Delaware Corporate Law Update

Updates on Delaware Corporate Law by Evan O. Williford, Esq., Delaware Corporate Litigation Attorney.

Goggin: LLC Fudges Fiduciary Duties

In MHS Capital LLC v. Goggin, the Court of Chancery had to interpret an oddly-drafted LLC agreement provision regarding fiduciary duties.  Goggin shows why it is in the interests of both LLC management and investors to have knowledgeable lawyers carefully review such documents.  It also shows a Delaware court dealing with the difficult task of interpreting such a provision and coming to a result that is equitable but also consistent with its plain language.

The lawsuit arose from a transaction in which the LLC’s manager allegedly diverted assets in a bankruptcy proceeding from the LLC to a group of entities of which the LLC was only one.  Plaintiff filed suit; the individual defendants moved to dismiss the complaint.

The LLC’s operating agreement contained two interesting provisions relating to fiduciary duties.  First, the agreement required the manager to act “with the care an ordinarily prudent person in a like position would exercise under similar circumstances” (as well as “in good faith” and “in a manner [he] reasonably believes to be in the best interests of the Company”).  As Delaware corporate litigation practitioners know, the default Delaware entity duty of care typically only requires behavior that is not grossly negligent, it does not impose the much higher standard of ordinary care.

Second, the agreement provided that the manager was not “liable . . . for monetary damages” for breach of his or her “duty as a Manager, except as otherwise required under the [Delaware LLC] Act.”  It is not uncommon to see waivers of damages for violating the duty of care (“Section 102(b)(7) provisions”), but those typically exclude other duties (such as good faith).

Defendants did not argue that the alleged conduct was not a breach of the fiduciary duties set forth in the agreement.  Rather, defendants argued that plaintiff’s case should be dismissed because the waiver of damages precluded a remedy.  The Court, however, emphasized that plaintiff was seeking to “disgorge the monetary proceeds received” from the alleged misconduct and “impose a constructive trust”.  The Court ruled that if a claim is stated, “the nature of [] relief [for that claim] is not relevant and need not be addressed.”  As such, the Court “need not decide whether [plaintiff’s] request for some forms of equitable relief is so close to a request for monetary damages that it runs afoul of the exculpatory provision.”  In so ruling, the Court stated that “the way the operating agreement’s ‘Manager’ standard of care—good faith and ordinary care—is meant to work with the exculpatory clause, which purports to eliminate all damages, is unclear to me.”

Faced with a non-standard fiduciary duty provision, the Court ruled that – in this case and at this stage of the litigation – the provision did not preclude plaintiff’s claims.  Thus, in a way the provision ended up costing both sides: defendants by not eliminating costly discovery and further proceedings on plaintiff’s claims; plaintiffs by preserving a chance that after such costly further proceedings the Court might hold that the appropriate remedy is unavailable after all.

The Goggin case shows the importance of having knowledgeable lawyers draft or review fiduciary duty provisions in LLC agreements before they are finalized.  Delaware fiduciary duties have many wrinkles that even an intelligent layperson, or a lawyer not familiar with the subject matter, might miss.  Costly litigation or uncertainty may be the price for not reviewing such provisions carefully.

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Filed under: Court of Chancery, Fiduciary Duties

What’s the Big Deal with Blockchain?

Over the past year or so there has been a good deal of discussion about using “blockchain” technology as a method to store corporate records, particularly about stockholders.  But what exactly is blockchain anyway, and is it coming soon to a Delaware corporation near you?

What is “blockchain”?  Blockchain technology was invented by the unidentified founder (alias “Satoshi Nakamoto”) of, and used in the establishment of, the currency “bitcoin”.  For those who have been living under a rock for the past ten years, bitcoin is a type of money that operates without a central authority and, as of January 11, 2018, had a market capitalization of approximately $240 billion.

Blockchain technology operates by replacing a single record-book with multiple identical record-books maintained by a network of participants.  For instance, with respect to bitcoin, it has enabled the creation of an entirely electronic currency (no actual coins or counterfeit-proof paper bills needed) without the necessity for a central authority to keep records of it (which central authority would need to be trusted and possibly paid by transaction fees).

There are several ways that technology has, both generally and with respect to bitcoin, to reduce the possibility of fraud.  For instance, it can apply decision rules to resolve disputes, such as when copies of the record-book disagree with others as to a transaction.

So what is the connection to Delaware corporate law?  One way in which blockchain technology shows promise is as a replacement for record-books of corporate stockholders.  As corporate lawyers know, but John Q. Stockholder might be surprised to learn, “stockholders” of large publicly held Delaware corporations frequently don’t hold their own shares.

