Recently, in In re Merge Healthcare Inc., C.A. No. 11388-VCG, 2017 WL 395981 (Del. Ch. Jan. 30, 2017), the Delaware Court of Chancery dismissed a complaint, which alleged that the board of directors of Merge Healthcare, Inc. breached its fiduciary duties in connection with its approval of a merger with IBM, because a majority of the disinterested, fully informed, and uncoerced stockholders of Merge approved the acquisition. The decision is the latest in a series of opinions from the court in the wake of the Delaware Supreme Court’s decision in Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015) and confirms that, where a majority of a corporation’s fully informed, disinterested, and uncoerced stockholders approve a transaction other than with a controlling stockholder, the business judgment rule will apply absent waste even if the transaction was approved by a conflicted board majority. The decision also helps to clarify some uncertainty created by various decisions of the Court of Chancery as to the effect of Corwin on interested director transactions.
Corwin and Interested Director Transactions
In Corwin, the Delaware Supreme Court held that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.” Because of Corwin’s literal holding, the decision created some uncertainty over whether all transactions subject to the entire fairness standard of review were incapable of being cleansed by a fully informed, uncoerced, and disinterested stockholder vote or whether just controlling stockholder transactions were not capable of being cleansed. Historically, transactions tainted by a conflicted board majority, but not a controlling stockholder, were reviewed under the entire fairness standard of review unless the transaction had been approved by a fully informed and disinterested stockholder vote or a special committee of disinterested and independent directors. The effect of a single cleansing mechanism on controlling stockholder transactions was merely to shift the burden of proof of entire fairness from defendants to plaintiffs because of the inherent coercion deemed present when a controller either stands on both sides of the transaction or extracts personal benefits from the transaction. Thus, there was some reason to believe that not all transactions subject to the entire fairness standard were incapable of being cleansed under Corwin—just transactions subject to the entire fairness standard ab initio because of a controlling stockholder.
Corwin suggested that fully informed, uncoerced, and disinterested stockholder approval of a conflicted board decision should be given cleansing effect, but the issue was not squarely before the court. Specifically, the court did not consider allegations that the entire fairness standard applied to its review of a merger because of a conflicted board majority, but rather whether entire fairness applied to the court’s review because of a controlling stockholder. Nevertheless, the court’s dictum was instructive. The court noted that “[f]or sound policy reasons, Delaware corporate law has long been reluctant to second-guess the judgment of a disinterested stockholder majority that determines that a transaction with a party other than a controlling stockholder is in their best interests.” In addition, the decision affirmed the Court of Chancery’s holding below, which stated that “even if the plaintiffs had pled facts from which it was reasonably inferable that a majority of [] directors were not independent, the business judgment standard of review still would apply to the merger because it was approved by a majority of the shares held by disinterested stockholders . . . in a vote that was fully informed.”
Subsequently, in City of Miami General Employees v. Comstock, C.A. No. 9980-CB, 2016 WL 4464156 (Del. Ch. Aug. 24, 2016), the Court of Chancery gave cleansing effect to a fully informed, uncoerced stockholder vote approving a merger only after determining that plaintiff failed to allege facts sufficient to establish that a majority of the members of the target’s board of directors were belaboring under disabling conflicts. In this case, the alleged conflicts related to the directors’ purported desire to obtain board seats in the surviving entity and inability to act independently from an interested party. The court ultimately dismissed plaintiff’s claims because the transaction was not subject to entire fairness review and the business judgment presumption applied under Corwin.The fact that the court determined that Corwin’scleansingeffect applied only after concluding that a majority of the members of the board were disinterested and independent suggested that the court did not believe that Corwin’s cleansing effect would have applied if a majority of the members of the board were conflicted.
By contrast, in Larkin v. Shah, C.A. No. 10918-VCS, 2016 WL 4485447 (Del. Ch. Aug. 25, 2016), the Court of Chancery stated that “[i]n the absence of a controlling stockholder that extracted personal benefits,” where a majority of a corporation’s fully informed, disinterested, and uncoerced stockholders approve the transaction, the business judgment rule will apply “even if the transaction might otherwise have been subject to the entire fairness standard due to conflicts faced by individual directors.” Like Comstock, Larkin involved claims that a majority of the members of a target’s board faced disabling conflicts when approving a merger. The alleged conflicts related to certain board members having contemporaneous employment with venture capital firms that held stock in the target corporation and the directors’ expectation of employment with the surviving entity following the merger. In rejecting plaintiffs’ claims and applying Corwin to dismiss plaintiffs’ complaint, the court made clear “that [] proper stockholder approval of [a] transaction [will] cleanse any well-pled allegations that [a] transaction was the product of board-level conflicts that might trigger entire fairness review . . . .”
Consistent with the court’s decision in Larkin, Merge Healthcare clarifies that, with respect to conflicted board transactions, a disinterested, fully informed stockholder vote will have a cleansing effect on the transaction.
Factual Background: In re Merge Healthcare
This case involved the acquisition of Merge Healthcare, Inc. by IBM. Prior to the merger, Merge’s Chairman, Michael Ferro, owned approximately 26 percent of Merge’s outstanding stock through an affiliated fund which also provided consulting services to Merge. As a result of the consulting agreement, Merge would have paid Ferro’s affiliated fund a $15 million cash fee in connection with Merge’s acquisition by IBM but for the fact that Ferro subsequently agreed to waive the fee in exchange for an increase in the offer price. The merger was completed on October 13, 2015. Nearly 80 percent of Merge’s stockholders voted in favor of the merger.
Following closing, plaintiffs brought this action, alleging, among other things, that (i) the Merge board ran an unfair sales process and deprived stockholders of the true value of Merge and (ii) the Merge board breached its duty of disclosure by disseminating materially misleading and incomplete information to the stockholders in connection with the proxy statement filed as part of the merger. Defendants moved to dismiss plaintiffs’ complaint on the basis of the ratifying effect of the Merge stockholder vote.
Parties’ Arguments: In re Merge Healthcare
Plaintiffs argued that the entire fairness standard of review should apply to the merger between Merge and IBM because a majority of the members of Merge’s board were conflicted, and Ferro was a controller. According to plaintiffs, Ferro’s relationships with the other board members, as well as his stock ownership in Merge, allowed him to control Merge and its board. Plaintiffs maintained that Ferro used the merger with IBM to satisfy an urgent need to sell illiquid stock holdings in Merge. Finally, to demonstrate that the merger vote had not been fully informed, plaintiffs alleged various disclosure violations related to the financial analysis performed by Goldman Sachs, Merge’s financial adviser. Specifically, plaintiffs argued that (i) the proxy statement failed to disclose Goldman’s treatment of stock based compensation as a cash expense, (ii) the unlevered free cash flows used by Goldman were not those disclosed in the proxy statement, and (iii) the proxy statement inadequately described the present value of Merge’s net operating losses. In addition, plaintiffs contended that defendants failed to disclose that the true purpose of Ferro’s waiver of the consulting fee was to avoid the creation of a special committee rather than to obtain a price increase from IBM.
In response, the director defendants relied upon the cleansing effect of Corwin, contending that, because the vote of the stockholders approving the merger was fully informed, disinterested, and uncoerced, defendants were entitled to the presumptions of the business judgment rule absent waste.
The Court’s Holdings: In re Merge Healthcare
The court held that the vote of Merge’s stockholders cleansed the transaction, entitling the Merge directors to the presumptions of the business judgment rule under Corwin. In so doing, the court, citing Larkin,held that, in the absence of a controlling stockholder that extracted personal benefitsfrom the transaction, a fully informed, uncoerced, and disinterested stockholder vote results in the application of the business judgment rule “even if the transaction might otherwise have been subject to the entire fairness standard due to conflicts faced by individual directors.” Thus, the court found largely irrelevant the allegations that Merge board members were conflicted and focused on whether Ferro was a controller who extracted personal benefits not shared equally with the minority. The court assumed for purposes of its analysis that Ferro was a controlling stockholder of Merge and found Ferro’s interests were fully aligned with the minority stockholders because of his pro rata treatment in the merger. The court rejected plaintiffs’ claim that Ferro had orchestrated the merger to sell his Merge stock because Ferro had been selling his stock in Merge for the past six years. Additionally, the court emphasized that Ferro’s waiver of the fee under the consulting agreement removed any unique benefit that he might have received in the merger.
Next, the court held that plaintiffs’ disclosure claims arising from Goldman Sachs’ summary of the analysis underlying its fairness opinion failed. Regarding plaintiffs’ contention that the reason for Ferro’s waiver of the fee under the consulting agreement was not disclosed, the court found that disclosure of Ferro’s subjective intent to waive the fee was not required.
Conclusion
The court’s decision in Merge Healthcare highlights the evolution of the court’s jurisprudence under Corwin. Specifically, Merge Healthcare confirms that a fully informed stockholder vote will cleanse a transaction in order to apply the business judgment rule to a board’s decision to approve the transaction even if a majority of the directors are interested in the transaction. Such a holding is not necessarily surprising—prior to Corwin, numerous Court of Chancery decisions held that the business judgment rule applied to a conflicted board’s decision to approve a merger where the stockholder vote approving the transaction was fully informed, disinterested, and uncoerced. Some confusion ensued after the Delaware Supreme Court held in Gantler v. Stephens, 965 A.2d 695 (Del. 2009) that stockholder ratification of a transaction is limited to “circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective.” However, in Corwin, the Delaware Supreme Court narrowly interpreted Gantler as a decision focused on the common law doctrine of ratification and not on the question of what standard of review applies if a transaction not involving a controller is approved by an informed, voluntary vote of disinterested stockholders. The court’s decision in Merge Healthcare clarifiesthat, with respect to the approval of interested director transactions by a fully informed, disinterested, and uncoerced stockholder vote, the effect of Corwin was to remove any doubt cast on the cleansing effect of a stockholder vote created by Gantler v. Stephens.
In February 2017 the Department of Justice (DOJ) Fraud Section quietly released a short paper entitled “Evaluation of Corporate Compliance Programs,” which sheds more light on how the Department’s new compliance expert will differentiate effective compliance programs from those that are superficially pretty. In the paper, the Fraud Section reiterates that the factors it considers in deciding whether to investigate, charge or negotiate with a corporation (called the “Filip Factors”) necessarily require a fact-specific assessment. And the topics the Fraud Section considers in conducting its assessment—like tone at the top, third party risk assessments and compliance resources—are not new. Yet, the paper provides an important glimpse into “common questions that we may ask” in evaluating how an individual organization passes muster under the Filip Factors. Many of the “sample questions” highlight where the Fraud Section will press to ferret out those corporations that have simply adopted a check-the-box compliance program, versus those that have embraced compliance as a cultural imperative.
Sample Topics
The paper enumerates 11 sample topics that the Fraud Section “has frequently found relevant in evaluating a corporate compliance program.” Many of these topics appear in the US Sentencing Guidelines, the DOJ and SEC FCPA Guidance from November 2012, and other compliance resources. Nonetheless, their presence here shows their durability as measures by which corporations will be judged. The topics include:
Analysis and remediation of underlying misconduct, including root cause analysis of compliance failures and whether similar incidents occurred in the past
Senior and middle management words and deeds to convey and model proper behavior
Autonomy and resources of compliance function including stature, qualifications and funding
Operational integration of compliance policies and procedures into a control framework
Risk assessment process and the role of metrics
Incentives and disciplinary measures and whether they are effective, consistent, and fairly meted out
Continuous improvement, periodic testing, and review
Thematically, the topics convey that a successful compliance program responds and reacts to each compliance failure. Compliance needs to bear the visible support of top—and middle—management and run under the leadership of well-resourced compliance professionals. Compliance does not exist isolated from a company’s day-to-day operations and strategic decision making, but is integrated throughout both.
“Common Questions” To Probe A Company’s Compliance Program
The Fraud Section is careful to note that it “does not use any rigid formula to assess the effectiveness of corporate compliance programs” and that each company’s “risk profile and solutions to reduce its risks warrant particularized evaluation.” Yet, the paper sets forth “common questions” that the Fraud Section may ask in making that individualized determination.
Many of the questions coalesce around three critical avenues to explore whether the company has embedded compliance into its culture: (1) the company’s processes for lessons learned, (2) the effectiveness of its gatekeepers and (3) the integration of compliance into the business.
Processesforlessonslearned. These questions probe whether the company is learning from prior compliance mistakes or simply punishing the wrongdoer without seeking and correcting systemic failures. For example:
“Were there prior opportunities to detect the misconduct in question, such as audit reports identifying relevant control failures . . . ? What is the company’s analysis of why such opportunities were missed?”
“What controls failed or were absent that would have detected or prevented the misconduct? Are they there now?”
“Has the company’s investigation been used to identify root causes, system vulnerabilities, and accountability lapses, including among supervisory manager and senior executives?”
“What information or metrics has the company collected and used to help detect the type of misconduct in question? How has the information or metrics informed the company’s compliance program?”
Effectivenessofgatekeepers. These questions explore not only stature and skill of compliance personnel and personnel in other control functions in the organization, but also whether reports of misconduct get to the right responders. For example:
“What has been the turnover rate for compliance and relevant control function personnel?”
“Who reviewed the performance of the compliance function and what was the review process?”
“Has the company outsourced all or parts of its compliance functions to an external firm or consultant? . . . How has the effectiveness of the outsourced process been assessed?”
“Has there been clear guidance and/or training for the key gatekeepers . . . in the control processes relevant to the misconduct?”
“Has the compliance function had full access to reporting and investigative information?”
Integrationofcomplianceintothebusiness.Many of the Fraud Section’s questions attempt to shine on light on whether a company has woven compliance into its day-to-day business, from board room to the floor.
Questions include:
“What specific actions have senior leaders and other stakeholders (e.g., business and operational managers, Finance, Procurement, Legal, Human Resources) taken to demonstrate their commitment to compliance . . . ?”
“What compliance expertise has been available on the board of directors?”
“What role has compliance played in the company’s strategic and operational decisions?”
“Have business units/divisions been consulted prior to rolling [new policies and procedures] out?”
These questions suggest that the Fraud Section will continue to press on a key vulnerability that plagues the compliance efforts of many organizations: how to translate a well-designed compliance program into the cultural fabric of the company. And prosecutors will not likely be impressed without demonstrable proof of action at all levels of the organization and across all aspects of its business.
On December 7, 2016, the Delaware Supreme Court sitting en banc heard oral argument in Golf Course Assoc, LLC v. New Castle County. The Delaware Supreme Court agreed with the county and affirmed the Delaware Superior Court’s opinion that New Castle County’s Unified Development Code (UDC) did not violate the U.S. Constitution. Golf Course Assoc, LLC v. New Castle County, 2016 WL 7176721 (Del. Dec. 9, 2016).
In Golf Course Assoc.,Toll Brothers, Inc. submitted an application to the New Castle County Department of Land Use and the New Castle County Council to construct a housing development on a golf course near Route 48 (Lancaster Pike) outside of Wilmington, Delaware. In determining whether to accept or reject such a proposal, the department relies on the process outlined in the UDC, a process which is based on the concept of concurrency—whether the infrastructure necessary to support the proposed development exists or will exist by the time the development is complete. The first step in this process is to determine the “carrying capacity” for a proposed development, or how much development the surrounding infrastructure will support. In this case, the main issue was the traffic carrying capacity which, pursuant to the UDC, is determined by a Traffic Impact Study (TIS). Once a TIS has been completed, the developer must provide it to the Delaware Department of Transportation (DelDOT) for its written review and comment. The primary metric for measuring traffic congestion is the Level of Service (LOS) of intersections within the area of influence of the proposed development. The LOS for intersections is calculated by traffic engineers using a standard formula, which considers the number of vehicles and the amount of time spent waiting at an intersection at peak travel times. The proposed development in this case would impact the intersection of Lancaster Pike and Centerville Road.
The TIS prepared in 2010 rated the intersection of Lancaster Pike and Centerville Road as LOS “F” and anticipated that in 2016 the intersection would continue to operate at LOS “F.” DelDOT’s engineering firm, hired to review the TIS, assessed the intersection and determined that in 2010 the LOS rating was a “D” and projected that it would be at LOS “F” in 2016. An “F” rating for 2016 meant that the anticipated congestion at the intersection would exceed the standards allowed by the UDC and that the intersection would be in failure.
Toll Brothers had anticipated that traffic at the intersection would pose a problem to its proposed development and, as a result, designed a remedy to fix the congestion. Toll Brothers’ remedy was estimated to cost $1.1 million. Through negotiations with DelDOT, Toll Brothers offered to pay for this proposed remedy. DelDOT, however, preferred another remedy with an estimated cost of $3.5 million, but was willing to accept Toll Brothers’ $1.1 million as a contribution to DelDOT’s preferred solution.
Based on the traffic congestion issue, the New Castle County Department of Land Use disapproved Toll Brothers’ TIS. Accordingly, Toll Brothers’ record plan could not be filed. At the time the county disapproved the TIS, the statutory time period, including two authorized extensions totaling 180 days, had run and thus Troll Brothers’ record plan was deemed expired.
