DE Chancery Court Won't Dismiss Action Seeking Dissolution of a Deadlocked Joint Venture

The venture was structured as a Delaware limited liability company. Although Lola owned 51% of the membership interests in Proto-Auto and Krohn owned the remaining 49%, the parties agreed to equal representation on Proto-Auto's governing board, with each member initially appointing one member. Krohn appointed Jeff Hazell, who had managed Krohn since its creation in 2005, as its board designee. Krohn also agreed to provide Hazell's services as Proto-Auto's chief executive officer to fulfill its primary obligation under Proto-Auto's LLC operating agreement.

After two years, it became clear that Proto-Auto proved would not be a successful enterprise. Lola contended that, in an attempt to improve the performance of Proto-Auto, it requested a meeting with Krohn to discuss replacing Hazell as chief executive officer. Krohn apparently refused to meet with Lola to discuss this managerial change.

In response, Lola filed suit against both Krohn and Hazell. With regard to Krohn, Lola claimed that Krohn had breached the LLC operating agreement in several respects, including by failing to provide Lola with vehicle test reports and to pay interest on loans Lola had made to Proto-Auto in excess of the amounts it was contractually obligated to provide. Lola also claimed that Krohn's engineers had been compensated by Proto-Auto for assembling several vehicles for Proto-Auto even though, under the terms of the LLC operating agreement, that responsibility lay with Lola. The latter also alleged that Krohn had violated the implied covenant of good faith and fair dealing in the LLC operating agreement by refusing to meet with Lola to discuss replacing Hazell as chief executive officer. With regard to Hazell, Lola claimed that he had breached his fiduciary duties of loyalty and care by mismanaging Proto-Auto and providing Krohn with “sweetheart” terms when Proto-Auto sold certain parts to Krohn. Lola asserted that Hazell's mismanagement and fiduciary violations caused Proto-Auto to suffer losses of approximately $2.2 million from March 2007 through January 2009.

Lola's complaint sought dissolution of Proto-Auto and the appointment of a liquidating receiver on the basis that “the Company can no longer realize or attempt to realize its stated business purpose,” as well as injunctive relief and damages. The defendants, Krohn and Hazell, countered with a motion to dismiss, arguing that: 1) Lola's dissolution action was preempted by a buy-out provision contained in Proto-Auto's LLC operating agreement that was triggered by a deadlock on the Proto-Auto board; 2) Krohn had no obligation under the LLC operating agreement or otherwise to consent to Hazell's removal as chief executive officer; and 3) Lola's action against Hazell was in the nature of a derivative claim for the benefit of Proto-Auto and, therefore, demand first should have been made on the board to bring such a claim. The court refused to dismiss Lola's complaint.

The Court's Analysis

Dissolution

As an initial matter, the court noted that Section 18-802 of the Act provides that judicial dissolution of an LLC is warranted “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” The court categorically rejected the defendants' contention that the statutory “reasonably practicable” standard requires that the business “has been abandoned or that its purpose is not being pursued,” stating that “[t]o hold that judicial dissolution is appropriate only when the business had been abandoned would belie the language of the Act.” Instead, the court relied on the three factors laid out in Fisk Ventures, LLC v. Segal (2009 WL 73957) for determining the appropriateness of judicial dissolution: 1)) whether the members' vote is deadlocked at the Board level; 2) whether there exists a mechanism within the operating agreement to resolve this deadlock; and 3) whether there is still a business to operate based on the company's financial condition.” The court also noted that “none of these factors is individually conclusive, nor must each be found for a court to order dissolution.”

The court determined that all three Fisk factors were at issue in the dispute between Lola and Krohn. With respect to the first two factors, the court noted that the board members were “allegedly deadlocked over whether to replace Hazell as chief executive officer,” and the only mechanism contained in the operating agreement to resolve the deadlock was “entirely voluntary.” With respect to the third factor, which requires an analysis of the practical difficulties in continuing to operate the business, the court observed that Proto-Auto continued to be dependent on its members for “significant additional working capital,” and took note of “Lola's allegations of mismanagement, coupled with Proto-Auto's poor performance and Hazell's apparent entrenchment as chief executive officer.” “In fact,” the court went so far as to remark, “it is difficult to imagine how any company can attain commercial success with, as alleged here, a careless and disloyal chief executive.” On this basis, the court determined that Lola's allegations satisfied the Fisk critera, necessitating a decision not to dismiss Lola's request for dissolution of the venture.

