FIRST STATE UPDATE: 2022 CASE LAW DEVELOPMENTS AND UPDATES TO DELAWARE'S LLC ACT
The Delaware limited liability company (LLC) continues to be one of the most popular global business entities, in no small part due to the contractual freedom and flexibility afforded under the Delaware Limited Liability Company Act.LEARN MORE
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Join us as we take a detailed look at the 2022 amendments to the Delaware Limited Liability Company Act and review recent case law developments in this complimentary continuing legal education (CLE) webinar. Inform and advise your clients looking to make the most of Delaware’s LLC statute with the most up-to-date information in your repertoire.
Presenters Matthew J. O’Toole, Michael P. Maxwell, and Alyssa Gerace Frank of Potter Anderson & Corroon LLP will share their insights, review associated case law, and discuss this year’s amendments to the Act. Attendees will have the opportunity to ask these experts about specific LLC-related case law and statutory amendments.
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Annie: Hello, everyone, and welcome to today's webinar, "First State Update: 2022 Case Law Developments and Updates to Delaware's LLC Act." My name is Annie Triboletti, and I will be your moderator.
Joining us today are guest speakers Matthew O'Toole, Michael Maxwell, and Alyssa Frank from Potter Anderson & Coroon. And with that, let's welcome Matt, Mike, and Alyssa.
Matt: Good morning, everyone. Thank you for joining us. This is Matt O'Toole. As Delaware lawyers, Mike and Alyssa and I are often or at least every now and again asked why Delaware is such a popular place for the formation of corporations, LLCs, and other business entities. And the answer that most any Delaware lawyer will provide usually involves a discussion of the so-called Delaware Advantage, which has various aspects but includes a supportive state government.
So as we seemingly emerge from the pandemic, and I'm knocking wood as I say that, we thought it might be interesting to take a quick, by no means exhaustive look at the performance of Delaware state government, its infrastructure that supports Delaware business organizations through the pandemic, starting with the Court of Chancery.
Looking at the couple of years before COVID and comparing those to 2020 and 2021, we see some fluctuation in the level of activity in terms of case filings and case dispositions. But all things considered, the volume and the output held relatively steady pre-pandemic through the pandemic and hopefully as we emerge from the pandemic. Maybe the most notable stat that we're showing here is the increase in requests for expedited case treatment.
In addition to providing a forum for the litigation of disputes involving Delaware companies primarily in Chancery Court, but also in the Complex Commercial Litigation Division of the Delaware Superior Court, Delaware offers a platform for entity formation in the Secretary of State's office, and there again, and we don't have the sales slide for this, but there again the numbers show continued smooth operation throughout the disruption caused by COVID. And that's not to say that there haven't been any challenges, but generally speaking things have proceeded pretty well.
And just to cherry-pick up a few statistics, the number of new LLCs formed in Delaware was up in 2020 by approximately 10% over 2019 and up again year-over-year in 2021. And one other statistic, the total number of Delaware corporations, LLCs, and limited partnerships in existence comparing year-end 2021 to year-end 2019 increased by about 15%. So from the quick look at the numbers, it seems pretty clear that both the judicial and the administrative arms of Delaware state government that are most prominent in the Delaware business entity field remained active and performed capably through the pandemic.
So with that little bit of background, Mike will now walk us through some of the recent LLC decisions to emerge from the Delaware Court of Chancery, starting with a case the name of which I will leave it to him to pronounce. So Mike, turn it over to you.
Mike: Thanks, Matt, and good morning, everyone. So as Matt noted, we have a few cases that we're going to discuss this morning, the first being Dlayal Holdings v. Al-Bawardi.
So in this case, the court addressed who constitutes a manager for purposes of personal jurisdiction. So in this case, Dlayal was a holding company that owned various subsidiaries, including a company called Oasis Direct Seven LLC, which we'll refer to as the "Company" as we discuss it. The Company in turn owned various pieces of real property located in a number of different states, including two ranches located in Kansas.
The Gracey family managed and ran the day-to-day operations of the two ranches. And the Graceys were Kansas residents, but were neither formal managers nor officers of the Company. And when I say "formal managers," I mean they were not designated as managers under the LLC agreement or under the LLC Act.
So when the company prepared to sell the ranches, it discovered financial improprieties and brought suit against the Graceys and Marwan Al-Bawardi, who was a former manager of the company. Al-Bawardi, who had delegated responsibilities to the Graceys, brought a third-party action against the Graceys for indemnification. The Graceys then sought dismissal for the claims filed against them based on lack of personal jurisdiction.
So the court began its analysis by noting that determining whether personal jurisdiction exists is a two-step process. First, they have to determine that service of process is authorized by statute, and second, the defendant must have certain minimum contacts with Delaware such that the exercise of personal jurisdiction does not offend traditional notions of fair play and substantial justice.