Following the expiration of its record plan, Toll Brothers appealed the county’s disapproval of the TIS and the resulting expiration of the plan to the New Castle County Board of Adjustments. Among other claims, Toll Brothers argued that an unconstitutional exaction had occurred. The board disagreed with Toll Brothers and dismissed its constitutional challenge. However, raising the unconstitutional exaction issue to the board preserved it for judicial review. The board agreed that pursuant to the UDC the plan had properly expired and that there was no constitutional violation. Toll Brothers subsequently filed an appeal with the New Castle County Superior Court. After briefing and oral argument, Judge Parkins of the Superior Court found in favor of the county, issuing its own well-reasoned opinion. The Superior Court’s decision was then appealed to the Delaware Supreme Court.
Toll Brothers’ Constitutional Claim
Toll Brothers argued before the board, the Superior Court, and the Delaware Supreme Court that the department and board’s rejection of the TIS constituted a violation of its constitutional rights under the “unconstitutional conditions” doctrine found in the Nollan/Dolan/Koontz trilogy of cases. This constitutional challenge involves the Takings Clause of the Fifth Amendment of the U.S. Constitution, made applicable to the states through the Fourteenth Amendment, which provides: “[N]or shall private property be taken for public use, without just compensation.” Dolan v. City of Tigard, 512 U.S. 374, 383-84 (1994) (internal citations omitted).The public policy behind the Takings Clause is “to bar Government from forcing some people alone to bear public burdens which, in all fairness and justice, should be borne by the public as a whole.” Armstrong v. United States, 364 U.S. 40, 49 (1960).
The Koontz Test
The unconstitutional conditions doctrine was first addressed in a 5–4 decision by the U.S. Supreme Court in Nollan v. California Coastal Commission, where a landowner wanted to tear down his existing beach front house to build a new one. In order to do so, the owner needed to obtain a building permit from the California Coastal Commission. The commission required the landowner to provide a public easement across his property before it would issue a permit. The state argued that this easement was necessary to protect the public’s view of the beach, assist the public in overcoming the “psychological barrier” to using the beach, and prevent congestion on the public beach. The U.S. Supreme Court struck down this requirement as an unconstitutional exaction stating:
[T]he lack of nexus between the condition and the original purpose of the building restriction converts that purpose to something other than wait it was. The purpose then becomes, quite simply, the obtaining of an easement to serve some valid governmental purpose, but without payment of compensation. Whatever may be the outer limits of “legitimate state interest” in the taking and land-use context, this is not one of them. In short, unless the permit condition serves the same governmental purpose as the development ban, the building restriction is not a valid regulation of land use but “an out-and-out plan of extortion.”
Seven years after the U.S. Supreme Court issued its opinion in Nollan, it was asked to clarify the “required degree of connection between the exactions and the projected impact of the proposed development.” Dolan v. City of Tigard, 512 U.S. 374, 386 (1994).This question was left unanswered in Nollan because the court concluded that the connection did not meet “even the loosest standard.” In another 5–4 decision by the U.S. Supreme Court in Dolan v. City of Tigard,the court adopted a “rough proportionality” test which, while there is “[n]o precise mathematical calculation,” requires that the state demonstrate “some sort of individualized determination that the required dedication is related both in nature and extent to the impact of the proposed development.”
It was not until 2013 that the U.S. Supreme Court would again address this doctrine in Koontz v. St. Johns River Water Mgmt.Dist. 133 S. Ct. 2586, 2593 (2013). In Koontz, in response to the state’s demand for property from a landowner for a Management and Storage of Surface Water permit and a Wetlands Resource Management permit, the landowner refused to transfer the property. Because there had been no actual taking due to the landowner’s refusal, this action raised the question as to whether the Takings Clause was applicable where there had been no actual taking of property. The court in Koontz also addressed the question of whether the Takings Clause was implicated when the State demanded money as opposed to an interest in land. The U.S. Supreme Court, in yet another 5–4 decision, found that under such circumstances the test enumerated in Nollan and Dolan was applicable. Specifically, as to the monetary issue, the court noted that a monetary obligation on a specific piece of land is a sufficient link between the government’s demand and the property to implicate the central concern in Nollan and Dolan, namely that “the risk that the government may use its substantial power and discretion in land-use permitting to pursue governmental ends that lack an essential nexus and rough proportionality to the effects of the proposed new use of the specific property at issue, thereby diminishing without justification the value of the property.” The court further explained that there could be a violation of the Takings Clause even though there was no property of any kind actually taken:
Extortionate demands for property in the land-use permitting context run afoul of the Takings Clause not because they take property but because they impermissibly burden the right not to have property taken without just compensation. As in other unconstitutional conditions cases in which someone refuses to cede a constitutional right in the face of coercive pressures, the impermissible denial of a governmental benefit is a constitutionally cognizable injury.
In Koontz the court made clear that in order to make out a claim for an unconstitutional exaction, there must first be a demand. This point was made most clear by Justice Kagan’s dissenting opinion in Koontz. This dissent provides in pertinent part:
Nollan and Dolan apply only when the government makes a “demand[]” that a landowner turn over property in exchange for a permit. I understand the majority to agree with that proposition: After all, the entire unconstitutional conditions doctrine, as the majority notes, rests on the fear that the government may use its control over benefits (like permits) to “coerc[e]” a person into giving up a constitutional right. A Nollan–Dolan claim therefore depends on a showing of government coercion, not relevant in and ordinary challenge to a permit denial. Before applying Nollan and Dolan, a court must find that the permit denial occurred because the government made a demand of the landowner, which he rebuffed.
Concerns Following Koontz
Following the majority’s opinion in Koontz there was widespread concern that local governments would stop negotiating with, and making suggestions to, developers about how to meet permitting criteria and, that instead would simply deny applications that did not meet municipal standards or improperly accept development plans. This was a concern because collaboration between the developer and local government “is essential to an orderly and efficient system of land use regulation.” Julie A. Tappendorf & Matthew T. DiCianni, The Big Chill?—The Likely Impact of Koontz on the Local Government/Developer Relationship, 30 Touro. L. Rev. 455, 471-72 (2014). Indeed, as part of the development process, local governments and developers often meet and discuss possible negative impacts of the proposed development and ways to mitigate concerns in an attempt to reach an agreement. Commentators have suggested that Koontz prevents these discussions from taking place by providing an additional, unnecessary risk of possible lawsuits based on an unconstitutional exaction theory. Specifically, the suggestion is that if the local government participates in what has become the normal back-and-forth with the developer, at any time during that process the developer could cease talks and file suit claiming a taking based on the unconstitutional exaction doctrine. The local government, therefore, has no incentive to take part in those discussions for fear of being accused of making a demand. This necessarily prevents local governments and land developers from reaching agreements that work for both parties and, in effect, prevents a property owner, like the one in Koontz, from having an “opportunity to amend their applications or discuss mitigation options.”
Another concern resulting from the Koontz decision is that if local governments do decide to partake in discussions with the developers, the developers are incentivized to only offer the “easiest and cheapest mitigation condition” because if that is rejected they can race to the courthouse claiming an unconstitutional exaction. See Michael Farrell, A Heightened Standard for Land Use Permits Redefines the Power Balance Between the Government and Landowners, 3 U. Balt. J. Land & Dev. 71, 74 (2013). The Koontz decision, therefore, places the developer in a stronger negotiation position forcing local governments to accept an unfavorable offer or risk litigation.
Applying the Koontz Test to Toll Brothers’ Claims
In Golf Course Assoc., LLC, the board, Superior Court, and, by extension, the Delaware Supreme Court found that the county never made a demand on Toll Brothers. Specifically, it was noted that there was no evidence in the record indicating that negotiations between the county and Toll Brothers had occurred. In fact, the New Castle County Department of Land Useasserted that it had no authority to negotiate with Toll Brothers (or other developers for that matter). Instead, the negotiations occurred between Toll Brothers and DelDOT. However, as the court noted, when it comes to traffic, DelDOT plays merely an advisory role. The court held that in order to implicate the constitutional exaction doctrine the county has to negotiate with the developer and not DelDOT. In the absence of such negotiations and, in turn, a demand by the county, Toll Brothers’ Nollan/Dolan/Koontz constitutional exaction claim failed.
The Superior Court properly noted that at most there was a denial of a land use permit which, by itself, was insufficient to amount to a constitutional violation. The Superior Court further clarified that a statutory restriction, evenly applied, does not constitute an unconstitutional exaction under the trilogy. The court held that the exaction “must come in the form of a demand arising from an administrative requirement particular to the requested land use permit,” something that was absent in this case.
Conclusion—The Impact
The Delaware Supreme Court’s decision to affirm the Superior Court’s opinion seemingly addresses many of the concerns discussed by commentators following the Koontz decision. Specifically, the Superior Court’s decision, upheld by the Supreme Court, implies that a local government can negotiate with a developer, and avoid an exaction claim, so long as the negotiations involve a non-binding governmental agency which only has an advisory role. By using such an agency (such as DelDOT in this case), the local government does not have to outright reject a plan that fails to satisfy the governing municipality’s rules. Instead, negotiations can occur and an agreement that works for both parties can be reached between the developer and the governmental agency, which is then ratified by the local government. In addition, the non-binding governmental agency can provide the developer with advice on how to meet the permit requirements without fear of possible litigation. Further, the developer’s incentive to offer the “easiest and cheapest mitigation condition” is taken off the table because if such an offer is rejected by the non-binding governmental agency that, in it of itself, does not constitute an unconstitutional exaction.
The Superior Court and Delaware Supreme Court’s decisions not to needlessly expand the unconstitutional exaction doctrine to applications of zoning and subdivision laws serve several additional key public policy considerations. First, the decision prevents a developer from having a constitutional right to taxpayer-funded level of service improvements for water, sewer, and traffic. Had the Superior Court ruled differently, a developer would have had a constitutional right to infrastructure improvements because the county could not deny the application under concurrency laws without violating the Takings Clause. Second, the Superior Court’s decision prevents the public from bearing the responsibility of funding infrastructure improvements merely because a developer seeks to personally profit from a proposed housing development. Lastly, it prevents government officials from being forced to make frequent ad hoc judgments as to whether certain code requirements constitute an unconstitutional exaction.
Disclosure: The case discussed in the article represents one of only a handful of state appellate courts to have, so far, considered and applied the U.S. Supreme Court’s application of the takings provisions under the Fifth and Fourteenth Amendments to the U.S. Constitution found in the Nollan/Dolan/Koontz trilogy of cases in connection with land use decisions and processes. Municipalities, developers, land owners, and the lawyers representing them will have an interest in seeing the latest application of those U.S. Supreme Court cases to the rejection of a planned residential community substantially impacting traffic/transportation.
The legal profession is changing. In making that statement, we do not refer to the increasing penetration of technology into how lawyers practice (although that is certainly the case), nor do we refer to the continuing consolidation within the ranks of law firms as regional and mid-size firms merge or create or join networks to compete with the larger firms. We refer instead to the changing dynamics of the relationships between in-house law departments and their external providers of legal service, including law firms.
The emergence and growth of corporate law departments as an ongoing fixture in the legal firmament remains one of the primary indicators—and the primary cause—of change in the legal profession with respect to corporate clients over the past few decades. As companies created and increased the size of their law departments (the largest law departments now include over 1,000 professionals), they have also improved the professional competencies of those departments to include considerable expertise in areas besides just those substantive specialties pertinent to the companies’ business operations. For some time, the in-house bar has been pursuing greater and greater sophistication in the application of business concepts and methodologies to their management of legal service. For example, where they once asked law firms for invoices with detailed time-entry data (often receiving considerable pushback when they did), law departments now expect such firms to apply sophisticated project-management techniques and other tools to their company’s matters.
They have also revisited their selection and retention of outside counsel. Data-driven selection methods (e.g., requests for proposals for legal service, seeking and using experiential information from candidate firms) now represent an accepted methodology. Perhaps more relevant for our purposes is the “convergence” movement, which seems to continue unabated. “Convergence” denotes the disciplined reduction by a law department in the number of law firms with which it works in an effort to forge greater efficiencies and closer relationships with the firms remaining on its “roster.”
By reducing the number of law firms with which it works, a corporate law department creates greater leverage in its dealings with the firms that remain. This leverage enables the law department to achieve several things: (1) it can assure itself of the technical competence of those remaining firms by utilizing that competence as the “price of admission to the dance”; (2) it can design the parameters of the relationship it wishes to have with those firms, secure in the belief that they will be willing and able to bear some costs associated with recalibrating the relationship; and (3) it can design better metrics for the management of legal service due to the smaller number of firms—and lawyers—with which it will work and manage going forward.
All of this means that the selection and retention of law firms by corporate law departments increasingly will revolve around “relationship issues.” By “relationship issues,” we do not mean to suggest that developing personal friendships with in-house lawyers by offering entertainment in the form of invitations to professional sporting events, musical performances, or high-priced dinner discussions will lead to greater business for law firms. Rather, corporate law departments increasingly will select those law firms that “get it” and demonstrate a willingness to work with their in-house compatriots as equal partners and in the way that each specific law department wants, even if that differs from how those firms work with their other clients.
The Implications of Change
What does this portend for the law profession and, in particular, for law firms? First, the future likely will involve much greater competition for a company’s business and, specifically, for its billings. Such competition will be different in terms of both quality and quantity because the inelasticity of the time-based billing paradigm has caused corporate clients, led by the in-house bar, to explore alternative means of delivering legal counsel and related services that their business operations need. Second (and this is related to the first point), the client’s substantive needs and service-focused preferences will dominate the selection process. The choice of which service provider to use increasingly will revolve around the relationship issues discussed above as expressed by the client. How can law firms successfully address those issues? The short answer is that they must make the client’s service preferences the central focus of their service delivery.
“Value”—What Do Clients Want and What Does It Mean?
The Association of Corporate Counsel (ACC) launched the ACC Value Challenge in 2008 “to reconnect the value and the cost of legal services.” ACC determined not to provide in the ACC Value Challenge a single definition of “value,” opting instead to exhort ACC members to discuss the issue with their outside legal-service providers and develop their own definitions of the term to suit their respective company’s needs. In the context of legal service, of course, the term “value” has not had a clear-cut or easily measureable meaning. Slightly more than one year after ACC launched the ACC Value Challenge, one commentator wrote, “[m]uch remains confused and unclear about that term.” R. Morrison, Making Some Sense Out of the Value Gap, Nat’l L. J. (Nov. 9, 2009).
Although a single definition remains elusive (at least at this stage of the dialogue within the profession), we can identify some traits or characteristics of higher-value legal service that could help us to forge something approaching a working definition. These traits (referred to herein as value-related qualities, or VRQs) may not comprise a definition in the pure sense of that word. They may, however, allow in-house and outside attorneys to develop a shared language to assist the company’s in-house and outside lawyers to provide legal service that more closely mirrors its value-related needs and expectations. In light of the variation among clients’ perceptions of value, perhaps we should not seek a single definition of “value,” but instead a framework or approach with which to construct a context-specific definition of the term.
VRQs can enable in-house and outside counsel to engage in a collaborative process to determine fee structures that more closely align outside counsel’s interests with those of their clients. Simultaneously, VRQs can provide the basis for more specific measures of the success of those arrangements and other aspects of the client-counsel relationship, including some that are less tangible. In short, VRQs can serve as that framework or approach to the conundrum represented by value.
In light of the confusion and uncertainty surrounding the concept of value, how can we successfully approach the challenge of defining and delivering high-value legal service? We must begin with the basics, recognizing that value does not exist in a vacuum and is not an immutable constant like the speed of light. Rather, it represents the relationship between the “cost” of something and the “benefit” that one enjoys from it. The cost may include more than out-of-pocket expense, and the benefit may be expressed in other than monetary terms.
In this way, the ACC Value Challenge really represents an effort to “recalibrate” value and cost, rather than to “reconnect” them. A connection between value and cost has always existed, but the relationship between them has become more and more attenuated and unsatisfactory as in-house counsel frequently have experienced instances where the cost outweighed the benefits. They have increasingly come to view the hourly rate as an incentive for outside counsel that does not coincide with clients’ interests in cost-effective service.
The benefit that a company derives from legal service can flow from several sources. Some transactions, such as real-estate-secured loans, simply cannot be effected without addressing legal matters; the legal service is integral to achieving the business goal. The resolution of business disputes typically involves the disputants’ lawyers, although companies can and do resolve their differences without much lawyering in many instances. Concluding such transactions and disputes so as to advance one or both parties’ business interests constitutes the benefit realized.
In other situations, legal service may be less central to the business activity, but by expediting that activity, preventing law-related complications, or taking advantage of opportunities that exist by virtue of statutory or regulatory structures, legal service can serve an important supportive role in achieving the business’s goals, allowing the company to realize more business benefit from the situation than it would have without the lawyers’ involvement. It might even add some value to the parties’ exertions distinct from their primary business-oriented focus.
What sort of “costs” might a client realize or incur in the context of legal service? (These include some costs that can arise from the purpose for securing legal service, such as litigation, rather than just as a direct result of the legal service itself.) Although some costs are “hard” costs (like legal fees, transaction-associated costs, expert fees and other out-of-pocket expense), others are less measureable, but just as real. They can include:
reputational harm
diversion of corporate executives’ attention from the business
heightened regulatory scrutiny
poisoned business relationships
distraction of company personnel aware of, but not primarily involved in, the matter
When assessing the value of legal service, one should account for as many costs associated with the matter as possible. The ultimate determination of the value of that service should reflect its net impact on the client’s position. If that position has improved, taking into account both costs and benefits realized from the representation, then the legal service provided positive value to the client. If that position has deteriorated, the legal service may have subtracted value from the business or the transaction.
