Delaware Court of Chancery: Deadlock Can be Genuine Even When Unilaterally Orchestrated

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A Delaware Court of Chancery case decided earlier this year provides some useful guidance on the interpretation of LLC agreements and what constitutes a “deadlock” under Delaware law. The case, Mehra v. Teller, involved a deadlock between co-managers of a Delaware limited liability company, EOS Investor Holding Company LLC (“Holdco”) and the resultant dissolution of that company.

Relevant Facts

Holdco’s operating agreement made Jonathan Teller and Sanjiv Mehra managers on Holdco’s two-person board. Unanimity was required to effect board action. Teller was a founder of Holdco and Mehra was responsible for day-to-day operations.

Holdco’s operating agreement also provided that if Teller and Mehra deadlocked, Holdco would be automatically dissolved. The operating agreement did not define deadlock.

Teller and Mehra held equal distribution rights in Holdco. In the event of a deadlock-triggered dissolution, Holdco would distribute its shares in Holdco’s subsidiary to members in proportion to their equity and the members would then replicate Mehra’s equal-distribution rights as to Holdco in the subsidiary.

After an initial period of success, Holdco experienced financial difficulties. Relations between Teller and Mehra deteriorated. Teller came to believe that Mehra was responsible for Holdco’s problems and decided to end the relationship. After consulting with his lawyers, Teller noticed a meeting of Holdco’s board. At the meeting, Teller proposed a resolution to remove Mehra as the CEO of Holdco’s subsidiary. Mehra refused to vote on the resolution and proposed his own resolution removing Teller from his positions. Teller declared a deadlock and dissolved Holdco. Teller distributed to Mehra his equity share in Holdco and Holdco’s subsidiary. However, Teller failed to replicate Mehra’s equal-distribution rights in Holdco’s subsidiary.

Mehra filed suit to invalidate the dissolution. He argued that the deadlock was contrived to create an inauthentic dispute. Mehra also claimed that Teller had the duty to protect Mehra’s interests and failed in that duty.

The Court’s Analysis

After holding trial on the narrow issue of the dissolution’s validity, the Court found that although the mechanism triggering a deadlock was contrived by Teller, he proved at trial that an irreconcilable disagreement existed as to Mehra’s continued management of Holdco. The Court also found that Teller breached his contractual obligation to replicate Mehra’s rights to equal distributions in Holdco’s subsidiary. Finally, the Court found that this breach did not invalidate the dissolution and that Mehra has future recourse against Teller for the breach.

The Court’s starting point was the statutory right that members of a Delaware LLC hold “to shape, by contract, their approach to common business relationship problems”. It noted that Holdco’s operation agreement did not define “deadlock”. The Court therefore considered dissolution provisions contained in the Delaware Revised Limited Liability Act, the Delaware Revised Limited Partnership Act, and the Delaware General Corporation Law. It concluded that as applied to board votes, “deadlock” means a failure to meet a voting threshold, which can result from “no” votes or the lack of “yes” votes.

The Court also held that a deadlock must be “genuine” and based upon differences over a “qualitatively significant” decision. The Court found that there was a fundamental good-faith disagreement between Teller and Mehra regarding who should run Holdco – even though the procedure resulting in the deadlock was plainly contrived to reach a pre-ordained result. The existence of a good-faith, qualitatively significant, disagreement trumped Teller’s triggering of the deadlock mechanism.

Finally, the Court found that the contrivance that Teller engineered to precipitate the deadlock was done with an honest belief that his conduct was necessary for Holdco’s viability. Thus, there was thus no breach of Teller’s contractual duty of good faith towards Mehra. As noted earlier, Mehra retains a right of recourse in separate proceedings for Teller’s breach of the obligation to replicate Mehra’s rights to equal distributions in Holdco’s subsidiary.

The Takeaways

  • The case confirms that Delaware courts will closely enforce the plain language of LLC agreements, intervening only in cases of bad-faith conduct.
  • When not defined in an operating agreement, “deadlock” as a basis for dissolution under Delaware law must be based upon a factually supported, genuine and qualitatively significant disagreement between members.
  • In the face of such a factually supported disagreement, even where a dissolution is unilaterally orchestrated or precipitated, Delaware courts will focus on the facts supporting the disagreement and not the fact of an orchestrated deadlock.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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