As to the first step, Dlayal asserted that the statutory basis for personal jurisdiction was LLC Act Section 18-109(a), which authorizes service of process on managers of Delaware LLCs. And Dlayal conceded that none of the Graceys were formal managers of the company, but argued that the Graceys were "acting managers" of the Company and therefore fell within the jurisdictional ambit. In support of this argument they noted that Section 18-109(a) does not specify that the defendant must be a formal manager, but rather provides that jurisdiction is proper when the defendant participates materially in the management of the LLC.
In considering the meaning of Section 18-109(a), the court noted that the plain meaning of the phrase "participates materially" has been interpreted as meaning taking part in or playing a role in an activity or event. Furthermore, the purported manager must take a meaningful part or play a significant role in the management of the LLC.
So after citing a string of cases expanding upon the definition of "material participation," the court found that the Graceys did not materially participate in the management of the company. And in support of that finding, the court noted that Rodger Gracey did not serve as an officer of the company, he did not oversee the company's operations, he did not participate in management of the company's investment portfolio, and did not have decision-making authority over all of the company's assets. And as I noted earlier, the company had other assets outside of the ranches in Kansas.
So the court found that although the company gave Rodger Gracey a power of attorney to purchase certain real property at the outset, his role was merely overseeing the day-to-day operations of the ranches. And the court found that overseeing operations at the ranches was not equivalent of participating in management. So therefore, Rodger Gracey did not qualify as a manager of the company, and there is no statutory basis for service of process.
Additionally, the court held that it did not have a statutory basis for personal jurisdiction, under 18-407, for a defendant who had been delegated authority by a formal manager. That provision provides that delegation does not make them a manager for purposes of the Act. So even though he had powers of attorney and authority to administer the ranch operations, that delegation itself did not provide that he was a manager or did not make him a manager, and therefore he was not a manager for purposes of personal jurisdiction.
Quickly, the court also, similar to the analysis of Rodger Gracey, dismissed the arguments that the rest of his family, Marnie and Betty were managers. They found that both of them had limited responsibilities over the management of the ranches, they didn't participate materially in the management of the company, and therefore there was no statutory basis for personal jurisdiction over that family, the Graceys. And so they dismissed the complaint pursuant to Court of Chancery Rule 12b-2.
Matt: So, Mike, recognizing that generalities often have to come with a caveat, in light of this case, can one conclude in general that a low-ranking LLC officer or a mere LLC employee is unlikely to be viewed as a "de facto manager" under 18-109(a), understanding that when I say "de facto," this is somebody who's not formally a manager within the overarching definition of that term in the statute, but is a manager for the limited purpose of 109(a) and its material participation standard?
Mike: Yeah, I think that's right. This court's statement that the day-to-day operations does not amount to material participation I think reflects that. And you really have to have significantly more I think . . . you know, day-to-day operations of a company versus management and overseeing and having a more significant role in the management of the LLC itself are the distinguishing factors I think there.
Matt: Yeah. So maybe some involvement with setting policy and things like that.
Matt: Those would be distinguishing factors. Okay.
Matt: And do you happen to know, off the top of your head, which judge on the Court of Chancery issued that opinion?
Mike: I do. It was Vice Chancellor Will.
Mike: All right. So moving on to our next case, in this case, the Court of Chancery addressed the validity of an amendment to an LLC agreement in determining who was the proper manager of an LLC. And this was a case from Vice Chancellor Slights, just for everybody's information.
So the parties to this dispute have been locked in litigation in a variety of courts, including the Court of Chancery, for over a decade regarding control over portfolio companies of the plaintiff, which is Zohar III Limited, which is a collateralized loan obligation vehicle that was formed years ago by the defendant Lynn Tilton. Now this particular case involved disputed claims of control over one of those portfolio companies, which is a Delaware LLC called Stila Styles, LLC, Stila or the Company.
But Stila, like all Delaware LLCs, is a creature of contract, and the LLC agreement set forth the parties' rights and obligations with respect to the governance and control of Stila. But Tilton had caused the formation of Zohar, who is the sole common member or unit owner in Stila. At the time, Tilton had owned 100% of Zohar's preference shares and until 2018 was Zohar's sole director. Tilton was also the initial Class A member of Stila upon its formation and remained so at the time of this case.
So the LLC agreement of Stila had created two classes of equity interest, as I mentioned, the common interests which were held by Zohar and the Series A Preferred interest. Zohar had held all of the Series A Preferred interest until they were redeemed in February of 2016.
Now there's a complicated procedural history involving bankruptcy and other proceedings not particularly relevant to what we're discussing today. But suffice it to say, in May of 2021, Zohar had filed a complaint against Tilton and Stila in Chancery Court requesting a judgment declaring that under 18-110 of Delaware's LLC Act that Zohar's designee as a manager, Kevin Carey, was the rightful manager of Stila.
The case was subsequently removed to the District Court of Delaware and then referred to the Bankruptcy Court for the District of Delaware at Tilton's request. And the Bankruptcy Court then remanded it to Chancery Court to make this determination.
So central to this case is a transaction that was accomplished in 2017. According to Tilton, in 2017, she had orchestrated a transaction that caused her to be appointed as Stila's sole manager, answerable only to a new class of units she had created pursuant to that transaction.