When developing a framework with which to define value in the context of legal services, keep in mind that the determination of the value of the legal service ultimately is the client’s to make. The primary determinant should consist of the degree to which legal service contributes to the client’s achievement of its business goals for the assignment. Inasmuch as the client retains counsel in order to achieve its goals with minimal law-related complications and such counsel should serve the client’s interests, the value of that service must be measured in the same context. Ultimately, then, value lies in the eyes of the client (or, for in-house counsel, the in-house clients with whom they work). S. Lauer, The Value-Able Law Department 4 (Ark Group 2010).
For each client, each law-related matter or project represents an often vastly different set of issues and risks. Each client’s appetite for risk varies from those of other business organizations. The legal-service provider must take this into account when delivering legal service. A client that willingly assumes a high level of risk may opt for legal service that elevates cost control to a higher plane even though “cutting corners” might invite greater legal scrutiny and risk. A client that cannot afford or does not want any law-related exposure, on the other hand, might be willing to pay some form of premium for the assurance that such will not occur. Satisfying clients with such disparate attitudes requires a finer calibration of effort by the lawyers (even without the lawyers knowingly assuming high risk).
Understanding how different VRQs matter to the client in a particular set of circumstances can provide the grounding needed to render that calibration. Is cost control the most important aspect of the work to the client at that time? Is a rapid resolution of the issue of greatest concern? Is complete vindication of its position in a dispute the only possible outcome the client would accept?
VRQs can also serve as the basis for a more informed discussion by client and counsel of possible alternatives to the hourly rate as the means of calculating a fee arrangement. Despite a great deal of discussion over the years of the “evils” of the hourly rate and a recognition that it can distort the efforts of client and counsel to reach a common vision with respect to cost control and budgetary certainty, it continues to serve as the basis for the great bulk of legal fees paid by business clients. For a discussion of the incentives of the hourly rate that disserve clients, see P. Lamb, Alternative Fee Arrangements: Value Fees and the Changing Legal Market ch. 2 (Ark Group 2011) (“You get what you pay for.”).
How do VRQs do so? By enabling counsel to focus on more discrete, measureable elements of value rather than the somewhat vague, nebulous term in its full scope. VRQs allow the dialogue of client and counsel to advance in such a way as to allow for more meaningful application of VRQs to that client’s situation. Rather than design a fee arrangement that delivers greater value to the client, VRQs permit the design of fee arrangements that align the thinking of in-house and outside counsel on particular criteria that, in the client’s eyes, represent ways in which the legal service can yield it greater business benefit. The incentives in that arrangement, based on VRQs, should lead to behavior by the lawyers that more directly reflects the client’s value-related expectations.
Satisfying Client Demands and Meeting Expectations
Understanding value and its subsidiary components (i.e., VRQs) intellectually and applying those terms to the daily practice of law require a thorough familiarity with both client demands and expectations. We suggest the following framework to reach that understanding.
Figure 1 helps the reader visualize the relationship between VRQs and client expectations. In that figure, specific VRQs are grouped to reflect typical, overarching, value-related goals of a corporate client to which they relate (the points of the pentagon). The internal triangle identifies the usual parties involved in handling a legal matter for such a client and demonstrates that all parties involved in that engagement (illustrated by the triangle within the pentagon) can influence the achievement of value or a failure to do so. The points on the triangle remain the same for the majority of legal engagements. Depending on the client’s identified VRQs for the engagement, however, the roles of the entities on the points of the triangle might differ from those for another engagement, as could the impact each entity has on satisfying the identified VRQs. In the majority of cases, the role of in-house counsel will be that of project manager in addition to legal counsel for the business unit.
When thinking about what value means to a client and using Figure 1 as a framework for discussion, one quickly sees that several VRQs could be made part of an engagement. One VRQ can structure an understanding of the cost-management expectation, e.g. budgets, predictability and “no surprises.” Level-of-service elements can emphasize teamwork, urgency, communications, and innovation. Elements around corporate goals, expertise, and resolution will also frame the value equation for this matter.
These VRQs do not stand alone or act independently. They are related and should be integrated and balanced. In some situations, cost management may trump all other VRQs, whereas resolution and urgency might outweigh cost in others. Corporate goals around reputation could very well be the key VRQ. Acknowledging the complex nature of legal services today, it is essential in every situation that counsel always demonstrate teamwork and innovation. Once the VRQ framework has been established for any one engagement, the appropriate roles and responsibilities become more evident.
In the center of the VRQ balancing act stands the in-house counsel. He or she serves as the quarterback of the team. Achieving the goal of each particular play (that play’s VRQ) requires engaging the disparate talents of all members of the team in the right sequence. Experienced project management and communication skills are keys to success. Let’s look at an example.
Corporation A has been served with a lawsuit that involves sifting through years of electronic media, such as e-mail, memos, internal policies, and referenced websites. Approximately half of the data that must be reviewed resides on headquarters servers, whereas the other half is spread across multiple field servers. The request covers 15 years of material. How can VRQs help shape the e-discovery effort of this matter?
Tackling e-discovery clearly requires teamwork if cost goals are to be achieved. The first steps of identifying where the data resides within the corporate IT structure and establishing a strategy for collecting it could be varied in approach. The task might be assigned to a third-party data-processing vendor and priced by the terabyte, but the vendor’s learning curve could be protracted, and missteps along the way are possible. What about using the company’s IT professionals to do the initial data gathering? Have them partner with the third-party service provider at every step of the way. Alternatively, if requisite software is available in house, assign an IT manager to execute the gathering per specifications agreed to by all counsel.
What if, during the contract attorney review, the responsive document hit rate seems extraordinarily low? Full speed ahead? Probably not. VRQs designed to address level of service would suggest that the results-driven component of the model is not being achieved. Perhaps additional expertise is required for the review of the criteria used to identify potentially responsive documents. Efficient communications and “no surprises” expectations again come into play. The attorney in charge serves as a project manager in order to get the project back on track, and the existence of the VRQ framework plays an important role in evaluating performance and value attainment by all involved.
Another example involves a company with a national footprint. Initially, a decentralized approach was deemed the best model to address a portfolio of relatively predictable and routine legal disputes. One firm’s performance stood above the rest. Thinking about the previous reference to convergence, the company’s law department initiated discussions to determine whether there was a model that would reduce the costs of managing the portfolio. Each of the models suggested required the development of specialized software. Thinking about a firm’s willingness to bear some of the costs associated with recalibrating and expanding their relationship with this client, one firm offered to assume the development costs for the software and was willing to host the software behind its firewall. That firm’s willingness demonstrated a best-foot-forward approach to the client’s work by investing in the relationship. Doing so served the client’s stated VRQs of reasonable cost and greater consistency among matters. Complete, transparent, and reasonable cost estimates were provided the client for decision-making purposes, and the law firm was able to identify a new competency in its marketing materials for other and potential clients. In this case, VRQs related to Level of Service, Corporate Goals, Expertise, and Cost Management were drivers of the recalibrated relationship.
Now, how do we know everyone is dancing to the same beat? In both examples, cost management was an evident VRQ. Costs related to e-discovery can be and often are unpredictable, unless the client has a grasp of previous experience. Still, the range of cost projections can be extreme. Agreeing to track costs on a per-document basis for variable costs and identifying elements of fixed cost, no matter the volume, should be achievable. Monthly reporting? Probably not frequent enough for variable costs. Expectations based on volume can be projected, and ranges can be established. Weekly variable costs can be reported, unless something drives cost outside of projected ranges, e.g., too many hits, interesting observations, etc. Then, pick up the phone!
Level of service can be evaluated based on feedback from key constituencies. A survey can be an effective way to solicit feedback if the survey is crisp, does not give the responder a clear line of sight to “ho hum” responses, and gives the responder an opportunity to expand on concerns and to make suggestions for improvement. (Responders that take the time to write additional feedback must be specifically acknowledged.) Expertise can also be subjected to feedback surveys.
One of the co-authors was responsible for the appeal of an adverse jury verdict. Due to the nature of the case and its implications on a portfolio-wide basis, three law firms were involved in the appeal. Soon after that verdict, the co-author called a meeting of the three firms to be held in the state in which the verdict was rendered (one of the three firms was based in that state, and the other two were based elsewhere). The host firm was represented by three attorneys (one associate and two partners—one of whom had been responsible for the matter during the trial phase, and the other of whom was a former chief justice of that state that the client had selected to “quarterback” the appeal). The second firm sent a senior partner and a senior associate, and the third firm sent one senior associate.
During the meeting, the senior partner of the second firm tried to take charge of the meeting, despite the presence of the host firm’s senior partners. After the meeting concluded and upon returning to the office, the author sent the three firms a memorandum assigning each firm a role during the appeal with delineated responsibilities. The author of the memorandum wanted to reduce redundant efforts and potentially overlooked issues that could result when three firms operate somewhat independently. The senior partner of the second firm (who had tried to run the planning meeting) objected to the memorandum, claiming that he had an ethical obligation to consider any issue that he deemed significant despite the other firms’ involvement. The presence of three eminently qualified firms (and a corporate law department with several hundred in-house attorneys) did not sway him from his view. Did that attorney’s actions demonstrate a sensitivity to and appreciation of the client’s VRQs and its desire for close collaboration among the firms? Decidedly not. Once an agreement has been reached regarding VRQs, determining a feedback mechanism or evaluative metric should be relatively easy. If it is not, perhaps the VRQ needs refinement.
We have been discussing VRQs as they apply to the management of legal matters; however, they also can be used to improve the general management of the corporate legal department. How many firms still casually send annual rate increase letters to their clients? Too many, we suspect.
Those letters usually attempt to justify increasing baseline rates or to recognize associates who have broken through to another billing level or status. The baseline increase in rates generally bears no resemblance to overall economic growth and inflation. (For years, corporate America provided two- to four-percent salary increases, and the U.S. economy struggled to keep pace. What was the rationale that many firms used to ask clients for across-the-board, 10-percent increases in hourly rates?) In some cases, clients fire a preemptive shot across the bow of the ship in the form of a letter such as this:
Dear Firm: We will not accept across-the-board rate increases for the next fiscal year. For those associates you deem entitled to an increase due to achievement, please provide us your firm’s specific performance rationale. We will then solicit input from our professional(s) in charge of the matters on which this associate works, analyze historical rate increases, and let you know if we find the increase appropriate.
Does such a process make sense? Does it feel client-centric? We believe that the answer is obvious.
We are not suggesting that rate increases are never justified. We are suggesting that the VRQ framework can help firms and clients arrive collaboratively at a mutually suitable rate structure, even if a firm is still wedded to the hourly rate methodology as a representation of the value of its legal service. A couple of VRQs jump off the page as particularly useful when discussing firm rate increases: expertise, communications, budgets, “no surprises,” and appropriate cost are examples. If the client is truly your focus, especially from the “long-term relationship” perspective, the model will help in other, nonmatter-specific business processes. Let us look at a couple and hypothesize how thinking differently about rate increases helps a firm become more client-centric.
Communications.How do you think a client would feel about receiving a thoughtful letter from the relationship partner seeking feedback about the services provided during the past fiscal period, feedback regarding specific attorney performance, and feedback suggesting how the firm could improve its overall performance in the next fiscal period? Specific performance data reflective of the client’s expressed VRQs enables you to negotiate from an informed position of strength in terms consistent with the client’s needs and expectations. Where increases may be warranted, the request can be effectively tailored using VRQs.
Budget Consciousness. Managing costs against a budget is a corporate mantra. Being over budget should signal an immediate problem for the relationship your firm enjoys with its client. Typically, professionals do not simply wake up one morning and find key matters suddenly over the budget set with the client. Potential cost overruns usually build over time. Do alarms go off if 50 percent of an annual budget has been spent during the first three months of a fiscal period? Do a firm’s systems allow it to monitor costs similarly to its client’s methodology? Is it a crime to be over budget? Clearly so, if a firm and its client do not know why! Keeping track of expenditures against a budget on a frequent schedule benefits both parties.
Summary
Corporate clients are demanding higher-value legal service because they have seen their legal fees continue to escalate without a demonstration of increased, proportionate business value. To address that demand in a systematic fashion, law firms need an approach that is simple, practical, and consistent. Moreover, whichever approach law firms use must also enable them to address clients’ interest in alternative fee arrangements in a similar way.
Alternative fee arrangements based on the VRQ framework will provide law firms the tools to design metrics and management systems that take into account a variety of fee arrangements because the measurement will be client satisfaction regardless of the specifics of the fee arrangement and without direct relationship to the dollars and cents of those fee arrangements, however those fees are calculated. The benefits of incorporating VRQs into a law firm’s service delivery can extend, however, beyond better fee arrangements; VRQs can lead to improved client relationships, enhanced client satisfaction, and more efficient and effective representation. In other words, they can enable a law firm to set itself up to succeed in the increasingly competitive environment for corporate representation.
In M&A transactions, the negotiation of contractual provisions intended to protect against claims for fraud based on extra-contractual statements may be contentious. A series of recent decisions from the Delaware Court of Chancery has provided additional insight into the effectiveness of such “anti-reliance” clauses as a tool for establishing the “universe” of information upon which a potential post-closing fraud claim may (or may not) be based.
Under well-established Delaware law, emerging from the seminal decision in Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006), an anti-reliance provision will effectively bar a fraud claim provided that the language reflects a clear disclaimer of extra-contractual statements. This result is based on the view that a prima facie element for fraud is reasonable reliance, and Delaware law recognizes the right of parties to bargain for a provision that precludes a party’s reliance on any statement (or omission) not contained within the agreement’s four corners. A typical formulation of an anti-reliance provision consists of an integration clause in conjunction with an “exclusive representation” clause—which disclaims reliance on any information not expressly embodied in a representation in the executed agreement. Although the decisions discussed in this article largely reinforce Delaware precedent as to enforceability of anti-reliance clauses, they remain instructive in reminding practitioners to guard against the foot faults associated with the inexact drafting of such provisions.
Prairie Capital III L.P. v. Double E Holding Corp., 132 A.3d 35 (Del. Ch. 2015).
In Prairie Capital, the purchasers under a stock purchase agreement asserted fraud claims based on allegedly falsified sales data provided by the company’s management. The agreement included an integration clause as well as an exclusive representations clause stating that the purchaser relied only on its own diligence and the seller’s express representations. The agreement, however, did not contain an express representation by the purchaser disclaiming reliance on extra-contractual statements. The Chancery Court dismissed the fraud claim, concluding that the integration clause and exclusive representations clause, when read together, were sufficient to “add up” to an enforceable anti-reliance clause.
Notably, the Chancery Court reasoned that although the exclusive representations clause was framed positively (i.e., purchaser’s representation that it was relying only on the specific representations in the agreement) rather than negatively (i.e., purchaser’s representation that it was notrelying on any representations other than as set forth in the agreement), it was equally operative in establishing the “universe of information” on which a purchaser could assert reliance. The Chancery Court explained that no formulation of “magic words” is necessary under Delaware law to form an effective anti-reliance clause, provided that the relevant language unequivocally demonstrates that the purchaser was not relying on extra-contractual information. In this respect, Prairie Capital may be read as a subtle departure from the Delaware decision in Anvil Holding Corp. v. Iron Acquisition Co., Inc., 2013 WL 2249655 (Del. Ch. May 17, 2013). In Anvil Holding, the Court of Chancery found that a disclaimer provision that lacked an explicit statement of non-reliance by the purchaser, in conjunction with a clause broadly reserving the purchaser’s right to assert fraud claims, nullified the anti-reliance provision in order to allow a fraud claim based on extra-contractual statements to proceed.
A corollary point addressed in Prairie Capital is the interplay between an anti-reliance clause and a fraud claim based on fraudulent concealment (or omission) versus a claim based on affirmative misrepresentations. The Chancery Court rejected the position that the relevant anti-reliance clause did not bar a fraud claim based on fraudulent concealment due to the failure to explicitly disclaim the purchaser’s reliance on the “omission” of any information by the seller. The Chancery Court reiterated that the critical inquiry in interpreting anti-reliance language is the “universe” of information identified in the agreement upon which the parties structured their bargain; rather than focusing on the distinction between “misrepresentations” and “omissions.” The Chancery Court observed the symbiotic relationship between fraudulent misrepresentations and fraudulent concealment—which potentially can allow an aggrieved party to simply recast a “misrepresentation” as an “omission” for purposes of a fraud claim. Prairie Capital’s observation that “magic words” are not necessary to preserve the effect of an anti-reliance clause represents a slight variation in approach in comparison to the decision in TransDigm Inc. v. Alcoa Global Fasteners, Inc., 2013 WL 2326881 (Del. Ch. May 29, 2013), in which the Court of Chancery found a claim for fraudulent concealment viable where the acquisition agreement was silent as to a disclaimer of the “accuracy and completeness” of the representations.