The court next addressed Krohn's contention that because judicial dissolution was not specifically listed in the LLC operating agreement as one of the circumstances in which the joint venture could be terminated, such a remedy was precluded. The court was not sympathetic with this argument. Rather, it found that, even “[a]ssuming for current purposes that Section 18-802 may be precluded contractually,” “the fact that this particular Operating Agreement merely contains several self-termination options and does not expressly provide for judicial dissolution does not make that statutory remedy unavailable ' . It simply cannot be true that a number of nonexclusive, permissive termination clauses in the Operating Agreement can preclude judicial dissolution as provided for in the Act.”

Implied Covenant of Good Faith and Fair Dealing

The court also rejected the defendants' motion to dismiss Lola's claim that Krohn had breached its implied covenant of good faith and fair dealing in connection with Lola's desire to discuss the removal and replacement of Hazell as Proto-Auto's chief executive officer. According to the court, the “covenant restrains a contracting party from engaging in arbitrary or unreasonable conduct that has the effect of frustrating the contract's overarching purpose and denying the other party the benefit of its bargain.” However, the court would not permit itself to “substitute its own notions of fairness for the terms of the agreement reached by the parties, and will therefore only invoke the implied covenant when ' the contract is silent to the disputed topic, and where 'it is clear from the contract that the parties would have agreed to that term had they though to negotiate the matter.'”

Applying these principles to the dispute between Lola and Krohn, the court agreed with Krohn that “the implied covenant may not apply to matters covered by the contract.” In this regard, Krohn argued that because the LLC operating agreement expressly gave it the sole right to appoint the venture's chief executive officer, its unwillingness to dismiss Hazell could not be governed by the implied covenant. However, the court also found that “Krohn mischaracterizes Lola's implied covenant claim, which rests upon Krohn's failure even to consider Hazell's termination or attend board meetings to that end and not upon Krohn's obligation (or lack thereof) to assent to Lola's demands.” Unlike the appointment of the chief executive officer, the right of either party to require the other to engage in a discussion of the chief executive officer's performance and status was not a matter specifically covered by the LLC operating agreement. Therefore, the court determined that even though Krohn may not have been under any obligation to agree with Lola's assessment that Hazell should be removed as chief executive officer, it could “draw a reasonable inference that Krohn acted inappropriately and in bad faith by failing to consider Lola's request to have Hazell removed.” In support of this inference, the court again pointed to the specific allegations of mismanagement on the part of Hazell, “which in turn has allegedly frustrated Lola's purpose for entering into the Operating Agreement.”

Breach of Fiduciary Duties

The court observed that Lola's fiduciary duty claims against Hazell were “plainly derivative.” Section 18-1003 of the Act requires that, in any derivative action, the complaint must either state with particularity that the plaintiff attempted to compel the LLC's management to initiate the suit, or explain why such an effort was not made. For reasons that seem obvious, Lola made no such demand upon the two-member Proto-Auto board. Nevertheless, the defendants argued that the fiduciary duty claims should be dismissed due to the absence of any such statement or explanation in Lola's complaint.

Citing Aronson v. Lewis (473 A.2d 805, 814 (Del. 1984)), the court explained that demand will be considered futile, and thus excused, “when the particularized factual allegations contained in the complaint create a reason to doubt that 1) the directors are disinterested and independent [or that] 2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” Focusing on the first prong of the Aronson test, the court stated that “[a] director may be considered interested in the litigation ' if such litigation threatens a materially detrimental effect upon the director but not the company or its shareholders.” In the court's view, Lola had pleaded with particularity facts indicating that Hazell faced a substantial risk of liability from the litigation initiated by Lola, including the profits Proto-Auto allegedly lost as a result of the breaches by Hazell. On this basis, the court concluded that Hazell “may be considered interested.” And because the Proto-Auto board “consists of only two directors with equal voting power,” the court found that Lola had satisfied the demand excusal standard.