As central features of this 2017 transaction, Tilton purported to first create a new class of Stila units, two, grant the newly created units the sole right to remove and replace an existing manager or appoint additional managers among other rights, three, issue newly created units to an entity she controlled, and four admit that entity as a new member of Stila. But Tilton purported to take these steps in her capacity as manager of Stila without seeking or obtaining Zohar's consent as Stila's sole common member.
The court, after its analysis, deemed that that was a mistake. So the court found that the 2017 transaction effectively amended Stila's LLC agreement, which expressly provided that, except for any amendments otherwise contemplated herein and except as otherwise provided by law, the LLC agreement and the certificate of formation could only be amended or modified from time to time by the members. But prior to the 2017 transaction, the LLC agreement explicitly granted either the common members or the Series A Preferred Members, which the Series A went away with the redemption, they had the right to remove and replace Stila's manager.
But Tilton argued, however, that she had authority under the LLC agreement to effectuate the 2017 transaction in her sole discretion, without Zohar's knowledge or consent, specifically arguing that under Sections 3.4 and 5.4 of LLC agreement, which authorized her the ability to issue new units, that that granted her the ability to grant an entity that she controlled Class A interests on terms that she deemed appropriate, including the sole right to remove, replace, and appoint Stila's manager as well as the sole right to amend the LLC agreement as needed to effectuate the transaction.
Zohar, for its part, acknowledged the manager's rights as stated in those sections, 3.4 and 5.4, but it maintained that nothing in those provisions specifically allowed the manager to bypass the LLC agreement's requirements for seeking the members' consent before amending the LLC agreement when such consent is required under the Amendment provision, which is Section 11.3.
So according to Zohar, Section 11.3 clearly provides that if a manager is not expressly given the authority to amend a provision of the LLC agreement unilaterally, then the amendment must be approved by the members. And the court agreed with that analysis.
Zohar then argued that, under 5.8 of the LLC agreement, the members have the right to replace the manager at will, and 5.8 is the Member Replacement provision, and that Section 11.3 explicitly precludes the manager from amending Section 5.8 because Section 5.8 did not include express permission to amend. So according to Zohar, the 2017 written consent amended Section 5.8 because it purportedly granted this new class of interest, the Class A interest the sole right to remove and replace an existing manager or appoint any additional manager.
The court, in agreeing with the logic from Zohar's arguments, held that the 2017 written consent purported to amend Section 5.8 by stripping the common members' contractual right to remove and replace the manager and granting that right to another Tilton controlled entity, and that violated Section 11.3 of the LLC agreement because it amended this provision without Zohar's consent.
The court went on to note that nothing in Section 5.8 can be construed, 5.8 again being the provision that provides for the appointment and removal of managers, so nothing in that section could be construed as expressly authorizing the manager to amend it unilaterally, even if the amendment was implicitly effected through creation and issuance of a new class of membership interest in reliance on Sections 3.4 and 5.4 of the LLC agreement. So by granting the new Class A members the sole right to appoint the manager, the 2017 transaction did not just create additional rights for Class A membership interest, but it also stripped away the rights of the common members to appoint the manager as expressly and exclusively granted to it in Section 5.8, thereby amending Section 5.8 without the requisite consent, which was Zohar's consent.
Additionally, Section 5.8, the court went on to note that because it's a provision that affects a member's voting rights and the company's governance, given the sanctity of the franchise, Delaware law requires that provisions affecting voting rights and governance are to be construed strictly, and any provision that purports to restrict a franchise must do so clearly.
The court found that there's nothing in 3.4, which is the provision that authorized creation and issuance of new units, nothing in that and its provisions remotely suggests that it authorized a manager acting alone to eliminate governance or consent rights enjoyed by the members. So although there are provisions in the LLC agreement that authorize the manager to amend them unilaterally, Section 5.8 was not one of those provisions and it could not be amended at the sole discretion of Stila's manager. The contractual right to remove and replace the manager could not be amended without the members' consent, and Tilton did not obtain that consent.
So the 2017 transaction was found invalid as a matter of contract, the court found at least as it relates to the removal and replacement of Stila's managers.
So one takeaway initially from this case I think is to carefully think through provisions that grant an ability to managers to control or establish or create additional classes of interest in an LLC. If you're granting those rights to a board or managers or whoever it is that you want to create additional interest and you need to amend the LLC agreement to do so, that right needs to be clearly set forth therein, including to override amendment provisions that might otherwise disenfranchise or take away other members' rights.
Matt: It's interesting because when lawyers are representing clients entering into these agreements, we're always looking to be careful in terms of making sure that the rights and protections that the clients have are clear and they're manifest in the agreement. But those rights and protections are only so good as they can't be amended without the client's input. And so it seems to me that this case really does reinforce the importance of the amendment provisions in the agreement and emphasizes the need to make sure that those provisions are negotiated pretty carefully.