Rather, they are what the law calls “beneficial owners”.  For historical reasons, the system that has evolved in the Unites States is that most such shares of stock are held by an organization called Depository Trust Company (“DTC”) and issued in the name of its nominee, Cede & Company (“Cede”).

So, if a “beneficial owner” wishes to vote their shares, they frequently must tell their broker to tell Cede to vote the way they want or use some other equivalent process.  This can give rise to costly unfair results.  For instance, in one phase of the Dell appraisal litigation, because the name of the stockholder of record changed, Delaware law requiring continuous ownership of shares was violated, resulting in a lost potential damages award.  In another, a mistaken instruction cost a stockholder a potential $200 million award.

One of the long-term promises of blockchain technology is to replace DTC, thereby reunifying beneficial and record ownership and hopefully eliminating some potentially unfair results under Delaware law.  A recently published article by Vice Chancellor J. Travis Laster and Skadden Arps lawyer Marcel Rosner, Distributed Stock Ledgers and Delaware Law, 73 Bus. Law. 319 (Spring 2018), goes into detail regarding blockchain technology and the promise it holds for various facets of Delaware law, and is recommended reading for those looking for a deeper understanding.

Is blockchain technology coming to a Delaware corporation near me?  The answer is maybe, but slowly.  The Delaware General Corporation Law was amended in 2017 to permit, theoretically and under certain conditions, keeping corporate records like stock ownership in blockchain format.  That being said, law and corporate America can be conservative.  The path is open for enterprising Delaware corporations to use and show the success of blockchain recordkeeping, and perhaps others will follow.

In the meantime, as Vice Chancellor Laster recommended in the first Dell decision discussed above, Delaware courts (or the Delaware legislature, for that matter), could consider changing Delaware law to ameliorate these argued unfair results.

Filed under: Appraisal, Court of Chancery

Back from the Dead: Inadequate Reserve Revives LLC

In a recent decision, Capone v. LDH Management Holdings LLC, the Delaware Court of Chancery nullified the certificate of cancellation of a Delaware LLC.  The Court did so because the LLC had established no reserve for legal claims previously known to it.  The decision highlights the requirement under Delaware law that, before an LLC is cancelled, it must make reasonable provision for known nonfrivolous claims:  zero is not enough.  If a reasonable reserve is not made, the entity may (as happened here) later be revived.

Plaintiffs were holders of units in a Delaware LLC (“Management Holdings”), which in turn was valued based on its holdings of units in another LLC (“LDH”).  Under the former LLC’s agreement, Management Holdings had the right to (and did) redeem plaintiffs’ units at a price set by a specified process.  Plaintiffs claimed that the valuation of LDH by which their units were valued was too low by some half a billion dollars, and they voiced those claims (vociferously in some cases) to management.

Nevertheless, Management Holdings’ certificate of formation was cancelled, with no reserve having been established for such claims.  Plaintiffs sued in New York on their claim that the valuation had been improper and thus a breach of contract.  When they discovered that Management Holdings had been cancelled, they filed a lawsuit in Delaware to nullify the certificate of cancellation.

On cross-motions for summary judgment, the Court granted judgment for plaintiffs.  After reviewing the applicable sections of the Delaware LLC Act and the nature of plaintiffs’ claims, the Court ruled that defendants were in fact aware of the claims due to plaintiffs’ complaints.

Next the Court discussed the establishment of a reasonable reserve under 6 Del. C. § 18-804.  In the Court’s view, that would involve factors including the potential amount of the claim as well as the likelihood of it becoming a liability.  The Court noted that a claim could in fact be “so obviously frivolous that a reserve of zero dollars would likely be sufficient”.  That being said, it concluded that plaintiffs’ reading of the LLC agreement was a “reasonable construction” and not “indisputably wrong,” and therefore a reserve of $0 was a violation of the Delaware LLC Act.  Accordingly, the Court nullified the LLC’s certificate of cancellation, thereby reviving the entity.

Key takeaways from the Court’s decision:

  • Establishing a $0 reserve for a nonfrivolous claim for a substantial amount of money may well result in an LLC’s certificate of cancellation being nullified.
  • Managers of an LLC must make reasonable provision for any known potential claims before filing a certificate of cancellation. In doing so, they may consider the likelihood that the claim will be successful, along with the potential liability if successful.
  • “[E]ven a relatively weak claim may justify a reserve,” particularly when the potential damages are large.