Conclusion

There are several noteworthy aspects to the Lola Cars decision. First, the court was willing to allow Lola's effort to dissolve the deadlocked venture to proceed, despite the fact that the LLC operating agreement provided for other remedies to an unhappy party, but not a judicially ordered dissolution. Second, although Delaware courts will generally not provide an “addendum” to contract terms negotiated between sophisticated parties by invoking the implied covenant of good faith and fair dealing, the court was willing to allow Lola's claim to survive a motion to dismiss due to the presence of facts supporting an inference that Krohn had acted “inappropriately and in bad faith.” And, finally, the court reiterated the principle that if a governing board has only two members and one member fails the test for independence or disinterestedness, then the demand requirement in connection with a derivative action for breach of fiduciary duty against the LLC management is excused.

Robert S. Reder, a member of this newsletter's Board of Editors, is a New York-based partner in the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. Rachel A. Fink is an associate in Milbank's Global Corporate Group, also located in the New York office.

Unsuccessful 50/50 joint ventures often lead to disputes between the partners and, in some cases, may produce noteworthy judicial decisions. Such is the case with Lola Cars International Limited v. Krohn Racing, LLC, et al. (C.A. No. 4479-VCN (Del. Ch. Nov. 12, 2009), available at http://www.delawarebusinesslitigation.com/), in which the Delaware Court of Chancery recently refused to dismiss claims arising out of a deadlocked joint venture structured as a limited liability company (“LLC”), including a request by one of the members for a judicial dissolution of the LLC pursuant to Section 18-802 of the Delaware Limited Liability Company Act (the “Act”). While courts are generally reluctant to interfere with contractual relationships negotiated by sophisticated parties, the Lola Cars ruling demonstrates that Delaware courts will intercede when participants in a commercial venture are genuinely deadlocked and specific allegations of bad faith are made, even if remedies to address the deadlock are available under the contract.

Background

In March 2007, Lola Cars International Ltd., a company specializing in the manufacture and sale of race car chassis and parts, and Krohn Racing, LLC, a company that operates a “Grand Am” automobile racing team, formed a venture named Proto-Auto, LLC. Proto-Auto was established to manufacture and sell specific “Daytona prototype” race cars. To this end, each party was responsible for distinct tasks: Lola was in charge of evaluating, testing and developing a chassis for the prototype racing car, while Krohn was tasked with purchasing from Proto-Auto and testing two of these vehicles for competition, as well as providing the venture's chief executive officer.

The venture was structured as a Delaware limited liability company. Although Lola owned 51% of the membership interests in Proto-Auto and Krohn owned the remaining 49%, the parties agreed to equal representation on Proto-Auto's governing board, with each member initially appointing one member. Krohn appointed Jeff Hazell, who had managed Krohn since its creation in 2005, as its board designee. Krohn also agreed to provide Hazell's services as Proto-Auto's chief executive officer to fulfill its primary obligation under Proto-Auto's LLC operating agreement.

After two years, it became clear that Proto-Auto proved would not be a successful enterprise. Lola contended that, in an attempt to improve the performance of Proto-Auto, it requested a meeting with Krohn to discuss replacing Hazell as chief executive officer. Krohn apparently refused to meet with Lola to discuss this managerial change.