Mike: Yeah, I think that's exactly right. And especially if you have, depending on your role in the LLC, but a controlling or minority interest or whatever role you may have, those member rights can be pretty important. And so a court is going to construe those strictly. But yeah, definitely something that we need to take into account as you're drafting LLC agreements.
Matt: Yeah, and parties can be confident that a Delaware court at least is going to enforce those provisions.
Mike: Exactly, exactly.
Matt: With the freedom of contract and enforceability principles that are baked right into the LLC Act.
Mike: Right. With great responsibility comes . . .
Matt: Whatever that phrase is.
Mike: Whatever phrase is. Right.
All right. So moving on to our next case, Metro Storage International v. Harron. So this case deals with breaches of fiduciary duties by officers of an LLC. Now, as you may recall, back in 2013, there was a series of cases that expressly provided that LLCs and managers of LLCs that owe fiduciary duties. In response to that, the legislature amended the LLC Act to expressly provide essentially that default fiduciary duties of loyalty and care, or I guess we don't specify loyalty and care, but default fiduciary duties would apply.
So in this case, we're dealing with fiduciary duties of an officer. And so non-party, Metro Storage LLC, we call it Metro US, is a privately held self-storage company in the United States. And in 2010, the defendant, James Harron approached the principals of Metro US, the brothers Blair and Matthew Nagel, about establishing a self-storage business in Brazil. In 2012, Harron and the Nagel brothers agreed to work together. To carry out the venture in Brazil and potentially future ventures elsewhere, they created an entity called Metro Storage International, LLC or Metro International and its wholly-owned subsidiary, which is also a non-party to this claim, Metro Storage Brazil, LLC.
Harron served as the president of Metro International, and he had committed to devote his full time to that position. Harron had spent most of his career as an investment professional, initially with a firm and then for 18 months on his own as an independent consultant. Harron and the Nagel brothers agreed that Harron would have six months to wrap up any existing engagements for other clients before devoting all of his time to Metro International. However, rather than wrapping up his engagements, Harron continued working for his other principal client, Patrick A. Gouveia.
Mike: Yeah. During his tenure as president of Metro International, Harron regularly provided consulting services to Gouveia and his associates and affiliates. And he conceded that the services he provided to Gouveia were fundamentally the same that he was providing to Metro International as its president. To assist Gouveia, Harron disclosed confidential information belonging to Metro International and its affiliates. Harron knew what he was doing was wrong, but he did it anyway, and he kept his activities secret from the Nagel brothers and the Metro companies.
So Metro Brazil eventually began to struggle. Its primary investor began to string out its financial commitments. One of Harron's responsibility was to find new capital, but nothing had materialized. And unbeknownst to the Nagel brothers, Harron was working on sourcing capital for a cold-storage venture for Gouveia.
In 2017, Harron identified an opportunity to invest in an existing self-storage business in Central America. The Nagel brothers, having not yet known about Harron's outside consulting, went ahead and backed the new venture. And to make the investment, they formed another entity called Metro Storage LATAM LLC. Harron became the president LATAM.
And by 2018, Metro Brazil was on the brink of failure. Metro International had not made any other investments, so it was also basically defunct. Metro LATAM, however, had not performed as well as expected, but that investment had appeared sound.
Shortly after that, Harron decided to jump ship and began working in the cold-storage business. When he left, he took confidential documents that belonged to the companies. And after he left, the Nagel brothers discovered his extensive consulting for Gouveia. They caused the companies and their affiliates to file this action against Harron.
But after a trial, the court found that the plaintiffs had proved that, among other things, Harron had breached the duty of loyalty that he owed as president of the companies, and Harron had breached confidentiality restrictions in the companies' governing agreements. As part of the remedies, the court disgorged certain of the consulting fees earned by Harron and found that the plaintiffs were entitled to mandatory injunction requiring him to return all confidential information belonging to the companies. And they also, not necessarily relevant to our discussion, but also found that that they had standing to bring claims under the Stored Communications Act, which is a federal statute.
So with respect to the officer duties, the court first discussed these officer duties under Delaware law, in particular how those duties may differ from the duties of a manager or director because of the overlay of agency law in an officer's role. So the court explained that Delaware law has long held that corporate officers owe the same fiduciary duties as a corporate director, and at a minimum, those duties are loyalty and care.
The court went on to note, however, that an officer's duty of loyalty has additional dimensions precisely because officers act as agents for the entity. Agents are fiduciaries. And the court highlighted that under a particularly well-developed body of fiduciary law, agents owe additional and more concrete duties to their principal.
They also noted that the duties of officers include duties of care and went on to discuss how a duty of care for an agent is different than the duty of care for director. Directors are generally held to a lesser standard of gross negligence, whereas an agent, a court might find negligence taking into account an officer's special knowledge or expertise.
But the court went on to note that recent decisions have resolved the debate of whether an officer, acting as an officer owes duties of care similar to that of a director or more akin to those of an agent. And those cases have resolved that they do use and look to the director model for an officer's duty of care. That is the gross negligence standard applies, and special knowledge and expertise are not taken into account.
