I just finished reading the newish Obeid v. Hogan decision, No. CV 11900-VCL, 2016 WL 3356851, at *5-6 (Del. Ch. June 10, 2016), which held that:
It is frequently observed that LLCs “are creatures of contract,” which they primarily are. The Delaware Limited Liability Company Act (the “LLC Act”) provides that “[i]t is the policy of this chapter to give maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18–110(b). Because of this freedom, “the parties have broad discretion to use an LLC agreement to define the character of the company and the rights and obligations of its members.” Kuroda, 971 A.2d at 880. One “attraction of the LLC form of entity is the statutory freedom granted to members to shape, by contract, their own approach to common business ‘relationship’ problems.” Haley v. Talcott, 864 A.2d 86, 88 (Del. Ch.2004) (Strine, V.C.). “Virtually any management structure may be implemented through the company's governing instrument.” Robert L. Symonds, Jr. & Matthew J. O'Toole, Delaware Limited Liability Companies § 9.01[B], at 9–9 (2015).
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), then the parties should expect a court to draw on analogies to partnership law. If the drafters have opted for a single managing member with other generally passive, non-managing members, a structure closely resembling and often used as an alternative to a limited partnership, then the parties should expect a court to draw on 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. See JAKKS Pac., Inc. v. THQ/JAKKS Pac., LLC, 2009 WL 1228706, at *2 (Del. Ch. May 6, 2009) (explaining that although a party to the LLC agreement at issue is “technically a member of the LLC,” its economic interest “is less that of an equity owner and more akin to a licensor with rights to royalties based on sales”).
This suggests an important wrinkle on freedom of contract. If you opt into a corporate-like LLC governance structure and you don’t want corporate law rules to apply by analogy presumably you will have to say so very explicitly in your governing documents. It also suggests that you’re going to have to be very careful about adopting some corporate-like features. How many are enough to trigger this rule? This decision is likely to result in a lot more transactional lawyering expenses for LLCs.
Our friend top Delaware lawyer Francis Pileggi reports that:
Obeid v. Hogan, C.A. No. 11900-VCL (Del. Ch. June 10, 2016), will be cited often as a reference guide for fundamental principles of Delaware corporate law including the following: (1) even in derivative litigation when a stockholder has survived a motion to dismiss under Rule 23.1, for example, in which demand futility is an issue, pursuant to DGCL Section 141, the board still retains authority over the “litigation assets” of the corporation, and if truly independent board members exist, or can be appointed, to create a special litigation committee (SLC), it is still possible for the SLC, under certain circumstances, to seek to have the litigation dismissed; (2) if an LLC Operating Agreement adopts a form of management and governance that mirrors the corporate form, one should expect the court to use the cases and reasoning that apply in the corporate context; (3) even though most readers will be familiar with the cliché that LLCs are creatures of contract, the Court of Chancery underscores the truism that it may still apply equitable principles to LLC disputes; (4) a bedrock principle that always applies to corporate actions is that they will be “twice-tested,” based not only on compliance with the law, such as a statute, but also based on equitable principles.
Counselor Pileggi was kind enough to observe that:
In closing, we are happy to note that the scholarship of a very good friend of this blog, and nationally recognized corporate law scholar, Professor Stephen Bainbridge, was cited in this court opinion at footnote 16. It is not uncommon for Professor Bainbridge’s scholarship on corporate law issues to be cited by the Delaware courts, but it is still worth noting.
My blushes. Go read the whole thing for more detailed analysis.
Richards, Layton & Finger has a detailed client memo on the case, which is also worth reading. I concur with their conclusion:
The Court’s opinion in Obeid confirms that Delaware courts may review the provisions of limited liability company agreements to determine the governance structure the parties intended and, absent other factors, may view that as evidence of an intent to have aspects of the entity law of similarly-managed entities apply to the limited liability company. In drafting limited liability company agreements, transaction planners and their counsel should give careful consideration to the provisions authorizing or restricting the delegation of authority to various parties and whether the governance structure may impact the ability to delegate certain authority to third parties.
Morris Nichols' analysis reaches the same conclusion as I did above:
The opinion in Obeid v. Hogan, CA. No. 11900-VCL (Del. Ch. Jun. 10, 2016), illustrates the importance of careful drafting in alternative entity governance documents. Particularly, drafters should consider (1) whether they intend to incorporate corporate governance principles into their limited liability company or limited partnership agreements and (2) the intended scope of delegation to non-managers, non-members and non-general partners.
So be careful out there.