Filed under: Court of Chancery, LLC

Delaware Chancery Orders Defendant Directors Deposed on SLC’s Motion to Terminate Claims

Courts are restrictive in granting a plaintiff discovery in connection with the motion of a special litigation committee (an “SLC”) to terminate claims.  That is particularly true with regard to discovery directed toward defendant directors.  In a recent transcript decision, Judy v. Agar, the Court of Chancery denied motions of two defendant directors for protective orders against their depositions and certain document discovery.  The Court cited the lengthy past litigation history of the company (characterizing it as having a “black halo”), but also discussed the kinds of allegations that in its view justified such depositions.  This decision is useful because there is little caselaw discussing the scope of discovery in this context other than from an SLC.

In this case, plaintiffs sought and received discovery from the SLC.  The key question on defendants’ motions was what discovery plaintiffs would be permitted from certain defendant directors who benefited from the SLC’s motion to dismiss certain claims.

The Court denied the motions and began with the observation that this was not “a typical case”.  Rather, it continued, the case was one “that I’ve had for however many years now where people hide things, they lie, they engage in fraud.”  “No phase of this company’s multi-phase history has ever involved actions that are inspiring of confidence,” said the Court.  But for that background, the Court said it would have been “highly likely” to “limit the scope” of discovery.

The Court also observed that other circumstances “were probably sufficient to warrant a deposition regardless”.  One director had engaged in communications with the (single-member) SLC concerning its functioning such as whether an in-person meeting with plaintiffs’ counsel was appropriate, fees the SLC should pay, and changes in SLC composition upon the election of new directors.  The Court held that those communications “are probably sufficient to warrant a deposition regardless.”  Similarly, it held that another director’s relationships with certain parties, particularly the SLC, were sufficient to warrant his deposition.

Separately, the Court noted that no live testimony would be permitted in the hearing on the SLC’s motion to terminate certain claims (a “Zapata” hearing), reasoning that the applicable standard was akin to a summary judgment motion.

The Court did not lay down a new rule or standard for discovery from defendant directors as to an SLC’s motion to terminate litigation.  It is a given that such discovery may be difficult to obtain and may require a particularized showing from plaintiff.  The Court, however, may be influenced by extensive past bad conduct on the part of the company or those associated with it.   It may also grant discovery into (1) communications between the SLC and the defendant director about the functioning of the SLC; and (2) specific relationships between the defendant director and others, particularly the SLC, that could have a bearing on the SLC’s motion.

The Williford Firm LLC serves as counsel for plaintiffs in this action.

Filed under: Court of Chancery, Derivative Actions, Zapata

Owners of a Delaware Business Entity

In talking about how a Delaware business entity functions, it is important to keep in mind three groups of people: (1) the managers; (2) the directors; and (3) the owners.  Not all business entities will have all three, and in some (particularly small) entities they might be the same people.

But each of these groups have different jobs.  The managers (or officers) run the entity on a day-to-day basis.  The directors hire and fire the managers and oversee their performance and the entity’s business.

And then there are the owners.  The owners of a Delaware corporation are its “stockholders;” and the owners of a Delaware LLC are its “members”.  As important as the managers are, as powerful as the directors can be, none of them own the entity – the stockholders or members do.

So what rights do the owners have?  We can think about their rights as generally dividing into three categories – transfer rights, other financial rights, and voting rights.

The first category of rights the owner has stems from the fact that they have a percentage ownership in the entity itself.  For example, stock in a well-known and publicly traded Delaware corporation like The Walt Disney Company will have a recognized price; the stockholder can sell their stock for that price.  To many stockholders that may be only right they care about.  An entity’s organizational documents could limit those rights.

Owners can have other financial rights.  An entity may choose to return a share of its profits to stockholders through “dividends”.  When a corporation is liquidated, the money left after it has paid its debts and sold its assets (if any) is divided among the stockholders.  And if a corporation is acquired through a merger, its stockholders could receive an amount equal to their interest in its fair value.

All of these rights would be worthless if not for the right to vote.  Owners have the right to vote on certain important matters, such as who will manage and run the entity.  For instance, a stockholder in a corporation may have the right to elect directors.  Stockholders may also vote on certain fundamental corporate changes such as mergers, dissolutions, and amendments to the articles of incorporation.

Filed under: Basic Law of Corporations

Registered Agents

Every business entity formed in Delaware – whether a corporation, LLC, or some other form – is required to have a “registered agent”.  A registered agent is a person or business physically located in Delaware that can receive documents and forward them on as necessary.

Why have a registered agent when someone can just send mail to business headquarters?  Because Delaware business entities and their managers can be sued in Delaware courts, someone must be present in Delaware to receive “service of process” (that is, typically the complaint along with a summons ordering the defendant to respond).  This reduces the risk that a business will intentionally avoid being served and thus having to defend itself in court.