So the court also briefly discussed whether the LLC agreement modified Harron's duties, and I think this is a point that is well-settled. It's well-established, but worth just mentioning again that elimination of liability for a breach of fiduciary duties or other contractual obligations is not the same as eliminating the underlying duties. And the court went on to note that as well, highlighting that the duties themselves continue to exist, and under well-settled case law if you're going to eliminate or modify your fiduciary duties or the underlying fiduciary duties, those need to be done clearly and unambiguously.
So the court then went on to discuss whether Harron breached his fiduciary duties as an officer, and interestingly, I think for our discussion here, it's just applied fiduciary duties and in particular the duty of loyalty took into account this agency overlay.
So on the first count, it found that the plaintiffs had proven that Harron violated his fiduciary duties of loyalty by placing his own interests and the interests of his other clients ahead of the company's interests. And noted that his duty of loyalty as an agent, including a duty to use the company's resources for their benefit and not use the company's resources for his own benefit and for the benefit of his other clients. So they had proven Harron had breached the duty of loyalty by devoting substantial time and energy to outside consulting projects when he was supposed to be devoting it to the building of this international business, Metro International.
They also found that he had breached an additional duty by failing to disclose his activities to the company, noting that an agent owes the principal a duty to provide information to the principal that the agent knows or has reason to know the principal would wish to have. So they found that his consulting was information that the Nagel brothers and companies would wish to have had, which I'm sure they would have done something differently had they known that.
They also found that he breached the duty by usurping a financing opportunity. In that instance, though, the court went through a more traditional analysis of I think it's the Broz factors of corporate opportunity. So I won't go into too much detail on that.
And then the court also found that Harron breached a duty of misuse of confidential information, noting that under settled principles of agency law, an agent has a duty to not use or communicate confidential information of the principal for the agent's own purpose or those of a third party. And this duty is a specific application of an agent's basic fiduciary duty of loyalty and the inherent breach of that duty. And the court also interestingly found that this is still applicable notwithstanding claims that were also asserted that he had breached the LLC agreement confidentiality provisions because this duty did not just arise from the contractual obligation but rather because of these agency duties that require protection of confidential information as well. So because they could have asserted those claims independently of one another, they allowed both claims to proceed.
Just a couple of quick notes on the remedies. The court did not disgorge his salary, even though that was requested, his full salary from the companies because the companies did not pay his salary and the entity that actually paid his salary was Metro US, which was not a party to the claim. As you read the case, I think part of the reasoning for that is they didn't bring a claim from Metro US under essentially an employment agreement because there's an arbitration provision. So I think they tried to steer clear of that. But because they did that, they didn't work through the structure of how all the entities fit together to get to a point where the court could say that the companies bringing the claims had paid salaries that should be disgorged.
But the court did note that because he had legally obtained profits, those profits were disgorged, so, i.e., his consulting fees were taken away.
And just a note, this court or this decision was a decision by I believe Vice Chancellor Laster, yes. And interestingly, we will also be talking about another decision, as we move to our last and final case, which is also by Vice Chancellor Laster as well.
So this is the XRI Investment Holdings LLC v. Holifield. So this is an interesting case because in this final case the court is addressing the effect of void and voidable actions and the effects of not complying with the requirements of an LLC agreement that then requires the action be treated as void. So there's the Absaloam case and the CompoSecure case in the recent last couple years, and actually there was an amendment recently that addressed this issue to the LLC Act.
Unfortunately, for, I guess, the defendants here, they argued the doctrine of acquiescence should apply, and the court found that that could not apply because of the voidness of the actions.
So diving into some of the relevant facts here. In this case, Gregory Holifield was a cofounder and member of XRI, which is an investment holding company, along with a man named Gabriel. So XRI was a water recycling and midstream infrastructure company that serviced the energy exploration and production industry. Entia was a related affiliated company formed by the same individuals as a service company, designed to provide management services and personnel to operating companies.
XRI eventually sold a controlling interest to Morgan Stanley, and Gabriel, the cofounder with Holifield, focused on XRI and Holifield focused on Entia and other operating subsidiaries.
So fast-forward a few years, Holifield wanted to raise money through Entia to provide funding to some of the operating businesses that were co-owned by Holifield and Gabriel. Now the trick to this was because of the XRI operating agreement and this large investor's investment there, there's restrictions on what he can do with his units, and the lenders and the financing options required some kind of collateral or at least backstop for the financing. So this trick was to get this financing that allowed a pledge of indirect interests of Holifield's certain units in XRI, not direct pledge but interest therein to do so without violating the operating agreement or triggering some other . . . putting Morgan Stanley and XRI in a lesser position.
So Gabriel, the cofounder with Holifield, assisted Holifield in coming up with a structure that would permit this additional financing while not running afoul of the requirements of the XRI LLC agreement.
So in June of 2018, Holifield formed the defendant GH Blue Holdings LLC or Blue as a single-member LLC. He then transferred all of his Class B units in XRI to Blue. And the LLC agreement that governed XRI contained a provision that generally prohibited members from transferring their interests, except for permitted transfers. And when Holifield engaged in the Blue Transfer, he sought to comply with this provision, this exception for a permitted transferee, which was defined in the LLC agreement to include an entity that was owned solely by the transferring member.