The decision in Prairie Capital is interesting in its refusal to elevate “form over substance” in analyzing anti-reliance clauses, however, it would be perilous to view the decision as being representative of a material shift in the approach of Delaware courts in strictly construing anti-reliance clauses. While Prairie Capital recognizes that a failure to include “magic words” may not preclude the effectiveness of an otherwise robust anti-reliance clause, the Chancery Court expressly acknowledged that “transaction planners can limit their risk by using tested formulations.” As such, relying on precisely drafted anti-reliance clauses using familiar “magic words” remains the most efficient means of producing the desired outcome in avoiding liability for fraud grounded in extra-contractual statements.
The FDG Logistics decision expanded on Prairie Capital and provided further clarity as to the analysis of anti-reliance clauses under Delaware law. FDG Logistics reaffirmed a bright-line standard in assessing the effectiveness of an anti-reliance provision—namely whether the party claiming reliance on an extra-contractual statement has unambiguously agreed in the contract not to rely on extra-contractual statements. In FDG Logistics, the acquirer in a merger asserted common law fraud claims based on extra-contractual statements made before execution of the merger agreement. The merger agreement included both an integration clause and an exclusive representations clause providing that no representations were being made beyond those embodied in the merger agreement. However, the merger agreement did not contain a reciprocal affirmative disclaimer of reliance by the acquirer on any representations outside the four corners of the merger agreement. The Chancery Court held that failure to include such an affirmative disclaimer of reliance by the acquirer precluded dismissal of the common law fraud claim. The Chancery Court observed generally that whether the anti-reliance language is framed positively or negatively is of less consequence than whether the disclaimer is framed from the point of view of the aggrieved party attempting to rely on the extra-contractual statements. FDG Logistics reiterates that the starting point under Delaware law as to the enforceability of an anti-reliance clause is whether the disclaimer is made by the party asserting fraud. In a sense, FDG Logistics reaffirmed that the “magic words” of establishing an unambiguous intent on behalf of the aggrieved party are a precondition to a viable anti-reliance provision.
In Haney, a stockholder representative asserted a fraudulent inducement claim following a merger, alleging that the acquirer failed to disclose an exclusivity provision in a contract to which the acquirer was a party. The exclusivity provision prevented the target company from entering into a post-merger contract with a customer, thereby depriving the former stockholders of the target company of earn-out consideration. The merger agreement included a fraud carve-out from the exclusive remedies provision as well as an integration clause, but did not contain an express anti-reliance provision. Despite the fact that the integration clause provided that no party made representations other than expressly set forth in the merger agreement, the Chancery Court concluded that the integration clause, standing alone, was not adequate to preclude fraud claims based on extra-contractual statements. It did so on the ground that the integration clause failed to rise to the level of an unambiguous acknowledgment of non-reliance by the allegedly aggrieved party, as required by Delaware law.
Haney reaffirms the decisions in Prairie Capital and FDG Logistics finding that an integration clause itself (without any corresponding exclusive representations clause) is insufficient to establish an unambiguous contractual acknowledgement of non-reliance on information outside the four corners of the agreement. The Haney decision illustrates that parties must be mindful of the inclusion of an anti-reliance provision in transactions where the acquirer makes representations that may affect an earn-out.
The Court of Chancery’s most recent decision in IAC Search dismissed a claim for fraudulent inducement under a stock and asset purchase agreement based on the provision of allegedly false sales information furnished during due diligence. The agreement included an integration clause as well as a representation by the acquirer that it conducted its own diligence process and relied only on the agreement’s express representations. The Chancery Court found the relevant provisions to be in line with the precedent in Abry, Prairie Capital and FDG Logistics as adding up to a “clear disclaimer of reliance on extra-contractual statements” that barred the fraud claim. The IAC Search decision reiterated that this exclusive representations clause, framed from the aggrieved party’s perspective, circumscribed the “universe of due diligence information” on which that party relied (and did not rely) in executing the agreement. Further, the Court of Chancery noted Delaware’s public policy in respecting freedom of contract and that the acquirer was a sophisticated party that negotiated for express representations concerning similar financial metrics provided during the diligence process.
Practical Takeaways
These decisions refine existing Delaware law regarding the enforceability of anti-reliance clauses, and are instructive to practitioners seeking to avoid potential hazards. The decisions reinforce the importance of precise drafting in crafting effective anti-reliance language. Among other things, it is important to include within the anti-reliance provision as broad a scope as possible as to the source of the extra-contractual statements, which can include not only the parties, but their affiliates and representatives as well. In addition, it is important to establish the relevant “universe” of information covered by the anti-reliance provisions, such as financial projections or management presentations. Similarly, the acquisition agreement should specify what information, such as material contracts, that have been “made available” to a party for purposes of certain representations. By defining more specifically documents that were “made available” (e.g., those that were uploaded to a virtual data room as of a date certain prior to closing), parties can preserve a snapshot of this information and mitigate against the risk of subsequent disputes as to the “universe” of information relied upon with respect to the relevant representations and warranties.
Similarly, the scrutiny of disclaimer language by Delaware courts dictates that careful attention should be given to avoid “back doors” that can negate the intended purpose of such anti-reliance clauses. For example, Delaware courts will enforce anti-reliance clauses relating to representations outside of the agreement but will not read such clauses so broadly as to permit a party to insulate itself from liability for intentional misrepresentations within the agreement’s four corners. In this respect, practitioners should be mindful of a broad carve-out for “fraud” from an anti-reliance provision, since the use of the term “fraud,” standing alone, may not necessarily be interpreted as being limited only to an intentional misrepresentation. Finally, choice of law potentially impacts the efficacy of an anti-reliance provision, since California and, to a lesser degree, New York, interpret such provisions differently than Delaware. As such, the utility of an anti-reliance clause in guarding against the specter of extra-contractual fraud claims can be a significant consideration in negotiations over choice of law. Delaware law provides significant assurances to parties seeking protection against fraud liability for extra-contractual statements—but only by taking advantage of the “playbook” outlined by the Court of Chancery. An ounce of prevention by including an enforceable anti-reliance provision in an agreement can be worth a pound of cure in preserving a party’s interest under Delaware law
One of the perceived benefits of the LLC form is the flexibility that exist with respect to inter se management structure. Although many statutes provide skeletal defaults for when the LLC elects to be either “member-managed” or “manager-managed,” these are only default rules that may, in any particular LLC, be modified in the manner the participants desire. One not uncommon modification is structuring an LLC that is managed by a “board.” Given that the structures are, with the exception of LLCs organizing in the three states discussed below, free-form, the clarity or ambiguity of the structure is dependent upon the precision of the drafting employed in the operative agreement. We have found that there often is a great deal of ambiguity in these provisions. In addition, a number of decisions, Obeid v. Hogan and Richardson v. Kellar the most prominent, counsel caution against using a board because doing so may unintentionally incorporate (pun intended) additional law.
The (Perceived) Benefits of a “Board” Management Structure
The perceived benefit of organizing an LLC with a “board” management structure is, in our assessment, based upon the familiarity with that format as utilized traditionally in the corporation. For example, when three independent venturers come together to organize a joint project, by utilizing a board to which each of the members may appoint one or more participants, each is assured that its viewpoint will be presented and considered. For example, particularized drafting of quorum provisions requiring at least one representative of each of the participants can further enhance those perceived protections.
This is not to say, however, that the “board” appointed with respect to an LLC is equivalent to the board of directors of a corporation. Initially, the board of directors of a corporation is sui generis; it is created by statute and exists independently of the shareholders. A corporation typically will have directors before it even has shareholders (see, e.g., MBCA §§ 2.6.21, 8.01). The faculty of the board to manage the affairs of the corporation is likewise dictated by statute (see MBCA §§ 8.01, 8.31) and, absent narrow circumstances, courts have rejected efforts to restrict or even eliminate the authority of the board of directors (see, e.g., CA, Inc. v. AFSCME Employee Pension Plan, 953 A.2d 227 (Del. 2008)).
In contrast, the “board” of an LLC is a creature of contract. Being foreign to the LLC acts of almost every state, the board will have such structure, authority, and limitations as are defined in the relevant operating agreement. This paradigm raises a variety of interesting issues. For example, corporate law does not conceptualize the board of directors as an agent of or otherwise representing the shareholders. Conversely, if the members of an LLC create a board and delegate to it particular authority, at least on an inter se basis, the board is exercising authority collectively delegated by the members and may be viewed, collectively, as their agent. The question raised is whether the board is then acting as an agent of the members collectively, or whether the board is the controller of the LLC that acts as to third parties as the principal. The implications of this shift in paradigm must be considered in the drafting of any operating agreement utilizing a board structure.
There are as well a significant number of implicit and explicit consequences of electing that an LLC will be “manager-managed” and then utilizing a “board.” For example, where an LLC has multiple managers, most statutes provide that each manager, acting individually, is an agent on behalf of the LLC and can bind it to transactions in the ordinary course (see, e.g., KRS § 275.135(2)(b)). If there is an organized board, is it intended that it be a collegial body, none of whose constituents have, by virtue of that office, agency authority on behalf of the venture (that being the corporate rule), or is there a collegial body for making decisions, but each constituent thereof is still a “manager” with agency authority on behalf of the LLC? In a corporation, the rule is already fixed, but in an LLC one option or the other must be selected in order to avoid a patent ambiguity in the agreement.
Another open question is the ability of a member of a board to vote by proxy. Many operating agreements give members and managers the express authority to vote by proxy, and certain LLC acts provide a default rule allowing proxy voting (see, e.g. Del. Code Ann. tit. 6, § 407). Conversely, except in Louisiana, directors may not vote by proxy (see, e.g., ABA Corporate Director’s Guidebook 8 (2011); MBCA § 8.20, comment). Are the members of the “board” of a particular LLC allowed to vote by proxy? A well-crafted operating agreement must address that question. In the absence of doing so, there will be ambiguity as the available analogies provide conflicting, indeed entirely opposing, answers.
Statutory Board Structures
As noted above, the “board-managed” LLC is foreign to almost every LLC act; however, there are three exceptions. The LLC acts of Minnesota, North Dakota, and Tennessee each provide for a statutory board-managed structure that may be elected (see Minn. Stat. § 322C.0407(4) (2016); N.D. Cent. Code § 10-32.1-39(4) (2016); Tenn. Code Ann. § 48-249-401(c) (2015)). If a particular venture desires to have a board-managed structure, organizing under one of these acts may be an effective means of achieving that outcome. Subject to modification in a particular operating agreement, the statutory rules with respect to the board-managed structure should reduce a transaction cost incurred in drafting an operating agreement for a board-managed LLC formed in another state.
The Problem of “Corporification”
“Corporification” is the term, possibly invented by Steve Frost, to describe the incorporation (pun intended) into LLCs of concepts and principles that have arisen in the context of corporations. See Steven G. Frost, Things You Thought You Knew About Delaware Law, But Maybe Don’t … Recent Delaware Partnership and LLC Case Law, J. Passthrough Entities, May-June 2013 at 25. Oftentimes the utilization of concepts developed initially in corporate law into an LLC leads to either confusing or unintended consequences because there exists ambiguity as to the degree to which corporate law is intended to be incorporated. A pair of recent cases provide clear illustration of these problems: Obeid v. Hogan, No. 11900-V CL, 2016 BL 185285 (Del. Ch. June 10, 2016) and Richardson v. Kellar, 2016 NCBC 60, 2016 WL 4165887 (Sup. Ct. N.C. Aug. 2, 2016).
The Obeid v. Hogan dispute arose out of a pair of LLCs: Gemini Equity Partners, LLC and Gemini Real Estate Advisors, LLC. Each of these LLCs was owned one-third by Plaintiff William T. Obeid, one-third by Christopher S. La Mack, and one-third by Dante Massaro. Between the two LLCs, they held in excess of $1 billion in real estate assets, including 11 hotels and 22 commercial properties. Prior to the disputes addressed in the litigation, Obeid managed the hotel properties while La Mack and Massaro managed the commercial properties. Defendant Hogan is a retired federal judge who was retained to serve as the special litigation committee on behalf of both the LLCs. Throughout the litigation, the court referred to Gemini Equity Partners, LLC as the Corporate LLC and to Gemini Real Estate Advisors, LLC as the Manager-Managed LLC.
The Corporate LLC, organized in Delaware, utilized a board of directors comprised of Obeid, La Mack, and Massaro through July, 2014, at which time La Mack and Massaro removed Obeid. With respect to the Manager-Managed LLC, Obeid, La Mack, and Massaro each served as a manager.
On July 1, 2014, La Mack and Massaro voted to remove Obeid as the president of the Manager-Managed LLC, installing Massaro in his place. Although Obeid remained a manager, Massaro took on day-to-day control of the Manager-Managed LLC. After a flurry of litigation ranging from North Carolina to federal and state courts in New York, the Corporate LLC and the Manager-Managed LLC, under the control of La Mack and Massaro, hired the Brewer firm to serve as outside counsel. One of its recommendations was that a retired federal judge be hired to serve as a special litigation committee to respond to a derivative action filed in New York with respect to both the LLCs. After a meeting at which no formal resolutions were adopted, the Brewer firm circulated the names of two retired federal judges it had identified as appropriate to serve as the special litigation committee. Hogan ultimately was retained to serve in that role pursuant to an engagement letter signed by La Mack and Massaro. Crucially for the outcome of this decision, Hogan was not appointed a director of the Corporate LLC nor a manager of the Manager-Managed LLC. Upon learning that Hogan had been so retained, Obeid filed this action in Delaware seeking a determination that Hogan could not act as special litigation committee on behalf of either LLC or otherwise take any action with respect to the derivative suit. In addition, Obeid sought a declaratory judgment that his removal as a director of the Corporate LLC was invalid.
With respect to Hogan’s service as the special litigation committee for the Corporate LLC, after setting forth its ultimate conclusion that he could not do so, the court began its analysis with a telling section heading: “The Implications of Mimicking a Corporation’s Governance Structure.” From there the court observed that LLCs may design their inter se management structure as they see fit, citing Robert L. Symonds, Jr. & Matthew J. O’Toole, Delaware Limited Liability Companies § 9.01[B] at 9-9 (2015) for the principle that “[v]irtually any management structure may be implemented through the company’s governing instrument.” The court wrote:
Using the contractual freedom that the LLC Act bestows, the drafters of an LLC agreement can create an LLC with bespoke governance features or design an LLC that mimics the governance features of another familiar type of entity. The choices that the drafters make have consequences. If the drafters have embraced the statutory default rule of a member-managed governance arrangement, which has strong functional and historical ties to the general partnership (albeit with limited liability for the members), the parties should expect the court to draw analogies to partnership law. If the drafters have opted for a single managing member with other generally passive, nonmanaging members, a structure closely resembling and often used as an alternative to a limited partnership, then the parties should expect a court to draw analogies to limited partnership law. If the drafters have opted for a manager-managed entity, created a board of directors, and adopted other corporate features, then the parties to the agreement should expect a court to draw on analogies to corporate law. Depending on the terms of the agreement, analogies to other legal relationships may also be informative. (citation and footnotes omitted).
Although going on to recognize that there are limitations in drawing analogies among LLCs and other organizational forms, the court, citing Elf Autochem N. Am., Inc. v. Jaffari, 727 A.2d 286, 293 (Del. 1998), observed that, “the derivative suit is a corporate concept grafted onto the LLC form” and concluded that, “absent other convincing considerations, case law governing corporate derivative suits is generally applicable to suits on behalf of an LLC.”
Having determined that the corporate law governing special litigation committees in derivative actions would be applicable to the corporate LLC, the court turned its attention to the decision in Zapata Corp. v. Maldonado, 43 A.2d 779 (Del. 1981). After an extensive review of that decision and the role of the special litigation committee, the court noted an absence of situations in which the special litigation committee was comprised of nondirectors and observed that, because derivative litigation does not fall into the ordinary course, these matters must, in the corporate context, be resolved by the board. The court observed that, “A board may not make a similarly complete delegation to an officer or a non-director. Doing so would risk an improper abdication of authority. Hence the requirement exists that a Zapata committee be made up of directors.” From there the court ultimately concluded that, “Judge Hogan is not a director of the Corporate LLC. Consequently, under the Corporate LLC Agreement, he cannot function as a one-man special litigation committee on behalf of the Corporate LLC.”
Turning to the manager-managed LLC, even as the court acknowledged it was not utilizing a board of director management model, it concluded that the manager-managed system employed was sufficiently analogous to a board structure to justify the application of Zapata and the ultimate determination that Hogan could not, with respect to that LLC, serve as a special litigation committee. “In my view, the resulting structure is sufficient to cause the reasoning that governed the Corporate LLC to apply equally to the Manager-Managed LLC.”
This brings us back to corporification. The drafter of the LLC agreement for the Corporate LLC wrote into the document significant aspects of the laws of corporate derivative actions. From that utilization, the court assumed that the entire body of law governing derivative actions, including the law developed exclusively through court decisions, was intended to be applied in the context of this LLC. In effect, the court read into the express terms of the LLC agreement the common-law penumbra of derivative actions. Whether that is what was actually intended by the drafter is unknown. Did the drafter intend that the common law of derivative actions be incorporated by a deemed incorporation by reference, or did the drafter intend that only so much of that law as was set forth in the agreement would apply? Curiously, the court did not reference the terms of the merger clause of either LLC agreement.
