable with the company to Shah for damages arising from their failure to pay Shah the fair value of his proportionate interest in the company.
In Domain Associates, the LLC was the management company of a venture capital firm. Shah was given a membership interest in the LLC based on his track record as an employee and his expertise in the medical devices industry. However, because of a “budgetary restructuring,” and because returns on medical device companies “severely lagged other sectors,” the other members decided that the company “no longer needed a medical devices professional.”
Shah “did not handle the news well.” He “became petulant,” asked for a written severance proposal, and “demurred or deferred” when asked for a face-to-face meeting. Eventually, the parties arrived at a “98% final draft” and agreed to let their attorneys finalize the agreement. “That would prove to be a fateful decision, because involving the lawyers caused matters to escalate.” The parties nonetheless arrived at a “handshake deal,” but when the company put the deal points in writing, Shah “rejected them out of hand and without explanation.”
The company’s operating agreement allowed for the removal of a member by the unanimous vote of all the other members. All of the members except Shah voted to remove Shah from the company. They took the position that upon his removal Shah was only entitled to the value of his capital account, $438,353.05, and not to the fair value of his membership interest. Shah contended that he was entitled to his proportionate share (12.1%) of the company’s cash on hand; his proportionate share equaled $1,553,667.
The company sued in the Delaware Court of Chancery for a determination of the amount due. The Court found that the LLC’s operating agreement did not specify what was due to a member upon a forced withdrawal. Nor did the Delaware LLC Act provide for treatment of members who withdraw involuntarily. The Court looked to Section 18-1104 of the LLC Act, which provides that in the absence of any applicable provision in the LLC Act, “the rules of law and equity … shall govern.” 6 Del. C. § 18-1104. Although the Court did not find any case law in the LLC context on point, it found that in Hillman v. Hillman, 910 A.2d 262, 271-78 (Del. Ch. 2006), then-Vice Chancellor Strine applied the analogous provision in the Delaware Limited Partnership Act, 6 Del. C. § 17-1104, to a case involving the expulsion of a limited partner. In Hillman, the Court referred in turn to Section 15-701 of the Delaware Revised Uniform Partnership Act, 6 Del. C. § 15-701, which requires that an expelled partner be paid the fair value of its economic interest in the partnership. The Court in Hillman reasoned that the same result should apply in the limited partnership context.
The Court in Domain Associates in turn reasoned that the same result should apply in the LLC context, particularly because the LLC in question was a “member-managed entity whose governance structure resembled a partnership.” The Court therefore concluded that Shah was entitled to the fair value of his proportionate interest in the LLC.
At trial, the parties presented competing experts on fair value. Shah’s expert opined that Shah’s membership interest was worth between $4.299 million and $6.067 million, while the company’s expert arrived at a fair value of $531,000. The Court adopted the company’s model, but with various changes to the inputs, most of which were favorable to Shah, and directed the parties to make the calculations. The Court also ordered that the company’s cash on hand, $12.8 million (less three months of operating expenses) should be added to its value.
Finally, the Court found, “[g]enerally speaking, a party to a contract is liable when it engages in breach. That is true for operating agreements, just as it is for other contracts.” The members of the LLC were parties to its operating agreement. They breached the agreement by failing to pay Shah the fair value of his membership interest, “while at the same time they each benefitted proportionately for the elimination of his interest.”
The members cited Section 18-303 of the Delaware LLC Act, titled “Liability to third parties,” which states that “the debts, obligations and liabilities of a limited liability company … shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager … shall be obligated personally for any such debt, obligation or liability … solely by reason of being a member or acting as a manager of the limited liability company.” The Court found, however, that Shah was not a “third party,” but rather was a member of the LLC, and the remaining members were not “passive actors,” but rather “acted by voting for Shah’s removal and then determining what positions to take regarding what Shah would be paid.” They were liable because it was their actions that resulted in breach of the operating agreement.
Domain Associates shows that although members of a Delaware LLC are not liable to third parties, they can be held liable under the Delaware LLC Act for causing breaches of the operating agreement that injure other members and benefit themselves. But given the freedom of contract inherent in the LLC form, it should be possible to draft an LLC operating agreement that would limit or eliminate that liability, for example so that a removed member would get only 50% of fair value or, if removed for cause, would get nothing but what the member originally invested. In Domain Associates, the Court made its ruling under the default provisions of the LLC Act and pertinent case law because the operating agreement did not specifically provide for payment to members who were compelled to withdraw.
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.