One of the requirements for this permitted transferee exception is that the transfer be made for no consideration. The court, in its analysis, however, found that because the record showed that Holifield made the Blue Transfer as part of a larger transaction, which Holifield secured a loan of $3.5 million for Entia, the service company that he was getting to fund some of the other operations of the portfolio companies, the court found that Holifield had thus received consideration in connection with the Blue Transfer and that that fact was enough to render the permitted transferee exception unavailable and caused the Blue Transfer to violate the no transfer restriction in the LLC agreement.
Matt: So he basically got it half right.
Matt: Yeah. It transferred to a wholly-owned sub, but it didn't tick the no consideration.
Mike: The no consideration. And unfortunately, the LLC agreement specified that any transfer that violates — and you see this a lot in LLC agreements and partnership agreements — that if you violate the no transfer provision, the transfer is void. And so having shown that the violation of the no transfer provision, XRI insisted that the Blue Transfer was void ab initio and it never became effective.
Now Holifield, for his part, responded that XRI's claim was barred by the equitable defense of acquiescence. And the court found that Holifield satisfied all the requirements to prove the defense of acquiescence. He demonstrated that XRI took a series of actions which caused Holifield to believe reasonably and in good faith that XRI did not object to the Blue Transfer, notwithstanding that it was part of a financing transaction. He also demonstrated that XRI took those actions knowing everything. And in the case, he details there's multiple emails and notifications and notices. They weren't necessarily hiding the ball. And so they knew everything they needed to know about the Blue Transfer and the associated financing.
And the court notes that the actions and knowledge of Gabriel, the cofounder, contributed significantly to that finding of acquiescence because Gabriel worked with Holifield to obtain the financing for Entia. He helped him just develop the structure, interacted with the lender, knew the loan was going to close contemporaneously with the Blue Transfer, and learned the loan had closed shortly afterward and actually took credit for helping Holifield obtain the loan. Gabriel, of course, focused his time with XRI and was working with the large investor, Morgan Stanley there, and so he knew all those facts. And the court deemed, as an agent, his knowledge was imputed to XRI as well.
Then 10 months later, XRI again contributed further to this finding of acquiescence on that point. They had obtained all the documents related to the financing. XRI lawyers had thoroughly analyzed whether the Blue Transfer violated the LLC agreement, and they concluded that the violation had occurred. But also the board made a business decision not to pursue it and did not take a position that the Blue Transfer was void until December of 2020, after this case was well underway.
But before then, they had acted as if they had no intention of challenging the transfer, which was understandable because at the time they weren't sure that there was . . . Well, first off, the Blue Transfer conferred benefits on XRI by isolating the transferred units in a special purpose vehicle and structurally subordinated the other creditors. So XRI was not in any worse position because of this financing and this transaction.
XRI contended the acquiescence could not apply because Holifield had misled them about the purpose of the transfer and failed to reveal that it would facilitate the loan to Entia. But again, the court found that the evidence actually disproved those assertions.
And so, again, the court noted that Holifield and his lawyers believe reasonably and in good faith that they complied with all the directives, all the restrictions that they needed to.
So then, as time passes, the loan from XRI to Holifield becomes due. Holifield finds that he lacks the liquidity to pay it. So he asks XRI to work with him. They were unable to come up with a resolution. And so as part of that, and again, I guess stepping back, XRI had superior financing or senior financing in a claim over his units, again, which were not affected by this additional financing that he had entered into in the transaction.
But XRI then claimed, in November of 2020, that it had seized the disputed units by engaging in a strict foreclosure. Just a quick background on strict foreclosure, it's a procedure that allows a secured creditor to agree with its debtor to accept collateral in full or partial satisfaction. And it's supposed to be a consensual transaction, but it deems a debtor to have consented to a strict foreclosure if a secured creditor makes an unconditional proposal to accept the collateral in full satisfaction of the loan and the debtor fails to respond within 20 days after the proposal is sent. At that point, then the secured creditor takes title to the collateral, and the loan is extinguished. So if it's worth less than the loan, the debtor does not owe any deficiency. But if it's worth more, the debtor does not receive any of the surplus.
And in this case, the evidence showed that while they disputed the value and said this $12 million loan, the units were not enough to satisfy that, Holifield actually showed at trial that it could be $40 million or $50 million in excess of the value of the loan. So there's some real value here, which is why they're fighting over this transfer.
XRI knew that Blue, not Holifield held the disputed units as a result of the Blue Transfer, but still sent the proposal for the strict foreclosure to Holifield's address and not to the Blue address.
So really, at the end of the day, this comes down to a dispute over the validity of the strict foreclosure. But the court recognizing that also addressed the predicate issue is whether the Blue Transfer validly transferred the disputed units to Blue or if Holifield remained the sole owner, and that could be determinative of whether the strict foreclosure procedures were complied with.