Richardson v. Keller, 2016 NCBC 60, 2016 WL 4165887 (Sup. Ct. N.C. Aug. 2, 2016), decided by the North Carolina Business Court, involved the interpretation of an operating agreement that incorporated by reference the usual authority of the president of a North Carolina corporation. In the course of its opinion, the court explained that the authority of the president of a corporation is open to interpretation.
This case arose out of an application by Richardson for a preliminary injunction, which relief was ultimately granted. Richardson, through a wholly owned LLC, and Kellar, through another wholly owned LLC, were the two, 50-percent members of a North Carolina LLC named TransWorld Medical Devices, LLC (TW Devices). Richardson and Kellar were the two directors of TW Devices. The organic documents of that company were quite specific in detailing the purpose of the company—namely, the development of a variety of cardiovascular-related medical devices. Ultimately, TW Devices became a shareholder in a subsequently organized corporation, Cleveland Heart, Inc. (CHI), which was also owned in part by the Cleveland Clinic Foundation. Kellar ultimately sought to marginalize Richardson, unilaterally voting the interest of TW Devices in CHI, asserting that he could do so in his alleged capacity as CEO/president of TW Devices.
At this juncture, the question turned ultimately on whether TW Devices was merely a holding company with respect to an interest in CHI, or rather had other business purposes. The court held that TW Devices was not a mere holding company. On that basis, the voting of TW Devices’s interest in CHI was an extraordinary matter that needed to be resolved by the LLC’s two-member board of directors. On the basis that Kellar was, in effect, stripping Richardson of his right to participate in those decisions, the requested temporary injunction was granted.
Back to corporification. Initially, Kellar argued that, because TW Devices should be viewed as a mere holding company, he had the capacity to vote the shares as the president/CEO thereof under the operating agreement. In furtherance thereof, he pointed to section 4.12(a) of the TW Devices operating agreement, which provides:
Any officer . . . shall have only such authority and perform such duties as the Board may, from time to time, expressly delegate to them. . . . [U]nless the Board otherwise determines, if the title assigned to an officer of the Company is one commonly used for officers of the business corporation formed under the North Carolina Business Corporation Act, then the assignment of such title shall constitute the delegation to such officer of the authority and duties that are customarily associated with such office, including the authority and duties that a President may assign to such other officers of the Company under the North Carolina Business Corporation Act.
The only problem was that, even as the operating agreement sought to incorporate the authority of an officer, including the president, those are actually open questions under North Carolina law. Rather:
North Carolina law does not provide definitive guidance regarding the “customary” authority possessed by corporate presidents. The Business Corporation Act does not define the duties or powers possessed by officers. North Carolina’s leading commentator on corporate law has noted that:
The allocation of authority and duties among corporate officers is usually outlined to some extent, either specifically or generally, by the corporate bylaws, and is then further defined in more detail by the directors and by the officers themselves. To the extent that these respective functions of corporate officers and agents are not thus defined by the corporation, they may be defined by the law and custom is developed by normal practices.
Russell M. Robinson, II, Robinson on North Carolina Corporation Law § 16.01 (7th ed. 2015) (footnotes omitted).
Corporification rears its head again; the operating agreement incorporated the unresolved point of a president’s authority even as it made the two members subject to the standards applicable to corporate directors. An LLC with two individual members is not the type of entity that most practitioners would envision adopting a corporate structure governed by corporate law. The dispute suggests that at least one of the parties did not envision the incorporation of corporate law. These cases illustrate that the use of corporate labels and principles may add uncertainty and provide the members of an LLC with a management structure they had not envisioned.
This article provides a framework for addressing the importance of adopting deadlock-breaking mechanisms in limited liability company (LLC) operating agreements as an alternative to seeking judicial dissolution when a deadlock arises in an LLC.
The problems arising from deadlock in the management of an LLC are obvious to almost all practitioners, so we will not spend too much time discussing them, but a few points bear addressing. First, deadlocks in an LLC typically arise in a number of circumstances involving important decisions, including:
1. the failure of equal members or managers to reach agreement; 2. the failure to obtain a required majority vote; 3. the failure to obtain a required approval from a member with approval rights; and 4. the failure to obtain unanimous consent where unanimity is required.
Second, the failure to provide deadlock-breaking mechanisms that address any or all of the above in an operating agreement will result in significant expense, hard feelings, loss of time, and possible mediation, arbitration, or litigation—all of which are covered later in this article. Third, the ultimate stage of unresolved deadlock often will result in dissolution of the LLC, which typically involves excessive expense, lost opportunity, and bitter consequences for the members of the LLC.
Judicial Dissolution
If a deadlock arises and an LLC has not adopted a deadlock-breaking mechanism in the operating agreement, the parties most often will turn to a court seeking judicial dissolution, or a court-ordered alternative to dissolution, to resolve the deadlock. “Dissolution” has been a term of art in the law of unincorporated entities since at least the time of Roman law. Joseph Story, Commentaries on the Law on Partnership § 266 at 408 (2d ed. 1850) (“The Roman law . . . declared[] that partnership might be dissolved in various ways. . . .”).
Under the Revised Uniform Limited Liability Act (RULLCA) promulgated by the Uniform Law Commission (last revised in 2013), a limited liability company is dissolved, and its activities and affairs must be wound up, upon the occurrence of any of the following:
(1) an event or circumstance that causes dissolution under the operating agreement;
(2) the affirmative vote or consent of all the members;
(3) the passage of 90 consecutive days during which the company has no members unless, before the end of the period:
(A) consent to admit at least one specified person as a member is given by transferees owning the rights to receive a majority of distributions as transferees at the time the consent is to be effective; and
(B) at least one person becomes a member in accordance with the consent;
(4) upon application by a member, the entry by the appropriate state court of an order dissolving the company on the grounds that:
(A) the conduct of all or substantially all the company’s activities and affairs is unlawful;
(B) it is not reasonably practicable to carry on the company’s activities and affairs in conformity with the certificate of organization and the operating agreement; and
(C) the managers or those members in control of the company:
(i) have acted, are acting, or will act in a manner that is illegal or fraudulent; or
(ii) have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant (“oppression” of one or more members in an LLC is a basis for judicial dissolution under RULLCA, but not in many other state LLC acts, even in some states that have adopted RULLCA-based LLC acts, such as Florida); or
(5) the signing and filing of a statement of administrative dissolution by the Secretary of State.
Deadlock as Grounds for Judicial Dissolution
Most state statutes rely on the judicial-dissolution provisions of the LLC Act as the judicially imposed remedy when the members or managers are deadlocked and are without a clear and effective private ordering provision to control the resolution of the deadlock. Of course, there are numerous problems with leaving resolution of member or manager deadlock disputes to the courts.
Under most states’ LLC Acts and case law, a Member or Manager may seek judicial dissolution in a judicial proceeding if it is established that:
1. the conduct of all or substantially all of the activities and affairs of the LLC are unlawful; 2. it is not reasonably practicable to carry on the company’s activities and affairs in conformity with its articles and operating agreement; 3. the members or managers in control of the LLC are acting or are reasonably expected to act in a manner that is illegal or fraudulent; 4. LLC assets are misappropriated or wasted, causing irreparable injury to the LLC or to one or more of its members; or 5. the members or managers of the LLC are deadlocked in the management of the LLC’s activities or affairs, the members or managers are unable to break the deadlock, and irreparable injury to the LLC is threatened or suffered.
The Court’s Power to Provide Alternative Remedies in Deadlock
It is important to note that some state statutes (e.g., Florida) that provide for deadlock as grounds for judicial dissolution also expressly provide in such a proceeding that the court has more flexibility than simply ordering dissolution. Such statutes typically include language such as the following: “in a proceeding brought under [the section addressing judicial dissolution] the court may order a remedy other than dissolution.” Consequently, one must be prepared for the court to fashion a remedy that one or more of the parties did not anticipate and would not appreciate, e.g., mandating that one of the members be bought out by the company or other member(s). Additionally, courts have exercised their equitable powers to fashion alternative remedies even though the statute does not contain the express statutory provision described above.
For example, in Lyons v. Salamone, 32 A.D.3d 757, 758, 821 N.Y.S.2d 188 (N.Y.A.D. 1 Dept. 2006), the court held: “[w]e reject plaintiff’s argument that the absence of a provision in the Limited Liability Company Law expressly authorizing a buyout in a dissolution proceeding rendered the IAS court without authority to grant the parties mutual buyout rights, and find that it is an equitable method of liquidation to allow either party to bid the fair market value of the other party’s interest in the business, with the receiver directed to accept the highest legitimate bid.
In the infamous Delaware case of Haley v. Talcott, 864 A.2d 86, 97 (Del. Ch. 2004), the court ordered dissolution under the “not reasonably practicable standard” even though the operating agreement provided a put mechanism as a method for avoiding the impasse, noting that the operating agreement did not expressly substitute the put mechanism for the judicial-dissolution remedy, and holding that the put mechanism was not fair and equitable because it would leave the exiting member personally liable on a mortgage.
The take-away from Haley is that, if a put is intended to be part of the “reasonably practicable” solution to a deadlock in the operation of the LLC, the operating agreement must explicitly state as much, and must expressly acknowledge that it is to be enforced by a court in lieu of the court exercising its equitable power to fashion a different remedy. Of course, in many states, such a provision must withstand any challenge that it is “manifestly unreasonable” and therefore unenforceable (perhaps because it results in imposing company liabilities on the remaining members and exempting the exiting member from those liabilities).
Mechanisms Addressing Deadlock
The creativity that parties can employ in creating a deadlock-breaking mechanism is nearly limitless. All states provide for contractual freedom in drafting operating agreements, subject only to the “nonwaivable” default rules in the applicable LLC act. Based on Haley, it is critical that the operating agreement specify whether a court must enforce the chosen deadlock-breaking mechanism, unless it is deemed “manifestly unreasonable” (more on this later).
LLC operating agreements that address deadlock generally do so with a few well-known mechanisms:
1. Buy-Sell Provisions. Most often these take the form of either: (i) an “appraisal” model (requiring an independent appraisal by a qualified expert as to the value of the interest to be purchased); or (ii) a “shotgun” or “Russian Roulette” or “Texas Shoot Out” (or any number of other colorful names) model, which essentially permits one member to offer to purchase the interest of the other deadlocked member at a set price and terms, and the offeree must then either accept that price and terms, or purchase the offeror’s interest for the same price and terms (assuming equivalent percentage interests). The results of so-called shotgun models have been seen to generate litigation and unfair results, particularly where the parties have wildly different ideas about value, where there is a significant gap in knowledge about the specific business or industry, or where the parties have significantly different economic resources. On the other hand, under the right circumstances, these mechanisms have proven rather effective at forcing parties to find a way to break a deadlock to avoid the potential of one party actually pulling this trigger.
2. External or Internal “Tie-breakers.” This is where the parties that are deadlocked will refer the decision to a tie-breaker, which may be a group like the board of an affiliated entity, inside or external professional advisors, one or more mediators/arbitrators, or “industry expert(s).” A significant problem with this approach often is that, in taking such an action, the decision is removed from the parties most familiar with the company and its business and put in the hands of third parties who may not have the requisite insight. Therefore, this mechanism should be used only when there are parties to whom the decision may be referred that have some history and familiarity with the specific business and industry.
3. “Rotating/Alternating” or “Casting” Vote Mechanisms. These mechanisms, which allow the members to rotate “tie-breaking” or “casting” votes whenever there is a deadlock on a decision, often are complicated to draft (to limit gamesmanship) and frequently leave everyone unhappy. In essence, the members (assuming a member-managed LLC) will try to reach agreement on a list of “major issues” when they arise, but if they fail to come to an agreement, one member will break the deadlock by exercising his or her casting vote. The next time there is a deadlock on a major issue, another member gets the “casting vote,” and so on it goes. Obviously, this has significant drawbacks and rarely is successfully employed.
4. “Put or Call Mechanisms.” These mechanisms are well known and often used as deadlock-breaking provisions in LLC operating agreements because they are common in many other contexts. However, the nuances of these mechanisms are significant and must be carefully drafted. Aside from the valuation issues in put and call mechanisms (which are an article unto themselves), perhaps the most important issues associated with put/call provisions involve the determination of triggering events. A triggering event is essentially the action, event, or circumstance that will allow one party to exercise a put or call. These provisions are heavily negotiated and careful drafting is essential. Consider questions such as whether they should be based on deadlock or on only a few specific matters (e.g., whether the company should take out a loan, make a capital call, admit a new member, or change the business), or whether they should be exercisable on matters that go beyond deadlocked vote. The list can be quite extensive, or it can be narrowly drafted. Some examples are below:
X’s Triggering Events:
Any material failure by [X] to perform its obligations under this Agreement that is not cured to [Y’s] reasonable satisfaction within ten (10) days after Notice of breach by [X] regarding monetary default and within thirty (30) days after Notice of breach by [X] regarding a nonmonetary default (provided that such cure period for a nonmonetary default shall be extended for an additional period, not exceeding an additional ninety (90) days, so long as [X] as the case may be, is diligently pursuing the cure of such default during such extended cure period);
The failure by [X] to fund, in full, any Required Amount under [the operating agreement];
Any transfer or encumbrance of [X’s] Membership Interest in the Company or any portion thereof or any direct or indirect interest therein not permitted herein without the Approval of [Y]; and
Any act of gross negligence, willful misconduct, or fraud by [X] concerning its obligations under this Agreement.
Y’s Triggering Events:
Any material failure by [Y] to perform its obligations under this Agreement as Member [or Manager] that is not cured to [X’s] reasonable satisfaction within 10 days after Notice of breach by [Y] regarding monetary default and within 30 days after Notice of breach by [Y] regarding nonmonetary default (provided that such cure period for a nonmonetary default by [Y] shall be extended . . . .);
Any material breach of a representation, warranty, or covenant: (i) by [Y] or its Affiliates under the Noncompetition and Right of First Opportunity Agreement; (ii) by the Manager under a Management Agreement; or (iii) by [Y] or its Affiliates under any Related Party Agreement, in each case in the event such material breach is not cured within any applicable grace period. . . .;
The failure by [Y] to obtain the Approval of [X] prior to taking any action requiring the Approval of [X] hereunder. . . .;
The failure by [Y] to fund, in full, any Required Amount under [the operating agreement] including any grace period provided therein;
Any transfer or encumbrance of [Y’s] Membership Interest or any portion thereof or any direct or indirect interest therein not permitted herein without the Approval of [X];
Any [Y] Material Change in Control not Approved by [X] under [Section _ of the operating agreement]; and
Any act of gross negligence, willful misconduct, or fraud by [Y] or by any Affiliate of [Y] under this Agreement or any Related Party Agreement or otherwise in connection with the management and operation of the business and affairs of the Company.
Remedies for [X or Y] Triggering Event:
Upon the occurrence of an X Triggering Event, and at any time thereafter, Y may, at its option, exercise any one or more of the following remedies without the Approval of any other Member:
cause the Company to market and sell the Properties to a third party for such price and on such terms as [Y] deems appropriate, without the need for Approval of [X] and without any right on the part of [X]to purchase any of the Properties;
dissolve the Company;
exercise, in its sole discretion, the Company’s right to terminate (or otherwise enforce any other remedy with respect to) any Property Management Agreement or any other Related Party Agreement between the Company or any Subsidiary and [X], or any Affiliate of [X];
replace [X] as the Member vested with day-to-day management control of the affairs of the Company as set forth in Section _, and/or remove [X] as the Property Manager with respect to the Properties; and
in the case of an [X] Triggering Event under Section _ only, purchase the Membership Interest of [X] for an amount equal to the lesser of: (i) seventy-five percent (75%) of the [unreturned Capital Contributions] of [X]; or (ii) the [Fair Market Value] of [X’s] Membership Interest.
5. Partition or Sale of the Company or Its Assets. The possibility ofpartition of the LLC business, or a forced sale of the Company or its assets, can also compel disagreeing members or managers to find a way to resolve their deadlock. Partition of the LLC assets or business can work only in limited circumstances, typically where the assets or business activities are easily segregated among the members without destroying the business model itself and where the values of those assets are equal and division is easily agreed upon by the disputing members. A forced sale of the company or its assets also has complications, particularly timing, market forces, lack of interested buyers, or understanding who sets the price and terms (remember there is already deadlock, so these issues may be difficult to agree upon later); therefore, the initial drafting must be comprehensive and often must be turned over to third parties to facilitate.
When All Else Fails: Litigation and Alternative Dispute Resolution Options
When deadlock-breaking mechanisms fail or are absent from the operating agreement, the most common alternatives include:
involuntary or judicial dissolution
custodianship or receivers
injunctions
specific performance
judicial expulsion
1. Involuntary or Judicial Dissolution
An action seeking involuntary dissolution by a member is by far the most common form of getting out of an LLC in the absence of a deadlock-breaking mechanism. Involuntary dissolution petitions may be coupled with claims for other forms of relief, such as demands for an accounting, appointment of a receiver or custodian, a change in control of the LLC, etc. The petitioner ordinarily must allege and establish the following elements: (i) there is a voting deadlock; (ii) the operating agreement does not provide a means for breaking deadlock; and (iii) the LLC is functioning only as the result of “residual inertia,” and there is no other reasonable method of resolving deadlock. The cons associated with judicial dissolution include a lower realized value for the membership interests or assets and an inability to continue the business.The respondent in a petition for involuntary dissolution often asserts bad faith by the petitioning member(s) as a defense. The remedy can rapidly become expensive.