In response, Lola filed suit against both Krohn and Hazell. With regard to Krohn, Lola claimed that Krohn had breached the LLC operating agreement in several respects, including by failing to provide Lola with vehicle test reports and to pay interest on loans Lola had made to Proto-Auto in excess of the amounts it was contractually obligated to provide. Lola also claimed that Krohn's engineers had been compensated by Proto-Auto for assembling several vehicles for Proto-Auto even though, under the terms of the LLC operating agreement, that responsibility lay with Lola. The latter also alleged that Krohn had violated the implied covenant of good faith and fair dealing in the LLC operating agreement by refusing to meet with Lola to discuss replacing Hazell as chief executive officer. With regard to Hazell, Lola claimed that he had breached his fiduciary duties of loyalty and care by mismanaging Proto-Auto and providing Krohn with “sweetheart” terms when Proto-Auto sold certain parts to Krohn. Lola asserted that Hazell's mismanagement and fiduciary violations caused Proto-Auto to suffer losses of approximately $2.2 million from March 2007 through January 2009.

Lola's complaint sought dissolution of Proto-Auto and the appointment of a liquidating receiver on the basis that “the Company can no longer realize or attempt to realize its stated business purpose,” as well as injunctive relief and damages. The defendants, Krohn and Hazell, countered with a motion to dismiss, arguing that: 1) Lola's dissolution action was preempted by a buy-out provision contained in Proto-Auto's LLC operating agreement that was triggered by a deadlock on the Proto-Auto board; 2) Krohn had no obligation under the LLC operating agreement or otherwise to consent to Hazell's removal as chief executive officer; and 3) Lola's action against Hazell was in the nature of a derivative claim for the benefit of Proto-Auto and, therefore, demand first should have been made on the board to bring such a claim. The court refused to dismiss Lola's complaint.

The Court's Analysis

Dissolution

As an initial matter, the court noted that Section 18-802 of the Act provides that judicial dissolution of an LLC is warranted “whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” The court categorically rejected the defendants' contention that the statutory “reasonably practicable” standard requires that the business “has been abandoned or that its purpose is not being pursued,” stating that “[t]o hold that judicial dissolution is appropriate only when the business had been abandoned would belie the language of the Act.” Instead, the court relied on the three factors laid out in Fisk Ventures, LLC v. Segal (2009 WL 73957) for determining the appropriateness of judicial dissolution: 1)) whether the members' vote is deadlocked at the Board level; 2) whether there exists a mechanism within the operating agreement to resolve this deadlock; and 3) whether there is still a business to operate based on the company's financial condition.” The court also noted that “none of these factors is individually conclusive, nor must each be found for a court to order dissolution.”

The court determined that all three Fisk factors were at issue in the dispute between Lola and Krohn. With respect to the first two factors, the court noted that the board members were “allegedly deadlocked over whether to replace Hazell as chief executive officer,” and the only mechanism contained in the operating agreement to resolve the deadlock was “entirely voluntary.” With respect to the third factor, which requires an analysis of the practical difficulties in continuing to operate the business, the court observed that Proto-Auto continued to be dependent on its members for “significant additional working capital,” and took note of “Lola's allegations of mismanagement, coupled with Proto-Auto's poor performance and Hazell's apparent entrenchment as chief executive officer.” “In fact,” the court went so far as to remark, “it is difficult to imagine how any company can attain commercial success with, as alleged here, a careless and disloyal chief executive.” On this basis, the court determined that Lola's allegations satisfied the Fisk critera, necessitating a decision not to dismiss Lola's request for dissolution of the venture.

The court next addressed Krohn's contention that because judicial dissolution was not specifically listed in the LLC operating agreement as one of the circumstances in which the joint venture could be terminated, such a remedy was precluded. The court was not sympathetic with this argument. Rather, it found that, even “[a]ssuming for current purposes that Section 18-802 may be precluded contractually,” “the fact that this particular Operating Agreement merely contains several self-termination options and does not expressly provide for judicial dissolution does not make that statutory remedy unavailable ' . It simply cannot be true that a number of nonexclusive, permissive termination clauses in the Operating Agreement can preclude judicial dissolution as provided for in the Act.”