There are many registered agents to choose from; they can be found quickly online and are often very inexpensive.  Some registered agents serve hundreds or thousands of businesses.

Once a registered agent has been hired, the business must designate that registered agent on a filing with the Delaware Division of Corporations.  A business can change its registered agent anytime by making a filing with the Delaware Division of Corporations noting the change.  You can find any Delaware business entity’s registered agent on the Delaware Division of Corporations’ website.

If a business entity fails to maintain a registered agent, then the Delaware Division of Corporations will serve as a fallback registered agent.  Eventually the entity’s certificate of incorporation or formation may be canceled, however, making it difficult or impossible for the entity to function legally.

Filed under: Basic Law of Corporations

Forming a Delaware Entity

So how does someone actually form a Delaware entity?  As it turns out, the actual tasks required to form one are not that expensive, nor do they take a lot of time.   But it is important to understand in advance why you want to form such an entity, as that will affect various choices you make along the way.  And, of course, it is always a good idea to get the advice of a qualified lawyer.

First, you must decide what kind of entity you want.  For example, do you want to form a corporation or a limited liability corporation (“LLC”)?  There are a number of other forms, though the ones specifically mentioned are among the most common.  We have discussed these common entity forms and their characteristics in a previous post – keep those in mind when selecting an entity form, do your own research and thinking, and seek qualified legal advice.

You will also need to choose a name for the entity.  That name will have to follow certain rules that you can find out from the Delaware Division of Corporations.  For example, obviously, it cannot be the same as an existing business.  There are other rules, such as that a corporation must including a word like “incorporated” or “corporation” (or an abbreviation like “inc.” or “corp.”).

If the entity will not have an office in Delaware, you will need to hire a “registered agent” and put their contact information on the forms you file with the Division of Corporations.  A registered agent is a person or company whose job it is to accept service of process if your entity is sued in a lawsuit in Delaware.  Hopefully that will never happen!  But the good news is that registered agents are relatively cheap.  A number of companies provide that service for a relatively low yearly price; information regarding them is available online.

It is a very good idea – and sometimes necessary – to put together certain organizational documents.  We have briefly discussed in a previous post what organizational documents are and how they create rules for that entity.  An attorney can help you do that, or you can look online for various resources, such as sample documents, to help you do that yourself.  If you are doing that yourself, be very careful to make sure that all the rules make sense for the entity you are forming.  Many lawsuits are caused or made worse when an entity has rules that apply not because they made sense for that entity, but because someone just adopted them without thinking about it!

Next, go to the Division of Corporations’ website and find out what they need from you to form your entity.  They will charge a filing fee, depending on what type of entity you want to form and whether you are in a hurry.  They will also tell you whether you need to file the entity’s organizational documents, and if so which ones.  When your paperwork is ready, mail or fax it to the Division of Corporations.

Now you have formed your own Delaware entity!  A Delaware entity has certain things it must do every so often in Delaware to maintain its good standing.  For example, corporations must file an annual report and pay a franchise tax; other entities similarly have to pay an annual tax.  Keep in mind there are a number of other things you may want or have to do that are outside the scope of this post, such as (1) getting an “Employer Identification Number” from the U.S. Internal Revenue Service; and (2) registering to do business in the State of Delaware, or another state.

Filed under: Basic Law of Corporations

Types of Delaware Business Entities and Limited Liability

The most well-known business entity, of course, is the corporation.  There are many others, however, such as limited liability companies (“LLCs”).  Each one has its own characteristics.  Which should a business owner choose?  That depends on their circumstances.

The corporation has a well-defined structure that most people dealing with it will be familiar with.  Its day-to-day business is run by certain key people called “officers.”  The officers themselves are hired, fired, and supervised by “directors,” who sit on what is known as a “board of directors.”  And the corporation itself is owned by “stockholders,” who can in turn elect the directors.

Another popular entity form is the LLC.  One of the big advantages of the LLC over a corporation is that it is possible to greatly customize how that LLC is structured, far beyond what is possible with a corporation.  With great freedom comes great responsibility, however.  Those forming an LLC should make sure that its structure, typically specified in detail in a document called an “LLC Agreement,” matches what is needed for the business.

Another consideration for those forming a business entity is taxation.  Some entities may elect with the U.S. Internal Revenue Service to pass income through to their owners, such as “S Corporations,” while others are taxed twice, once at the entity level and again at the owner level.  Those considering this issue should consult their accountants as to which tax treatment is best for them and what business forms qualify.