2. Custodianship/Receivership
Think of a custodian as a form of receiver. A custodian may be appointed by a court to operate the LLC in circumstances where the members’ division is so severe that it prevents the orderly operation of the business and threatens the entity with irreparable injury. The court-appointed custodian effectively replaces the members or managers in control of the company and is charged with the responsibility to operate the business until the court fashions a more permanent remedy. The principal advantages of custodians include that the cause and effect of the members’ division, and the management’s inability to manage the business, are removed, and the company may be saved from liquidation unless it is already insolvent. The principal disadvantage is that management decisions are placed in the hands of a third party rather than in the hands of the members or managers of the company. The custodian’s exit from the scene should be accompanied by a negotiated mechanism to resolve future deadlock should the need again arise. A receiver can be appointed to liquidate the company if there is no viable alternative.
3. Injunction
Injunction is a familiar tool to most litigators. An injunction is a court order prohibiting or requiring the performance of certain conduct that is necessary to prevent irreparable injury to the company or its members. Injunction is often a precursor to eventual dissolution and may be used in the context of deadlock offensively or defensively. In other words, a party may petition the court for an injunction to prevent looting, waste of corporate assets, breach of fiduciary duties, or oppression by managing members. A party that is the target of a petition for judicial dissolution or appointment of a custodian may seek an injunction to neutralize the attack. Injunction orders can be very simple affairs that prevent or mandate a well-defined behavior, or they can be more complex documents that specify the manner in which the company will do business and the managers who will manage it. Injunctions may be granted only where the requesting party can demonstrate a likelihood of success on the merits of its claim, where there is no other adequate remedy at law (e.g., the absence of a deadlock-breaking mechanism in the operating agreement and no guidance from the LLC statute), and there is a risk of irreparable harm if the relief is not granted. Although an injunction theoretically allows for the continuance of the company’s business, it does not resolve deadlock, it holds a bad relationship together, and it is difficult to obtain due to a high standard of proof.
4. Specific Performance
A party may seek specific performance of obligations owed by another party if the claim arises under a contract that describes the obligations to be performed, but that the respondent is not performing. Essentially, the petitioner asks the court to force the respondent to perform its contractual obligations (including obligations under the operating agreement). The standard of proof often is “clear and convincing,” which is a higher standard than for most claims (preponderance of the evidence). Specific performance is not always available due to the existence of remedies at law. It features the unfortunate characteristic of forcibly keeping a contentious relationship together without providing a method to resolve future deadlock.
5. Judicial Expulsion
Expulsion is an extreme remedy because it removes a member from the LLC. The standards of proof parallel those for involuntary dissolution, where it is “not reasonably practicable” for the LLC to serve the purposes and function specified in the operating agreement. The remaining members may continue to operate the company. The inquiry is peculiarly fact-driven, and the trier of fact must be satisfied that the high standard of proof establishes adequate “fault” to support expulsion of a member. Mere disagreement over how to operate the company is not sufficient. Not all states provide the remedy of expulsion.
6. Alternative Dispute Resolution: Mediation and Arbitration
Operating agreements that do not provide mechanisms for breaking deadlock may nevertheless provide alternate methods of resolving disputes, such as mediation and arbitration. Mediation is a voluntary negotiation presided over by a neutral that assists the parties to overcome their differences and achieve a voluntary resolution through negotiation. Many sophisticated courts now feature mandatory mediation programs. Mediation is useful in situations where the parties are motivated to compromise, but it may be fruitless when the parties are so hostile and entrenched that compromise is impossible. A strong neutral, frequently a retired judge, often is the key to a successful mediation. A strong neutral can force the parties out of their echo chambers and recognize the risks and expense—and the distraction from profitable activity—that is associated with continued litigation.
Arbitration is another option. Like mediation, arbitration is conducted out of court, but unlike mediation it does not involve achieving a negotiated compromise. Arbitrations essentially are private trials. One or more neutrals are paid to function as trial judges. They conduct discovery and motions practice, often in a streamlined manner, and preside at trial. Testimony is taken and evidence is submitted to the arbitral panel for consideration. The goal of arbitration is to obtain a resolution in an adversary manner more quickly than might occur in state or federal court. An advantage of arbitration is that the parties participate in selecting the triers of fact and, as a result, are often able to secure the services of neutrals with substantial experience with the subject matter in dispute. A drawback to arbitration is the need to compensate the arbitrators, an additional expense not associated with traditional litigation in which the parties pay only their attorneys. Arbitration awards may be recorded as judgments and enforced in like manner.
A thoughtful and properly drafted operating agreement will provide deadlock-breaking mechanisms that may help the members of LLCs avoid the need for costly and distracting litigation. When all else fails, however, these tools provide parties with flexible alternatives to obtain resolution through adversary proceedings.
This article is based on materials and a panel discussion presented by the authors at the 2016 ABA LLC Institute in Arlington, Virginia, as members of the ABA Committee on LLCs Partnerships and Unincorporated Business Entities.
LLCs increasingly intersect with the nonprofit sector. LLCs are used within the sector as tax-exempt subsidiaries (see, e.g., IRS Announcement 99-102 (requiring I.R.C. section 501(c)(3) organizations to report the activities of their single-member LLCs (SMLLCs) on the organization’s annual IRS Form 990)); as vehicles for charitable giving (see e.g., IRS Notice 2012-52 (allowing contributions to an SMLLC owned by a (c)(3) to qualify for a charitable contribution deduction under I.R.C. section 170); see also Priv. Ltr. Rul. 200150027 (Dec. 14, 2001) (disregarded SMLLC established by (c)(3) to receive contribution of real property subject to potential environmental liabilities)); as private foundation substitutes; and as stand-alone, tax-exempt entities in lieu of nonprofit corporations or unincorporated nonprofit associations (see Reg. § 301.7701-3(c)(1)(v)(A) (submission of application for (c)(3) status constitutes an election to be treated as a corporation for federal income tax purposes)). A few states even have a nonprofit form of the LLC (see Ky. Rev. Stat. Ann. §§ 275.520–540 (2017); Minn. Stat. § 322B.975 (2017); N.D. Cent. Code §§ 10-36-01 to -09 (2017); Tenn. Code Ann. § 48-101-809 (2017)).
Furthermore, because it is so flexible, the LLC has proven useful for hybrid for-profit/nonprofit endeavors (i.e., the benefit LLC and the L3C) (see generally Cassady V. Brewer, Elizabeth Carrott Minnigh & Robert A. Wexler, Social Enterprise by Non-Profits and Hybrid Organizations, 489 Tax. Mgmt. at A-33) and joint ventures between tax-exempt and nontax-exempt entities (see, e.g.,Rev. Rul. 2004-51 (attributing “insubstantial” activities of an ancillary LLC joint venture to an exempt member); Rev. Rul. 98-15 (attributing “substantial” activities of a whole hospital LLC joint venture to an exempt member)).
Using a hypothetical to illustrate, this article summarily explores the use of LLCs within the nonprofit sector, including a few words about their use as hybrid for-profit/nonprofit enterprises.
Hypothetical
Assume that a local, unincorporated men’s group has been operating an annual four-day men’s retreat in the Smoky Mountains for the past five years. Each year there are approximately 50 attendees. The retreat is educational in nature, focusing upon the role of men in the family and upon living a more spiritual life. Special, invited guests speak at the retreat, and the attendees participate in workshops and discussion groups centered upon each speaker’s topic. Selected leaders of the group annually front the expenses of the retreat (accommodations, meeting rooms, food, drink, etc.) and are reimbursed via collections taken from all the attendees during the retreat. Last year, however, a fatality occurred during the men’s retreat, so the leaders of the group have decided to seek the assistance of an attorney to explore their options for liability protection and possible incorporation as a nonprofit.
Discussion and Analysis
Unincorporated Nonprofit Association
Organizations with a charitable, educational, religious, or other exempt purpose such as our hypothetical men’s retreat often begin operating without a formal legal structure. Eleemosynary associations such as literary clubs, church groups, and “friends of” organizations largely begin as self-funded organizations that may not even consider themselves “nonprofit” in the traditional sense. Nevertheless, these organizations are in fact operating in a recognized legal form: the unincorporated nonprofit association.
The unincorporated nonprofit association is the nonprofit equivalent of a general partnership (see Revised Uniform Unincorporated Nonprofit Association Act (RUUNAA)).The law varies from state to state as to whether an unincorporated nonprofit association is considered a legal entity apart from its members. California and states that have adopted versions of the Uniform Unincorporated Nonprofit Associations Act (UUNAA) regard the association as a separate entity. (Thirteen jurisdictions adopted the original version of the UUNAA (1996): Alabama, Arkansas, Colorado, Delaware, DC, Hawaii, Idaho, Illinois, Louisiana, North Carolina, Texas, Wisconsin, and Wyoming. So far, six have adopted the RUUNAA: Arkansas, DC, Iowa, Kentucky, Nevada and Pennsylvania. California has had an unincorporated association law since 1947, and the law was significantly revised in 2004 and 2005.)
Tax-exempt status is obtainable for an unincorporated nonprofit association, just as with a charitable trust or a nonprofit corporation. (More informal aggregations of individuals are not automatically considered a “corporation, community chest, fund, or foundation” that can claim exempt status under I.R.C. section 501(c)(3) (see Trippe v. Commissioner, 9 TCM (CCH) 622 (1950)). If, however, the organization has sufficient organizing documents binding the members, then the tax “entity” can be considered a “corporation, community chest, fund, or foundation” and therefore qualify for exempt status (see Morey v. Riddell, 205 F. Supp. 918 (S.D. Cal. 1962), in which the court found organizing documents sufficient to support a finding that an entity was created). The principal requirement is that the unincorporated nonprofit association and its members subject themselves to the “nondistribution constraint” (see I.R.C. § 501(c)(3): “no part of the net earnings of which inures to the benefit of any private shareholder or individual”) that is standard for I.R.C. section 501(c)(3) organizations. However, even though an unincorporated nonprofit association may qualify as an organization separate from its members and thereby exempt under federal law, not all jurisdictions recognize it as a separate legal entity under state law. In these states, the association may not be authorized to hold title to property, may not be able to enter into and enforce contracts, may not be able to sue or be sued, and may not offer liability protection for its members (see UUNAA, at 2). The RUUNAA and UUNAA ameliorate these legal problems in adopting states, but most states have not adopted either statute.
Although there are valid reasons (e.g., (i) the organization has both U.S. and non-U.S. members (e.g., Canada) and does not want to create separate entities in each country; (ii) the organization does not want governmental regulation that accompanies incorporation; (iii) the organization does not want to comply with the legal formalities associated with a juridical entity; (iv) the organization is too small or engages in activity (e.g., a literary society) that seldom, if ever, requires liability protection or a formal governance structure; or (v) the organization is simply a local chapter of a national organization (e.g., a labor union)) why an eleemosynary organization such as our hypothetical men’s retreat may want to operate as an unincorporated nonprofit association, in most cases a formal legal entity makes more sense. Where a formal legal entity is chosen, the choice most often comes down to one of two forms: a nonprofit corporation or an LLC. (In the authors’ experience, charitable trusts generally are not used because trusts typically do not engage in active business or charitable endeavors. Most trusts are formed for the sole purpose of passively holding and managing assets and making distributions to beneficiaries. There are exceptions, of course, but trusts are not as flexible with respect to changes in purposes or activities or changes in governance (unlike nonprofit corporations and LLCs)). A nonprofit corporation for our hypothetical men’s retreat is a logical choice, and it undoubtedly is the predominate form (see C. Brewer, Chapter 14: Nonprofit and Charitable Uses of LLCs in Research Handbook on Partnerships, in LLCs and Alternative Forms of Business Organizations 229 (R.W. Hillman & M.J. Lowenstein eds., Edward Elgar 2015)), but the LLC also may be a proper choice in the right circumstances, as explained further below.
Limited Liability Company—Either For-Profit or Nonprofit, but Not Tax-Exempt
The men’s group in our hypothetical almost certainly could be formed as an LLC organized to operate the annual retreat. Virtually all states allow an LLC to be organized for any lawful purpose—unlike for-profit corporation statutes which typically require a “business” purpose. Moreover, as noted above, four states authorize nonprofit LLCs. Formation as an LLC offers significant advantages over an unincorporated nonprofit association, not the least of which would be liability protection for the members of our hypothetical men’s group. The members of the men’s group could become members of an LLC, could fund the retreat via payments—arguably capital contributions—to the LLC, and could appoint managers of the LLC to arrange and manage the retreat.
From a federal income tax perspective, the LLC essentially would operate as an expense-sharing arrangement, and thus most likely would not be treated as a partnership or other tax entity for federal income tax purposes (see Reg. § 301.7701-1(a)(2) (two or more persons joining together to construct a drainage ditch does not constitute a partnership for federal income tax purposes)). Even if the LLC were considered a partnership for federal income tax purposes, its expenses almost certainly would match its income from the payments (capital contributions?) by the members. Note, however, that the contributions of the men towards the expenses of the annual retreat would not be tax deductible. Instead, such contributions would be considered nondeductible personal expenses (see I.R.C. § 262). To be tax deductible, the LLC would have to qualify under I.R.C. section 501(c)(3), and any contributions by the members would have to qualify as charitable gifts under section 170, not payments in exchange for the return benefit of goods and services received at the retreat (Reg. § 1.170A-1(h)).
Interestingly, the IRS’s current position is that an LLC patterned after our hypothetical men’s group cannot function as a (c)(3) organization unless all of its members are (c)(3) organizations, governmental units, or instrumentalities thereof. Apparently, this is the IRS’s position even if the organization otherwise would qualify as charitable, educational, religious, or exempt in some other fashion under section 501(c)(3). Note, however, that this is only the IRS’s position. It is not settled law. Clearly, a nonprofit corporation with an exempt purpose may have nonexempt, nongovernmental members and nevertheless qualify as a (c)(3) organization, provided the “nondistribution constraint” is met, and other required provisions are set forth in the organization’s governing documents. If the IRS’s position is litigated, it is conceivable that a properly organized and operated LLC could qualify as a (c)(3) organization even if it has nonexempt, nongovernmental members. Arguably, this clearly should be so if the LLC is formed in one of the four states that statutorily authorize nonprofit LLCs. Those four states noted above impose the “nondistribution constraint” (as well as other requirements) on nonprofit LLCs similar to the restrictions imposed upon nonprofit corporations. It is unlikely, though, that a taxpayer would be willing to challenge the IRS’s position when a duly formed nonprofit corporation easily can obtain IRS approval for (c)(3) status.
SMLLC Subsidiary of Tax-Exempt Organization (or Fiscal Sponsorship)
Alternatively, our hypothetical men’s group could be formed as a SMLLC owned by an existing charitable organization that is exempt under section 501(c)(3). For instance, if the men’s group was affiliated with a church, then the church could form and be the sole member of an LLC that conducts the annual retreat. The SMLLC owned by the church would be considered an exempt division of the church itself.
A variation of the charitably owned SMLLC is a “fiscal sponsorship” using an LLC (see S. Chiodini & G. Colvin, The Use of LLCs in Fiscal Sponsorship—A New Model, 22 Tax’n of Exempts 7 (2011)). A fiscal sponsorship arrangement essentially lends the sponsor’s (c)(3) status (including administrative functions) to a project aligned with the sponsor’s exempt purpose. The fiscal sponsor thereby may receive charitable grants and tax-deductible contributions that it otherwise would be unable to receive. For example, a church or other (c)(3) affiliated with our hypothetical men’s group could enter into a fiscal sponsorship agreement with the LLC (likely owned by the (c)(3) but conceivably owned by the members) to conduct the annual retreat. So long as the (c)(3) exercises complete control over the LLC’s finances concerning the retreat, grants and contributions to the LLC (provided they are not payments for goods or services) should be tax deductible as if contributed to the (c)(3) itself.
Although the church also could form a nonprofit corporation instead of an SMLLC to organize and conduct the retreat, the SMLLC has at least one significant advantage. Specifically, before the existence of disregarded SMLLCs, (c)(3) organizations or their donors used “supporting organizations” or “title-holding corporations” to function as exempt subsidiaries. Because they are not disregarded like an SMLLC, however, supporting organizations are highly regulated and must separately apply to the IRS for recognition of their exempt status. Title-holding corporations are, as the name suggests, exempt organizations formed to hold title to real property. Although not required to separately apply for exempt status, title-holding corporations are subject to strict limitations on their activities (I.R.C. § 501(c)(25) (limited to being organized to hold title to real property and collect the income therefrom for remittance to the title holding company’s exempt parent)). Operating a men’s retreat likely would not be permitted.