So as I mentioned, there's a number of reasons why they're doing this now that there's some actual value there. But XRI therefore wants to avoid a defense of acquiescence because if it can avoid that, then it complied with the strict foreclosure and it will be a little more easy for it. Although there are, I guess, probably other disputes and other arguments to be made. But this was a very important issue for them.
So XRI argued that there are two reasons why its acquiescence did not apply and the court should not consider it. First was the claim for the breach of no transfer provision was an equitable defense. The court is essentially saying that equitable claims could not be a defense to a legal claim. And the court walked through the history of equitable defenses and found that courts of equity, that that as an overarching statement is not true, that there are certain equitable defenses, such as laches, that have been found not to be permitted to legal claims. And there's a debate over whether unclean hands could be available. The acquiescence is not precluded from applying to a legal claim.
The more significant and determinative issue here is that because the LLC agreement use the word "void" and he violated the transfer restriction, the consequence of that noncompliant act, they specified the act is void ab initio under the CompoSecure cases. And the court was required to follow the Supreme Court's decision in CompoSecure, which essentially means that with all of the implications, of course, that that term carries in common law, but it's so egregiously flawed that the parties cannot fix it whether voluntarily or by conduct. So likewise, in any litigation over the void act, a party cannot invoke equitable defenses to bar the plaintiff from challenging the void act. So in short, the act is incurably void.
The court, unfortunately, found that they could not apply the doctrine of acquiescence and therefore the transfer was void.
Now, interestingly here, the court also goes on though to note that could it apply the doctrine of acquiescence, that it would do so and lays out essentially a roadmap for an appeal of why it thinks that maybe the courts and the Supreme Court should overturn at least the reasoning of CompoSecure that equity cannot serve or that just being void itself can't have the consequences of contractual noncompliance. The court noted that the approach effectively gives private parties the ability to contract out of equity and that there are reasons that that should not have to be required. And the court notes also that the inequitable result here given the circumstances, but it's required by the case law.
Matt: Yeah. The court's decision, you can understand where the Vice Chancellor was coming out in terms of the result and also his apparent reservations because the outcome does seem kind of harsh considering the equities. And as you said, Mike, the court all but invited an appeal. The opinion was only issued last week, the beginning of last week. Do you know, off the top of your head, if an appeal has been taken already?
Mike: I do not. I looked this morning and I did not see anything that had been filed yet, so.
Matt: Well, there may well be.
Mike: Yeah, I would expect given the way this opinion was laid out. And interestingly enough, just a general practice tip, not necessarily relevant for this case in particular, but in response to the CompoSecure case, the legislature amended the LLC Act I think last year, under new Section 106 I believe.
Matt: Yeah, 18-106.
Mike: Yeah, 18-106 to provide an ability to ratify void or voidable acts. Now, there's a process to be followed in that statute. But it does provide some relief to the extent that the parties want to override a void or voidable act. It doesn't necessarily help with the litigation here, but it's something to keep in mind as you're drafting those agreements or dealing with those types of issues.
Matt: Got it. Thank you.
So we talked earlier about the pandemic performance of the Chancery Court and the Secretary of State's office, another prominent feature of the Delaware Advantage. The critical part of the state's business entity infrastructure is the General Assembly, and that legislative group is typically focused on the importance of Delaware's business laws and in fact have been keeping them up to date.
And just like the judicial and the executive branches, the legislature remained as active as ever in updating the business entity statutes the last few years. This year was no exception. Alyssa will now take us on a pretty quick trip through the 2022 amendments to the LLC Act. Alyssa.
Alyssa: Thanks, Matt. So yeah, just some brief background. These amendments were introduced under Senate Bill 275, and they were passed by the Delaware General Assembly over this past summer and signed into law by the governor on July 27, 2022. The amendments became effective on August 1st.
So I think perhaps the best way to characterize this year's amendments are as cleanup or clarifying in nature as many of them relate back to prior amendments to the LLC Act that took place from 2018 through 2020, or they clarify the effect of various provisions of the LLC Act.
For example, the amendments relating to the revival of an LLC on its registered and protected series provide clarification relating to the 2018 amendments that permitted the establishment of registered series and overhauled the LLC Act's series provisions. Similarly, so do the amendments to the definition of LLC agreement.
Likewise, the amendment regarding the permissibility of electronic signatures for certificates of limited liability company interest relate to the 2019 amendment that permitted broader use of electronic signing and delivery.
There's also a minor change to a provision regarding service of process to managers and liquidating trustees. And finally, the balance of this year's amendments generally relate to provisions of the LLC Act that provide flexibility by allowing for future effective dates or times.
So what I'm going to do is walk through the amendments in the order that they appear in the LLC Act. So we'll begin with the amendments to Section 18-101(9).
So for here, the definition of "limited liability company agreement" contained in Section 18-101(9) of the Delaware LLC Act was amended such that certain references to "limited liability company" for purposes of the definition of LLC agreement now include any protected or registered series of such company. These changes have the effect of providing that a series of a LLC does not have to execute the LLC agreement, but it's bound by the LLC agreement regardless of whether it has executed it or not.
