Corporate

Delaware Court of Chancery Appoints Custodian to Break Deadlock of Profitable Corporation

 In re: Shawe & Elting LLC, C.A. No. 9661-CB (Del. Ch. Aug. 13, 2015) [subscribers can access an enhanced version of this opinion: lexis.com | Lexis Advance].

There are many important principles of Delaware corporate law addressed in this 104-page post-trial opinion, but for the benefit of busy readers, I will highlight those aspects of this decision that have the widest practical applicability to those involved in corporate and commercial litigation.

Background

The factual background of this case involves a company called Transperfect Global, Inc., owned by two 50% stockholders who were also the only two directors of the company.

The primary issue addressed was whether the court should grant a petition to appoint a custodian under DGCL § 226 even though the corporation is highly profitable. The court found that the state of management of the corporation devolved into one of complete dysfunction between the two directors/stockholders who were also co-CEOs. The irretrievable deadlocks over significant matters caused the business to suffer and threatened the business with irreparable injury notwithstanding its profitability.

The court found that the requirements of both § 226(a)(1) and § 226(a)(2) were satisfied. A separate request for dissolution of a LLC subsidiary  pursuant to 6 Del. C. § 18-802 was also granted to dissolve that entity. DGCL § 273, which provides a summary basis to dissolve a joint venture which is owned 50/50, could not be used because technically speaking, the stockholders in this case were not 50/50 stockholders. They were 50/50 on a de facto basis, but 1% was actually held by a third party who was controlled by one of the directors/co-CEOs.

Painfully detailed facts take up more than half of the opinion. The factual background could be the basis for a compelling novel, but for purposes of this brief blog post, I will focus on the most useful legal principles involved.

Key Legal Principles

  • • DGCL § 226(a)(1) allows the court to appoint a custodian for a solvent corporation when “at any meeting held for the election of directors the stockholders are so divided that they have failed to allow successors to directors whose terms have expired or would have expired upon qualification of their successors.” This provision does not require irreparable harm as a prerequisite. The court found that the requirements of this statute were met, but even so, the appointment of a custodian is discretionary.
  • • DGCL § 226(a)(2) is slightly different, and allows the court to appoint a custodian for a solvent corporation when the business is suffering or is threatened with irreparable injury because the directors are so divided respecting the management of the corporation that the required vote for an action by the board cannot be obtained, and the stockholders are unable to terminate the division.
  • • The court explains in extensive detail why the deadlock on substantive matters was real. The court distinguished at footnote 291 a decision that denied relief under § 226(a) based on the conclusion that the alleged deadlock was caused by one of two directors who “sought to create a deadlock by refusing to consider any issue until the deadlock is resolved.” That opinion concluded that such facts were not the type of conduct that should support the appointment of a custodian, unlike the instant case.
  • • The parties in this case engaged in what was described as “mutual hostaging” in which one party refused to agree to any action unless his or her demands were met. [It is not readily apparent how this differs from the facts of the case distinguished at footnote 291 above.] The court distinguished this case from the case at footnote 291 based on the reasoning that the disputes in this case were “genuine, good faith divisions” between the two parties, of a “fundamental and systemic nature on how the company should be managed.”
  • • The court discussed other cases where deadlocks existed in a solvent and profitable corporation, and for which custodians were appointed, as well as those instances where a custodian was not appointed. See, e.g., footnotes 320 and 321.
  • • In connection with appointing a custodian to evaluate the possible sale of this company, the court provided options including a “Texas shootout”, which is a type of auction in which either party would specify a price, and the other party would have the option to either buy the other’s interest at that specified price or sell his or her own interest at that price.
  • • The court explained why it would not exercise its equitable authority to order a dissolution of the company which it had the power to do, for example, in extreme cases as a remedy for breach of fiduciary duty. See footnotes 330 through 335.
  • • The articulation of the fiduciary duty of directors is always useful. In this opinion the court reiterated that:

“Directors of a Delaware corporation owe fiduciary duties of care and loyalty to the corporation and to its stockholders. The duty of care requires the exercise of an informed business judgment. The duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally. To that end, a director may not allow his self-interest to jeopardize his unyielding obligations to the corporation and its shareholders. A director must, therefore, exercise good faith in advancing the corporation’s interest.”  (footnotes omitted.)

  • • The court held that the breach of fiduciary duty claims were barred by both unclean hands and acquiescence.
  • • A separate analysis of the dissolution claim for an LLC subsidiary under § 18-802 is helpful. Also useful is the court’s reference to § 18-402 of the Delaware LLC Act which provides for the majority owner of an LLC or members constituting more than 50% of the LLC to prevail in the absence of any contrary provision in the limited liability agreement. Also of practical application is a discussion of the distribution of assets upon dissolution of an LLC (The court also referred to § 18-804(a) which providthat unless otherwise specified in connection with the dissolution of an LLC, the assets of the company shall be distributed to the company’s creditors and then to its members in connection with the dissolution).
  • • Lastly, I want to note a quote of widespread applicability that needs to be credited to The Chancery Daily which referred to a case involving another dysfunctional business relationship in a Chancery decision that was not quoted in this opinion but that The Chancery Daily provided. The quote is as follows:

“The Chief Justice once observed, with respect to business co-managers or co-owners whose relationships have soured, that ‘if people are really good business people . . . you just wonder . . . whether they’re only able to use their brains in some limited compromised way that allows them to make money, then, when they function on a broader dynamic, all their economic rationality and intuition just goes out the window.”

Utilisave, LLC v. Khenin, C.A. No. 7796-CS, Transcript (Del. Ch. Jan. 11, 2013; filed Jan. 15, 2013). See also more recent decisions in the Khenin case, unrelated to this quote: Utilisave, LLC, et al. v. Mikhail Khenin, C.A. No. 7796-ML, final report 2 (Del. Ch. Aug. 18, 2015) [lexis.com | Lexis Advance].

 Read more Delaware business litigation case summaries and commentary on Delaware Corporate and Commercial Litigation Blog, a blog hosted by Francis G.X. Pileggi, of Eckert Seamans.

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