Despite the advantages associated with the use of disregarded SMLLCs by (c)(3) organizations, some caveats are in order. For instance, SMLLCs are not disregarded for employment tax purposes (Reg. § 301.7701-2(c)(2)(iv)-(v)rev’g Notice 99-6, 1999-1 C.B. 321). Therefore, if a nonprofit or charitable organization’s disregarded SMLLC has employees, it ordinarily will be subject to employment tax filings and payments distinct from the parent organization (seeReg. §§ 31.3121(b)(3)-1T; 31.3127-1T; 31.3306(c)(5)-1T; 301.7701-2T (generally treating SMLLC as separate entity for employment tax purposes but also permitting SMLLC to be disregarded for certain religious exceptions)). Furthermore, even though most states follow the default federal income tax classification of SMLLCs as disregarded entities, not all states do so. Moreover, nonincome-based state taxes—such as franchise, sales, use, and property taxes—can apply to nonprofit and charitable SMLLCs absent a specific exclusion. Finally, as far as the authors are aware, current law is unclear whether federal or state charitable immunity or other laws protecting volunteers of nonprofit organizations (as opposed to the organization itself) from tort claims apply to volunteers of disregarded SMLLCs of nonprofit organizations. Tort liability protection for volunteers could be a critical determining issue for our hypothetical men’s retreat.
“Social Enterprise” and LLCs
In addition to their growing use within the nonprofit sector, LLCs are used for quasi-charitable (social enterprise) purposes. Social enterprise has no legal definition, but generally it is understood as using traditional for-profit business approaches to address social or environmental concerns. For instance, if our hypothetical men’s group sought to operate the retreat on a for-profit basis, opened it to the public, and charged fees to attendees, then the organization might be considered an educational social enterprise. Note that there are no tax benefits associated with operating a business as a social enterprise.
Low-profit limited liability companies (L3Cs) can be used to conduct a social enterprise with a charitable or educational purpose. An L3C essentially is a variant of a regular LLC (and the enabling statute typically is set forth in the jurisdiction’s normal LLC statute). To be an L3C, an LLC: (i) must further the accomplishment of a charitable purpose; (ii) would not have been formed but for its relationship to the charitable purpose; (iii) must have “no significant purpose” of producing income or appreciation in property; (iv) must not have a political or legislative purpose; and (v) must use the name “low-profit limited liability company” or the abbreviation “L3C” in its name. Eight states have L3C statutes:
At one point, North Carolina had an L3C statute, but repealed its law effective January 1, 2014 (see N.C. Gen. Stat. §§ 57D-2-01, 57D-2-21, 55D-20(a) (2013) as repealed by S.B. 439).
L3Cs are designed to dovetail with and satisfy (at least in their organizational documents) the program-related investment (PRI) requirements set forth in the I.R.C. (at section 4944) and corresponding regulations (at section 53.4944-3). PRIs are investments made with a primary purpose of accomplishing a charitable purpose. PRIs occasionally are used by private foundations to make risky but worthwhile investments (e.g., low-interest loans) in private enterprises to accomplish charitable purposes rather than simply making a grant to the same enterprise. In other respects, the L3C statutes leave the details of the economics, management duties, transaction approvals, voting, indemnification, and other matters of the L3C to the articles of organization and the operating agreement.
Critics justifiably point out that, because the L3C is not preapproved by the IRS to accept PRIs, unless and until such preapproval is granted, the L3C has no meaningful advantage over a traditional LLC. In fact, the ABA Business Law Section opposes L3C legislation. On the other hand, although the L3C originally was envisioned as a vehicle for PRIs, there is no requirement that an L3C be funded by a PRI or that an L3C have even one private foundation or other tax-exempt member. Hence, if our hypothetical retreat charged fees to attendees and served the purpose of educating men on their role in families and living a spiritual life, it could be organized as an L3C (including an SML3C) instead of an LLC (or SMLLC). Of course, an LLC with appropriate language in its governing documents regarding its educational role also would be sufficient to consider the LLC a social enterprise.
Another social enterprise form of the LLC—the benefit LLC—exists in two states: Maryland (at section 4A-1107(b)) and Oregon (at sections 60.750 to -.770). Oregon’s approach is slightly different than Maryland. Instead of having a separate statute applicable to LLCs like Maryland, Oregon’s statute sets forth the requirements for a “benefit company,” which includes both benefit LLCs and benefit corporations. The Maryland and Oregon benefit LLC statutes essentially mirror the respective statutes for a Maryland or Oregon benefit corporation. In particular, a Maryland or Oregon benefit LLC must have the purpose of creating a “general public benefit” through “activities that promote a combination of specific public benefits.” A “general public benefit” is defined for this purpose as “a material positive impact on society and the environment, taken as a whole.” A benefit LLC also may (but is not required to) adopt a specific public benefit purpose. Specific public benefits (if any) must be set forth in the LLC’s articles of organization and include, but are not limited to, the following: (i) providing low-income or underserved individuals or communities with beneficial products or services; (ii) promoting economic opportunity for individuals or communities beyond the creation of jobs in the normal course of business; (iii) preserving or improving the environment; (iv) improving human health; (v) promoting the arts or sciences or the advancement of knowledge; (vi) increasing the flow of capital to entities with a public benefit purpose; and (vii) accomplishing any other identifiable benefit for society or the environment.
Other requirements also are imposed upon Maryland and Oregon benefit LLCs—similar to the requirements imposed upon Maryland and Oregon benefit corporations. Importantly, the Maryland and Oregon benefit LLC statutes offer fiduciary liability protection to the managers of a benefit LLC when making decisions concerning the pursuit of profit versus the benefit purposes of the LLC. This added fiduciary liability protection might make the Maryland or Oregon benefit LLC especially attractive in some circumstances. On the other hand, most LLC statutes allow the operating agreement of an LLC to limit the fiduciary liability of the managers under any circumstances—regardless of any quasi-charitable purpose for the LLC. Uniquely, Maryland requires a benefit LLC to use the term “benefit” in its name.
Beyond the foregoing, the Maryland and Oregon benefit LLC statutes, like the L3C acts, leave the details of the economics, management duties, transaction approvals, voting, indemnification, and other matters of the LLC to the articles of organization and the operating agreement. In essence then, aside from the specific statutory provisions summarized above, Maryland and Oregon benefit LLCs should be treated just like regular LLCs.
For the same reasons that our hypothetical men’s group could be organized as an L3C, it similarly could be organized as a benefit LLC with a general public benefit and a specific public benefit of promoting the “advancement of knowledge” (i.e., the role of men in the family and living a more spiritual life).
Conclusion
As demonstrated above, an LLC in one of its many variations might be the best solution for our hypothetical men’s group. An LLC could provide liability protection, unlike an unincorporated nonprofit association, without imposing the added compliance burdens that accompany a standalone, tax-exempt nonprofit corporation. The table below summarizes the various choice-of-entity considerations discussed in this article.
Factors to Consider
Unincorporated Association
Nonprofit Corporation
LLC (Including Nonprofit and Hybrid LLCs)
Limited Liability for Owners
Generally, no, but some states grant protection
Yes
Yes
Ease of Formation
Yes
No
Moderate
501(c)(3) Exempt Status Possible?
Yes
Yes
Law is unsettled. IRS position is “No” unless all members are (c)(3)s.
Formalized Management and Governance
Generally, no, absent a written association agreement.
Yes
Yes
Hold Title, Sue and Be Sued, Enforce Contracts, and Otherwise Have Legal Rights as an Entity
Generally, no, but some states grant legal rights.
Yes
Yes
Contributions Deductible?
Yes, if (c)(3) exempt status has been obtained.
Yes, if (c)(3) exempt status has been obtained.
Yes, if (c)(3) exempt status has been obtained. If not, then no charitable deduction and contributions likely treated as personal cost sharing arrangement under Reg. § 301.7701-1(a)(2).
Can Be Disregarded for Tax Purposes
No, but practically speaking, many unincorporated associations effectively are disregarded by members from legal and tax perspective.
An oft-touted feature of the limited liability company as a preferred choice of entity is the extraordinary flexibility it accords to equity owners for structuring their legal and economic relationships. Seasoned practitioners in the field of entity planning and governance have found that the LLC permits the largely unhindered private ordering of relationships among business owners, investors, and other relevant stakeholders, especially in jurisdictions such as Delaware and others whose LLC statutes endorse a broad, “contractarian” approach. Corporations, by contrast, often operate under more rigid and well-established legal principles that often are difficult, and sometimes impossible, to circumvent.
Prior to the adoption of the so-called check-the-box regulations in 1996, the choice of a particular form of business entity (i.e., corporation or partnership) usually dictated the tax regime to which it was subject. The check-the-box regulations largely decoupled the choice of tax regime from the choice of entity. They allow limited liability companies and other entities not organized as a business corporation under state law to “elect” to be classified for federal tax purposes as a corporation or, if the entity satisfies the applicable criteria, to further elect to be taxed as an S corporation under the Internal Revenue Code (the Code).
For a variety of reasons, several of which are discussed below, it has become increasingly common for LLCs to choose to be taxed as subchapter S corporations. This article will explore some of the possible rationales for choosing the S corporation tax regime. Following that discussion is a brief recap of the rules applicable to subchapter S corporations and the mechanics of the subchapter S election. After contrasting some of the relative advantages and disadvantages of being taxed as an S corporation, the article concludes with practice points and drafting guidance for the organization, governance, and operation of a limited liability company that has elected to be taxed as an S corporation.
Why Choose Subchapter S?
When considering the relative costs and benefits of electing subchapter S taxation, it is important to first ask the question: “relative to what?” Generally, it is relative to the federal income tax regimes applicable to a regular C corporation, a disregarded entity, or a partnership. Although LLCs can (and for a variety of reasons often do) elect to be taxed as a C corporation, the C corporation lacks the benefit of “pass-through” taxation afforded to S corporations. The C corporation remains a viable, and indeed preferential, option in several settings. Although a full exposition of those circumstances is beyond the scope of this article, in many cases pass-through taxation may not be desirable to certain investors (such as 501(c)(3) qualified entities). In addition, the potential for gain exclusion afforded to qualified small business stock under section 1202 of the Code is only available to C corporation shareholders.The choice between subchapter S and disregarded entity status is relevant only for entities with a single equity owner. In the case of the solo business owner, the perceived potential for payroll tax savings, as discussed in greater detail below, is an oft-cited reason for making an S election. That benefit must be contrasted with the necessity of filing a separate tax return for the entity, and more importantly, the limitations of subchapter S. Finally, there is the choice between federal income taxation of S corporations and partnerships. The tax accounting required for partnerships generally is more complex and compliance more expensive—a situation often compounded by unique and complex economic arrangements among the parties. The trade off, of course, is the planning limitations associated with the S corporation regime.
There are perceived payroll tax advantages under subchapter S. It is important to note that there is no real distinction between subchapter S and subchapter C in this regard—subchapter C offers the same payroll tax advantage as subchapter S, but only subchapter S offers pass-through taxation. Generally, corporations are allowed a deduction for “reasonable compensation” paid to employees, even if the party receiving the compensation is also a shareholder of the corporation. In contrast, allocated profits from a partnership potentially are treated as earnings from a trade or business and therefore taxed as self-employment income. As a general rule, in an S corporation, a shareholder’s pro-rata share of net income is not considered earnings from self-employment either when earned or when distributed as dividends unless, and to the extent that, the dividends are paid in lieu of reasonable compensation for services rendered to the corporation by the shareholder. In that case, the income may be recharacterized as wages subject to employment taxes. Using a simple example, if an S corporation shareholder is paid an annual salary of $120,000, and his or her distributable share of net income is $380,000 (assuming that the $120,000 payment represents “reasonable compensation” to the shareholder for services rendered to the corporation), the $380,000 distributive share of net income is not subject to employment taxes. Under the partnership tax rules, that same $380,000 distributive share of net income (irrespective of whether it is characterized as a guaranteed payment in exchange for services rendered by the partner or as the partner’s allocable share of net income) could result in imposition of an additional employment tax liability of nearly $15,000. Given that there is no cap on the Medicare tax or the additional employment tax imposed under the Affordable Care Act, the higher the distributive share of net income, the greater the potential employment tax savings (as a subchapter S corporation) or employment tax liability (as an LLC taxed as a partnership under subchapter K).
There is a tension between the self-employment tax (which generally is imposed on a partner’s active trade or business income) and the net investment income tax (which generally is imposed on passive income). With proper planning, including the use of “guaranteed payments” made to a member as reasonable compensation for services, it is possible to limit the amount of partnership income subject to self-employment taxes, but also maintain a sufficient level of activity in the business to avoid imposition of the net investment income tax. Service partnerships (i.e., those in which all of the members provide professional or other consulting services) and member-managed LLCs present special planning challenges and more limited planning opportunities around these issues. If care is taken in the proper characterization of income and preparation of the underlying documents, however, in many cases the perceived payroll tax benefit thought to be available to S corporations can be achieved in the partnership context.
Several other planning considerations may drive a decision in favor of subchapter S taxation. Although a detailed review of these situations is beyond the scope of this article, they include utilization of an employee stock ownership plan, partial shifting of the tax burden on built-in gains, and effecting gain deferral through the use of a tax-free reorganization with another S corporation or a C corporation.
The Choice of Entity
As noted above, decoupling the decision on the form of entity from the applicable mode of taxation allows the planner to independently consider the relative nontax advantages of one form of entity over another. Most state law corporate enabling statutes impose certain rules relating to the formation and operation of those entities. In some cases, the rules are mandatory (i.e., they may not be modified in the corporation’s organizational documents or in a separate shareholders’ agreement). In others, the rules are normative (i.e., they will apply in the absence of a contrary provision in the certificate or articles of incorporation or the bylaws). In all cases, however, one must first look to the statute as the primary “roadmap” for permissible “alternative routes.” In contrast, enabling legislation for LLCs (especially more modern iterations) generally ensconce the characteristic of “freedom of contract” and impose few mandatory requirements. Although most of these LLC statutes also contain many normative provisions, these usually can be modified (to a greater or lesser extent) by the agreement of the members. The adage that with great power comes great responsibility applies with particular force in this context, as this freedom of contract imposes an enhanced obligation of care and precision on the draftsperson.
Among the areas of entity governance and operation for which LLCs offer great flexibility are enforceability of restrictions on transfer, including the ability to relegate a nonpermitted transferee to the status of an “economic interest holder.” Additional benefits include the elimination of formalities associated with the roles traditionally ascribed to shareholders, directors, and officers; the ease with which alternate classes and series of equity may be established; the creation of individualized governance, management, and voting structures; the modification or elimination of rights and duties, including fiduciary duties; and the ability to restrict access to information and, in some states, access to judicial remedies such as derivative claims, oppression claims, and judicial dissolution. In view of the expansive capacity for creativity and innovation, it is little wonder that LLCs are preferred by many practitioners.
Although many of the benefits of the LLC form are preserved following an S election, there are several important areas in which it is curtailed, particularly those involving economic rights. However, with careful consideration of the subchapter S restrictions and equally careful drafting, much flexibility, especially in the area of control and governance, can be retained. There is practically nothing that can be done by or with a corporation that cannot also be done equally well or better with an LLC. As one practitioner stated: “I have formed my last corporation.” Although the corporate form is not yet fully obsolete, given the choice (at least in the realm of privately held companies), the LLC has undeniable advantages.
Subchapter S Basics and How to Get There
Many mistakenly believe that a subchapter S corporation is a corporation that is taxed like a partnership. Subchapter S modifies the rules applicable to the taxation of corporations that elect subchapter S status. It is a series of modifications to the rules that otherwise apply to all corporations. Although the tax results under subchapter S and subchapter K may be similar in some circumstances, in many others they are significantly different.
The eligibility requirements for subchapter S status apply at both the entity and shareholder levels. At the entity level, the entity must be one that: (i) is formed within the United States; and (ii) does not have more than a single class of stock. At the shareholder level, the entity may have no more than 100 shareholders (a husband and wife are treated as a single shareholder), all of whom (with limited exception) must: (i) be individuals; and (ii) not be a nonresident alien. Certain estates and trusts, employee stock ownership plans, and other tax-exempt entities may also be eligible shareholders of an S corporation.
In order for an LLC to elect to be taxed as an S corporation, it must make certain filings with the Internal Revenue Service. The regulations allow an LLC that otherwise would be classified as a partnership or a disregarded entity to elect to be taxed as a corporation. There are two, primary means to accomplish the election. The first is for the LLC to initially elect to be treated as an “association taxed as a corporation” by filing Form 8832, Entity Classification Election. Once the LLC elects association status, its owners may further elect S corporation status by filing Form 2553, Election by a Small Business Corporation. It often is not necessary to first file Form 8832 to elect association status and Form 2553 to elect S corporation status. The regulations allow a single election to be made solely via the filing of Form 2553. A timely filed Form 2553 is a deemed filing of Form 8832. The “deemed association” election accomplished in this manner is effective only if the electing entity meets all of the qualifications of an S corporation as of the time of filing, and is not effective if the entity does not meet those qualifications. An LLC that first files Form 8832, but does not qualify to be taxed as a subchapter S corporation upon its subsequent filing of Form 2553, will revert to the status of a regular C corporation. By contract, an LLC that files only Form 2553 (which is effective only if all qualifications for subchapter S are satisfied as of the date of the election) will result in the entity reverting to its default tax classification (usually a partnership or disregarded entity). However, if the entity initially qualifies as a subchapter S corporation by timely filing of Form 2553 and subsequently becomes disqualified, it will revert to the status of a C corporation as well.