Implied Covenant of Good Faith and Fair Dealing

The court also rejected the defendants' motion to dismiss Lola's claim that Krohn had breached its implied covenant of good faith and fair dealing in connection with Lola's desire to discuss the removal and replacement of Hazell as Proto-Auto's chief executive officer. According to the court, the “covenant restrains a contracting party from engaging in arbitrary or unreasonable conduct that has the effect of frustrating the contract's overarching purpose and denying the other party the benefit of its bargain.” However, the court would not permit itself to “substitute its own notions of fairness for the terms of the agreement reached by the parties, and will therefore only invoke the implied covenant when ' the contract is silent to the disputed topic, and where 'it is clear from the contract that the parties would have agreed to that term had they though to negotiate the matter.'”

Applying these principles to the dispute between Lola and Krohn, the court agreed with Krohn that “the implied covenant may not apply to matters covered by the contract.” In this regard, Krohn argued that because the LLC operating agreement expressly gave it the sole right to appoint the venture's chief executive officer, its unwillingness to dismiss Hazell could not be governed by the implied covenant. However, the court also found that “Krohn mischaracterizes Lola's implied covenant claim, which rests upon Krohn's failure even to consider Hazell's termination or attend board meetings to that end and not upon Krohn's obligation (or lack thereof) to assent to Lola's demands.” Unlike the appointment of the chief executive officer, the right of either party to require the other to engage in a discussion of the chief executive officer's performance and status was not a matter specifically covered by the LLC operating agreement. Therefore, the court determined that even though Krohn may not have been under any obligation to agree with Lola's assessment that Hazell should be removed as chief executive officer, it could “draw a reasonable inference that Krohn acted inappropriately and in bad faith by failing to consider Lola's request to have Hazell removed.” In support of this inference, the court again pointed to the specific allegations of mismanagement on the part of Hazell, “which in turn has allegedly frustrated Lola's purpose for entering into the Operating Agreement.”

Breach of Fiduciary Duties

The court observed that Lola's fiduciary duty claims against Hazell were “plainly derivative.” Section 18-1003 of the Act requires that, in any derivative action, the complaint must either state with particularity that the plaintiff attempted to compel the LLC's management to initiate the suit, or explain why such an effort was not made. For reasons that seem obvious, Lola made no such demand upon the two-member Proto-Auto board. Nevertheless, the defendants argued that the fiduciary duty claims should be dismissed due to the absence of any such statement or explanation in Lola's complaint.

Citing Aronson v. Lewis (473 A.2d 805, 814 (Del. 1984)), the court explained that demand will be considered futile, and thus excused, “when the particularized factual allegations contained in the complaint create a reason to doubt that 1) the directors are disinterested and independent [or that] 2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” Focusing on the first prong of the Aronson test, the court stated that “[a] director may be considered interested in the litigation ' if such litigation threatens a materially detrimental effect upon the director but not the company or its shareholders.” In the court's view, Lola had pleaded with particularity facts indicating that Hazell faced a substantial risk of liability from the litigation initiated by Lola, including the profits Proto-Auto allegedly lost as a result of the breaches by Hazell. On this basis, the court concluded that Hazell “may be considered interested.” And because the Proto-Auto board “consists of only two directors with equal voting power,” the court found that Lola had satisfied the demand excusal standard.

Conclusion

There are several noteworthy aspects to the Lola Cars decision. First, the court was willing to allow Lola's effort to dissolve the deadlocked venture to proceed, despite the fact that the LLC operating agreement provided for other remedies to an unhappy party, but not a judicially ordered dissolution. Second, although Delaware courts will generally not provide an “addendum” to contract terms negotiated between sophisticated parties by invoking the implied covenant of good faith and fair dealing, the court was willing to allow Lola's claim to survive a motion to dismiss due to the presence of facts supporting an inference that Krohn had acted “inappropriately and in bad faith.” And, finally, the court reiterated the principle that if a governing board has only two members and one member fails the test for independence or disinterestedness, then the demand requirement in connection with a derivative action for breach of fiduciary duty against the LLC management is excused.

Robert S. Reder, a member of this newsletter's Board of Editors, is a New York-based partner in the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. Rachel A. Fink is an associate in Milbank's Global Corporate Group, also located in the New York office.