A key feature of many business forms is “limited liability.”  That means business owners are not generally liable for the business’s debts.  Thus their “liability” has been “limited”.  This was an important historical reason behind the rise in popularity of the corporation.  Investors wanted the ability to take risks by investing their money into a business without the possibility that if the business failed its creditors might go after them.

To form a Delaware business entity like a corporation or LLC, one needs to file the appropriate forms with the Delaware Division of Corporations, as will be discussed in another post.  But what happens if a business is run without creating a legal business entity?  The answer depends upon the state the business is operating in, but one possible result is the formation of a “sole proprietorship” or “general partnership”.  Such entities typically do not have limited liability.  That is one of many reasons it is important to properly form a business entity with a state like Delaware.

Filed under: Basic Law of Corporations

Governing Documents

While the state of Delaware creates rules that Delaware entities have to follow, all Delaware entities have some flexibility to create rules for themselves (though some, like LLCs, have more than others, like corporations).  They create those rules in “governing documents.”  What those are depends on what kind of entity it is.

Let’s start with the classic business entity, the corporation.  It typically has two core governing documents: (1) a “certificate of incorporation” (also called a “charter”); and (2) a “bylaws”.

The certificate of incorporation must be filed with the Delaware Division of Corporations (so it is “public” in the sense that anyone who wants to pay for a copy can get one).  This is a short document that must contain certain basic information or rules about the corporation, including certain details about the corporation’s stock and the name of the person forming the corporation.  It can also contain other rules, like eliminating directors’ liability to pay money for breaches of the fiduciary duty of care (we’ll talk about fiduciary duties in another post) or requiring the corporation to pay directors’ legal fees if they get sued.

The corporation can also have bylaws.  This is typically a longer document that contains more detailed rules, such as the procedures for its annual stockholder meetings and its board meetings, how stock is issued and transferred, and the duties of its officers.  If there is a conflict between the bylaws and the charter, the charter wins.

An LLC does not really have anything like a charter.  Rather, it is only required to file a “certificate of formation” with the Division of Corporations, which only needs to include its name and registered agent.  LLCs are sometimes preferred because of this additional privacy.

The primary governing document for an LLC is an “operating agreement” or “LLC agreement,” which basically serves as the LLC’s charter and bylaws all rolled up in one.  It is even more important because an LLC has much greater flexibility than a corporation to create its own rules.

There are many sample charters, bylaws, and LLC agreements on the internet.  But beware!  It can be very complicated to create business rules that work with existing law and to anticipate and provide for potential emergencies or disagreements.  If you are going to use a form, think very carefully about how you want the business to function and carefully edit the form accordingly.  But usually it is far better to hire a lawyer with business governance experience to draft the documents.  Once a lawsuit is filed it is too late to make rules that would have prevented it.  As Benjamin Franklin once said, “an Ounce of Prevention is worth a Pound of Cure.”

Filed under: Basic Law of Corporations

Why Delaware?

You may have noticed that many large U.S. and international businesses are incorporated in the U.S. state of Delaware.  (For that matter, the authors are Delaware lawyers.)  Why is that?  After all, Delaware is a small state and very few large businesses are headquartered there.

The United States of America has a federal system of government:  national law governs some subjects while state law governs others.  Business formation and governance (the way the business is structured and controlled) is one subject typically governed by state law.  Thus, each state has its own laws governing businesses formed in that state.

Delaware has a long history of laws allowing businesses to form the entities most appropriate for their needs.  Those laws are designed, and amended typically every year, to allow a flexible response to any business conditions that might be encountered while also protecting the rights of investors.

Delaware also has a separate court, the Court of Chancery, which over the years has evolved into a court that specializes in resolving many business disputes.  Cases involving Delaware entities, particularly regarding their formation and governance, will often be brought or transferred to that court.  Its five judges specialize in resolving those cases fairly and predictably under Delaware laws and the court’s past decisions interpreting those laws.  Therefore, a business has some assurance that if it forms in Delaware a lawsuit brought in that state of formation will proceed predictably.

For these reasons and more, businesses that are large or seek investment will often form in, or move to, Delaware.  Small U.S. businesses, particularly those that anticipate doing business only in one state, might consider forming in that state instead.

Filed under: Basic Law of Corporations, Uncategorized

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Disclaimer

Delaware Corporate Law Update solely reflect the views of Evan Williford of The Williford Firm, LLP. Its purpose is to provide general information concerning Delaware law; no representation is made about the accuracy of any information contained herein, and it may or may not be updated to reflect subsequent relevant events. This website is not intended to provide legal advice. It does not form any attorney-client relationship and it is not a substitute for one.