Subchapter S or Subchapter K
From a planning perspective, the clearest disadvantages of subchapter S taxation are the so-called single-class-of-stock rule and shareholder eligibility requirements. The single-class-of-stock rule applies solely to economic rights and requires that all equity owners receive allocations of income and loss as well as distributions of cash or property in strict proportion to their ownership percentages. Although voting and management need not be proportional to share ownership, economic rights must be. Similarly, the inability to issue or transfer shares to nonnatural entities can severely restrict the pool of available equity capital. Finally, the consequence of a “blown” subchapter S election, which will trigger a reversion to regular C corporation status and its attendant second layer of taxation, could be catastrophic. Imposing an absolute restriction on transferability of LLC interests may provide an extra layer of protection against this possible consequence. However, it may not be possible under certain state’s LLC statutes to restrict the transferability of economic interests, which presumably would have the same negative consequences.
A nonexclusive list of potential additional advantages of subchapter K over subchapter S include the ability to:
include entity-level debt in partner basis;
step up the basis of the partnership’s assets upon the death of, or other transfer of interests by, an equity owner;
make disproportionate or special allocations, including in the year in which an interest is sold or redeemed;
allocate built-in gain or loss to the contributing owner; and
maintain consistency between inside and outside basis.
Additionally, if an entity plans to expand through acquisition in exchange for equity, the constraints of section 351 of the Code (subchapter S) may not permit the transaction to be a nonrecognition event for the contributing owner, whereas section 721(subchapter K) is much more flexible and often can accommodate a more favorable result.
There are many other differences between the two tax regimes, a thorough discussion of which is beyond the scope of this article. Suffice it to say that it is never safe to assume that the tax consequences of any transaction under subchapter S are identical to those under subchapter K.
Practice Points and Drafting
All too often, operating agreements for an LLC that has elected to be taxed as an S corporation contain the full complement of provisions that address capital account maintenance, which are designed to satisfy the “substantial economic effect” requirements of section 704 of the Code. Among the provisions typically found in these agreements are requirements that liquidating distributions be made “in proportion to the members’ positive capital account balances.” Given that it is quite possible (and perhaps likely) that those balances do not and will not be strictly proportionate to the party’s ownership percentages, the effect of that provision is an immediately “blown” subchapter S election. The only potential silver lining in this situation is that S elections are more commonly made only by filing Form 2553 (rather than filing Form 8832 ahead of Form 2553), so the S election was defective from the start. As noted above, this results in “no change” to the entity’s default classification. This is but one example of the importance of proper drafting of operating agreements to account for the special qualifications of an S corporation. It is not enough to simply cut and paste into the document the subchapter S maintenance provisions from your favorite form of shareholder agreement. The drafter must also take care to excise the subchapter K provisions from the agreement. In certain states, the LLC statute itself may provide for a “default” liquidating distribution scheme that, if applicable, would be a prima facie violation of the single-class-of-stock rule. In that case, the operating agreement must contain language that specifically overrides any offending statutory scheme.
Examples of the kinds of provisions that must be considered in operating agreements of an LLC that has elected to be taxed as an S corporation include the following:
Heading. Indicate in the agreement’s heading (cover page, first page, signature page, and unit/share tabulation page) that the LLC is an S corporation.
Recitals. Recite the filing of Form 2553 to be classified as a corporation electing to be taxed as an S corporation, and any wholly owned corporate subsidiaries thereof electing to be taxed as qualified subchapter S subsidiaries.
Company-Purpose Provision. Consider: “Company’s Purpose. The purpose of the Company is to engage in any lawful business or other activities for which a limited liability company may be organized under the Act other than engaging in any activities that may cause it to become an “ineligible corporation” within the meaning of Code § 1361(b)(2) or that may otherwise cause the Company’s status as an S corporation to terminate (the “Company’s Business”).” When including provisions that require vigilance such as this, consider the exposure to the manager/management and whether there should be personal liability for noncompliance or absolution/exculpation.
S-Election Provision. Consider: “Election and Preservation of Company’s Status as an S Corporation. The Company and the Interest Owners shall take all necessary and appropriate actions to elect, preserve, and if need be restore the Company’s status as an S corporation (including taking such action as may be necessary under Code § 1361(f) to remedy an inadvertent termination of the Company’s election to be an S corporation). Each Interest Owner shall execute, acknowledge, and cause to be filed with the appropriate taxing authorities (including the Internal Revenue Service) any certificates, statements, forms, schedules, reports, or other documents as may be required, or that the Manager determines to be necessary or appropriate for the Company to be, and otherwise be treated as, an S corporation (including signing Internal Revenue Service Form 2553 acknowledging Interest Owner’s consent and agreement to the Company’s election to be an S corporation, and taking such actions as may be necessary or appropriate to maintain or reinstate or otherwise restore that election or status as an S corporation). In furtherance of the foregoing, the Company shall not issue any Shares or other ownership interests to any corporation, partnership, limited liability company, trust, or any other Person who is not eligible to be a shareholder of an S corporation as contemplated by Code §§ 1361(b)(1)(B) and (C) or issue any Shares or other ownership interests that may be considered to be a second class of stock as prohibited by Code § 1361(b)(1)(D).”
Capital Contributions and Ownership Interests. Consider: “Special Vote to Issue Additional Shares. Without the consent of at least [____%] of the Voting Shareholders, the Company may issue only Shares, and each Share must be deemed to be of the same, single class of Shares (within the meaning of, and as necessary to satisfy the “one class of stock” requirement of, Code § 1361(b)(1)(D)), and those Shares may only be issued to individuals (i.e., natural persons) other than nonresident aliens and to certain estates and trusts that are eligible to be shareholders of S corporations; that is, a Person’s ownership of Shares in the Company must not result in the Company ceasing to be an SBC, or that Person’s ownership of Shares or other membership or economic interests in the Company must not otherwise cause the termination of the Company’s election to be an S corporation.”
Change S Status. Consider: “Special Vote to Change the Entity Character of the Company. Without the consent of at least [____%] of the Voting Shareholders, the Company shall not convert or reorganize the Company into another Entity form (including a corporation) or cause the Company to be taxed as a “C” corporation (as defined by Code § 1361(a)(2)) or a partnership (as defined by Code §§ 761(a) or 7701(a)(2)) for federal income tax purposes or otherwise cause the Company to be deemed to have sold all of its assets or dissolved or liquidated for federal income tax purposes except in accordance with Section 10.1 hereof.”
Allocation of Profits and Losses. Consider: “Allocations. The Company’s income or loss, as determined in accordance with applicable federal income tax accounting principles, including all items of income, gain or loss (whether taxable or tax-exempt), deduction and expense, and all credits, are to be allocated among the Interest Owners in the manner provided and otherwise contemplated by Code § 1366 and, more generally, Subchapter S of the Code, the Code itself, and other applicable federal and state income tax Law.”
Nonliquidating Distributions. Consider: “Distributions. Each Share (whether a Voting Share, Nonvoting Share, Economic Interest Share, or any other Share that may be outstanding) shall confer identical economic rights (i.e., identical rights to distribution and liquidation proceeds as contemplated in Treas. Reg. § 1.1361-1(1) for the Company to be deemed to have only one class of stock outstanding as, and to the extent required by, Code § 1361(b)(1)(D)) as any of the Company’s other outstanding Shares.” This provision is in addition to the general requirement that distributions (including tax distributions) are to be made in accordance with percentage interests (i.e., in proportion to outstanding shares/units).
Restrictions on Transfers and Encumbrances. Consider: “General Prohibition without Authorization by the Manager. An Interest Owner may not Transfer or Encumber all or any portion of the Interest Owner’s Interest: (i) in a way that may cause the Company to be deemed to have more than one class of stock outstanding as contemplated by Code § 1361(b)(1)(D); (ii) to a corporation, partnership, limited liability company, trust, or other Person described in Code §§ 1361(b)(1)(B) or (C) whose ownership of such interest will cause the Company to fail to be an SBC; (iii) to any Person or Persons if by doing so may cause the Company to have more than one-hundred (100) “shareholders” as prohibited by Code § 1361(b)(1)(A) for the Company to be an SBC; or (iv) in any other way or to any other Person or Persons that would cause the termination of the Company’s election as an S corporation; and any purported Transfer or other Encumbrance or other action by an Interest Owner in violation of the foregoing or that would otherwise cause the termination of the Company’s election as an S corporation shall be void ab initio and will have force and effect whatsoever and shall otherwise be treated as if that transaction or other action had never taken place or occurred.” The above restriction is in addition to the more general restriction requiring board, member, or other approval to any transfer or encumbrance of ownership interests, which approval may be denied, or otherwise withheld, in the decision makers “sole discretion,” which (as that term may be defined) need not be objectively reasonable or disinterested.
Certifications of Shareholder Eligibility. Consider: “Written Attestations, Eligibility of Transferee to Be an S Corporation Shareholder. In the case of the Transfer of Shares, the proposed transferee’s delivery of a written certification or other statement to the Company that the prospective transferee is a “United States person” within the meaning of Code § 7701(a)(30) and is not a person described in Code §§ 1361(b)(1)(B) and (C) whose ownership of Shares other than ownership interest in the Company will cause the Company to cease to be an SBC.”Ineligible members/shareholders include corporations, limited liability companies, partnerships, nonresident aliens, and most trusts. If the proposed transferee is a trust, consider giving the board, members, or other decision makers the right to require an opinion of counsel that the trust is eligible to be a shareholder of an S corporation.
Liquidating Distributions. Consider: “Liquidating Distributions. The balance [after payment of liabilities], if any, to be distributed to the Interest Owners in accordance with their Percentage Interests at the time those distributions are to be made. Each Share (whether a Voting Share, Nonvoting Share, Economic Interest Share, or any other Share that may be outstanding) shall confer identical economic rights (i.e., identical rights to distribution and liquidation proceeds as contemplated in Treas. Reg. § 1.1361-1(l) for the Company to be deemed to have only one class of stock of outstanding as, and to the extent required by, Code § 1361(b)(1)(D)) as any of the Company’s other outstanding Shares.”
Vote to Terminate S Election. Consider: “Revocation of S Election. Consent of at least [____%] of the Voting Shareholders is required to cause the Company to revoke its S election under Code § 1362(d)(1), or take any other action with the expressed written intent to cause the Company to cease to be an S corporation. In connection with, or following, the amendment to this Agreement to cause the revocation or other termination of the Company’s S election, the Company and all of the Interest Owners shall take such action as may be necessary or appropriate to effect such revocation or other termination of the Company’s S election, including executing and filing with the Internal Revenue Service or other Governmental Authority all consents and other certificates and documents that may be necessary or appropriate to cause that revocation or other termination to occur as directed by the [Voting Majority].”
Certain Definitions
“‘Economic Interest’ of an Interest Owner means only the Interest Owner’s right under this Agreement and applicable Law to: (i) share in the profits and losses of the Company; and (ii) receive distributions from the Company and therefore does not include any right to participate in, vote on, or authorize or approve any decision concerning the management or affairs of the Company or any other matter subject to the vote or approval of members of a limited liability company under the Act or of the Members under this Agreement.”
“‘Economic Interest Owner’ means a Person who holds an Economic Interest but has not been admitted as, and otherwise is not, a Member. The limited rights of an Economic Interest Owner are described in Section [____].”
“‘Economic Interest Share’ means the Shares that comprise an Economic Interest. Each Economic Interest Share confers identical rights as any other of the Company’s outstanding Shares to “distribution and liquidation proceeds” as contemplated by Treas. Reg. § 1.1361-1(l) and therefore are not to constitute a separate class of stock or otherwise cause the Company to have more than “one class of stock” within the meaning of Code § 1361(b)(1)(D).”
“‘Interest Owner’ means an Economic Interest Owner or a Member.”
“‘QSSSs’ means each of those Entities, if any, that would otherwise be classified as a corporation (as defined by Code § 7701(a)(3)) in which the Company is the sole shareholder or member and that is a “qualified subchapter S subsidiary” under Code § 1361(d).”
“‘S Corporation’ means an SBC that has an election under Code §§ 1362(a)–(c) in effect to be an S corporation (within the meaning of Code § 1361(a)(1)).”
“‘SBC’ means an Entity that meets the requirements for being, or otherwise is treated as, or is deemed to be, a “small business corporation” within the meaning of Code § 1361(b)(f).”
“‘Shares’ means the shares or units of ownership into which an Interest Owner’s Interest is divided and includes Voting Shares and Nonvoting Shares as well as Economic Shares. Except with respect to voting and approval rights or as otherwise provided in this Agreement, the relative rights, privileges, benefits, preferences, and limitations attributable to Voting Shares and Nonvoting Shares are identical, and the Economic Interest Shares, Voting Shares, and Nonvoting Shares confer identical rights “to distribution and liquidation proceeds” as required by Treas. Reg. § 1.1361-1(1) for the Company to be recognized as having only one class of stock under Code § 1361(b)(1)(D). Unless otherwise provided herein, references made to an Interest Owner’s Shares include all of that portion of the Interest Owner’s Interest that relates, or is attributable to, those Shares. Notwithstanding anything in this Agreement or any other agreement to which the Company may be a party or deemed to be a party or otherwise subject to, the outstanding Shares are to be treated as a single class of common stock for purposes of Code § 1361(b)(1)(D), for which Code § 1361(c)(4) recognizes and otherwise allows “differences in voting rights among the shares of common stock” to not cause the corporation or association taxable as a corporation to be deemed to have more than one class of stock.”
Conclusion
As hopefully is evident from the preceding discussion, the decision of an LLC to elect subchapter S status must be based on thoughtful consideration of all potential benefits and pitfalls, not solely as a gambit on potential employment tax savings. The cost of an ill- considered or improperly executed subchapter S election often will far outweigh the potential short-term benefits.
If subchapter S is the best alternative, care in drafting and, equally important, care in execution by the entity will help ensure realization of the tax benefits that were sought at the planning stage.
This article is based upon a presentation by the author, together with Warren Kean, Esq. of Schumaker, Loop & Kendrick of Charlotte, North Carolina, and Professor Martin J. McMahon, James J. Freeland Eminent Scholar and director of The Graduate Tax Program at the University of Florida Law School, that was made at the ABA Business Law Section LLC Institute in November 2015. The sample contract provisions included under “Practice Points and Drafting” were part of Warren Kean’s program materials and are used with his permission. The author would like to thank both Warren and Marty for their contributions to the program, their dedication to legal education and scholarship, and most importantly, for their patience with my (nontax practitioner’s) vain attempt to address these concepts from the perspective of the uninitiated.
Each fall, the committee on LLCs, Partnerships and Unincorporated Entities sponsors the LLC Institute. Historically held in Arlington, Virginia, over the course of two days, the LLC Institute uniquely brings together practitioners and academics to discuss and exchange ideas about both the substantive law of LLCs and partnerships and as well the interrelationship of those areas of law with tax, bankruptcy, securities and other fields. Under the leadership of current committee chair Garth Jacobson, the 2017 LLC Institute will be held on November 2–3. Block out those dates on your calendar now to attend; registration information will be distributed via the ABA.
This mini-theme issue of Business Law Today features four articles, three of which are based upon presentations from the 2016 LLC Institute and one from the 2015 LLC Institute.
The first of these articles, “Nonprofit LLCs,” addresses the often ignored the issue of whether and how nonprofit LLCs may be utilized. The article as well considers the Unincorporated Nonprofit Association, a new organizational form available in a variety of states. These and other issues are compared and contrasted against a hypothetical venture.
The next article, “Deadlock-Breaking Mechanisms in LLCs—Flipping a Coin is Not Good Enough, But is Better Than Dissolution,” addresses why it is important that LLC operating agreements incorporate mechanisms to address deadlock. As the authors point out, in the event of a failure to do so, the only remedy that may be available is judicial dissolution of the venture. By addressing the issue in the operating agreement, it likely will be possible to preserve the value of the venture for those who continue with it while increasing the value to the parties who are bought out or otherwise separated.
The last of the articles from the 2016 LLC Institute, “It’s a Bird, It’s a Plane, No, It’s a Board-Managed LLC!”, addresses issues that arise when corporate organizational structures such as a board of directors and officers with titles such as “president” are incorporated (pun intended) into LLC operating agreements. Based upon a pair of decisions, the article explains how the utilization of corporate concepts in LLCs, referred to as “Corporification,” can actually add ambiguity to the agreement. Hence, to the degree that such corporate law concepts are incorporated into the document, they must be done with great precision and is well appropriate limitation.
The fourth article, based upon a presentation from the 2015 LLC Institute, addresses those LLCs that elect, rather than as the typical rule of being taxed as a partnership, to be taxed as an S-Corporation. In that most LLC Acts presuppose that any LLC created thereunder will be taxed either as a partnership or as a disregarded entity, careful drafting of S-Corp LLC operating agreements is absolutely necessary. This article provides guidance as to those requirements.
We hope to see you at the 2017 LLC Institute.
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