The other amendment was adding a new clause (c) to Section 18-101(9) of the Delaware LLC Act, which is the definition of LLC agreement, to provide that an LLC agreement may consist of one or more agreements, instruments, or other writings and it may include or incorporate one or more schedules, supplements, or other writings containing provisions as to the conduct of the business and affairs of the LLC or any of its series.
Matt: Yeah. And I think these amendments are really clarifying in nature. They probably were understood by most practitioners as already applicable. But the explicitness of them is a helpful change.
Alyssa: And one other thing to note is that the synopsis to the amendments, which kind of gives some of the thinking behind the people drafting these legislative amendments, states that the amendments to 18-101(9) are not intended to imply that other references to a limited liability company in the LLC Act don't include protected series or registered series of a Delaware LLC to the extent required by context.
All right. So the next amendment was found in 18-109(b) of the LLC Act. This section sets forth rules for serving process on managers and liquidating trustees of limited liability companies. Service of process is generally effected by serving the Delaware LLC's registered agent in the state of Delaware with a copy of such process. Where a Delaware LLC does not have a registered agent, the LLC Act permits service of process to be made on the Delaware Secretary of State instead.
Once a service has been made, the prothonotary or the register in chancery of the court in which the civil proceeding is pending has to send copies of the process, among other materials, to the company's manager or liquidating trustee. So previously 18-109(b) provided that this service of process was supposed to be made to the company's registered office. The amendment that passed in 2022 now requires these materials to be sent to the company's principal place of business if such address is known. The amendment to this section doesn't change the existing requirement for these materials to also be sent to the manager or liquidating trustee at such party's address last known to the party desiring to effect service of process.
Matt: So important changes, but hardly the most exciting subject matter.
Alyssa: All right. So the next change was to Section 18-113. So importantly and especially relevant in the COVID-19 era, in 2019, there was a new section 18-113 added to the LLC Act to provide for electronic signing and delivery of documents. These provisions explicitly state that where a signature is required or permitted under the LLC Act or an LLC agreement, an electronic signature is a permissible mode of execution.
However, Section 18-113(b) provides that certain documents and actions are not governed by these new provisions, including certificates of limited liability company interest. So this then prompted an amendment to Section 18-113(b) to confirm that a signature on a certificate of limited liability company interest may be a manual, facsimile, or electronic signature.
The next amendment is to Section 18-204 of the LLC Act. So this section provides for execution of LLC related documents, including certificates that are to be filed with the Delaware Secretary of State. Generally speaking, the various certificates and other instruments that must be filed with the Secretary of State are effective when they're filed unless they provide for a future effective date or time.
Prior to the 2022 amendment, the LLC Act provided that execution by a person of a certificate filed with the Secretary of State constitutes an oath or affirmation, under penalties of perjury, that, to the best of such person's knowledge and belief, the facts stated therein are true. But in light of the ability to provide for future effectiveness, Section 18-204 was amended to clarify that a person's execution of such a certificate constitutes an oath or affirmation that the facts stated therein shall be true at the time that the certificate becomes effective, rather than at the time that it's executed.
So this kind of goes hand-in-hand with the next set of amendments. So generally speaking, instruments that are filed with the Secretary of State become effective when they're filed unless they provide some future effectiveness. So the Delaware LLC Act previously required that the filing of a certificate of conversion or domestication must be preceded by approval of the conversion or domestication of the LLC company to be domesticated or converted. And the approval has to be in the manner provided for by the document, instrument, agreement, or other writing governing the internal affairs of the converting or domesticating entity.
So in light of the flexibility that allows conversions and domestications to take place at a future effective time, Sections 18-212 and 18-213 of the LLC Act, which relate to domestications and conversions, were each amended to provide that the required approvals must be obtained prior to the time that a certificate of conversion or domestication becomes effective rather than prior to the time that it's filed.
All right. So the last set of amendments were to Sections 18-1108 and 18-1109 of the LLC Act, and they relate to the effective revival on a registered or a protected series of an LLC. So as I noted at the beginning of this summary of this year's amendments, they are largely responsive to amendments in recent years. And while the Delaware LLC Act series provisions have existed since 1996, these provisions were overhauled in 2018 and became effective in 2019. The 2022 amendments to 18-1108 and 18-1109 provide some cleanup and some clarity, including with respect to issues that may arise pursuant to the more substantive series amendments from 2018.
So by way of background, the certificate of formation of an LLC can be canceled for a few reasons that relate to failure to comply with certain requirements for registered agents. There's a lot of text relating to this amendment, but to cut through some of the statutory verbiage here, the gist of the amendments are basically to provide that if a company is canceled and then revived, the act of revival is supposed to bring back the whole company, including its series.
Where it gets a little complicated is that there's a carve-out for if a series was terminated before, not in relation to the cancellation of the company, the administrative cancellation, then such terminated series will stay terminated and will not also be revived.
And there are also the fewer minor conforming changes to 18-1108 regarding cancellation of the certificate of registered series.