The dispute in Mehra v. Teller arose out of the dissolution of EOS Investor Holding Company, LLC (Holdco), a consumer goods company. Before the disputed dissolution, the plaintiff, Sanjiv Mehra, and the defendant, Jonathan Teller, had shared control of Holdco for years. Although the defendant, a founder of Holdco, held a greater equity stake in the company, the plaintiff had responsibility for most of Holdco’s day-to-day management. The two agreed that these contributions warranted granting equal say over member and board decisions, and that they would each have a right to equal distributions above a specified threshold.
The parties’ agreements on shared control and equal distributions were memorialized in Holdco’s LLC Agreement (the LLC Agreement). In relevant part, the LLC Agreement made the parties managers on the two-person board and required unanimity to effect board action. If the parties were deadlocked, the LLC Agreement provided that Holdco would be automatically dissolved. Further, in the event of a deadlock-based dissolution, Holdco would distribute its shares of a first-tier subsidiary to Holdco members in proportion to their equity stakes, and the members would replicate the plaintiff’s equal-distribution rights at the first-tier subsidiary level.
After several successful years, Holdco suffered a series of setbacks that soured the parties’ relationship, created financial difficulties, and left the defendant strapped for cash. Under the LLC Agreement’s deadlock provision, one member could propose a business divorce to the board, declare deadlock if the other disagreed, and exit the shared-control arrangement between the two parties. As such, the defendant held a meeting where he proposed a resolution to remove the plaintiff as CFO of a Holdco subsidiary. Because the parties could not agree on this resolution, the defendant declared the board deadlocked and dissolved Holdco.
The plaintiff brought suit before the Delaware Court of Chancery to invalidate the dissolution in order to restore the shared-control arrangement between the parties. The plaintiff argued that the deadlock was a contrivance – an inauthentic dispute designed by the defendant to deliver himself control over distributions since he was cash-strapped. The plaintiff further argued that the defendant was obligated to protect the plaintiff’s interests but failed to do so, thereby breaching his fiduciary duties when effecting the dissolution. The court ruled in the defendant’s favor.
The court’s decision recognized that under Delaware law, LLC agreements – like other contracts – are objectively interpreted through consideration of the language chosen by the parties in their bargained-for agreement. In the case at hand, the LLC Agreement did not address what constituted a “deadlock,” requiring the court to look to statutory guidance and precedent to define the term. That authority provided that, absent being otherwise defined within the LLC Agreement, a “deadlock” means failure to meet a voting threshold, either due to negative votes or abstentions recorded as no votes. The authority further provided that a “deadlock” must be genuine to have any legal effect.
Based on this authority, the court concluded that a deadlock between the parties existed and upheld the defendant’s right to dissolve the company. The court explained that, although the defendant contrived the deadlock by pre-planning the circumstances surrounding the vote, the defendant proved that the parties had an irreconcilable disagreement concerning the plaintiff’s continuing management of Holdco. In fact, the court found there was well-documented deterioration in the parties’ business relationship, which was the primary motivation for the defendant’s decision. Thus, the defendant’s need for liquidity was not the “driving force” behind the defendant’s decision. As such, the court determined that the deadlock was genuine and sufficient to warrant dissolution. For similar reasons, the court held that there was not a breach of fiduciary duty by the defendant when effecting the dissolution.
Key takeaways
- Delaware’s Limited Liability Company Act grants members of a limited liability company the statutory freedom to shape, by contract, their own approach to common business relationship problems, and, in resolving governance disputes in the LLC context, the court first looks to the rights and obligations as set forth in the parties’ bargained-for operating agreement.
- Under Delaware law, for deadlock to be given legal effect as a basis for dissolution, a deadlock must be the product of a genuine, good faith disagreement.
- The court’s decision in Mehra demonstrates that a genuine deadlock may exist, warranting dissolution of a limited liability company, where the circumstances forcing the moment of deadlock are contrived and the outcome predetermined. However, a deadlock does not exist, for example, where one side has manufactured the deadlock by simply refusing to consider an issue.
Client Alert 2021-097
