By Andrew Skouvakis and Thomas Meyer
In Finger Lakes Capital Partners, LLC v. Honeoye Lake Acquisition, LLC, the Court of Chancery held that proceeds from a limited liability company’s liquidity event distributed to the members of the limited liability company should be reallocated in accordance with prior agreements between the members. The Court found that an integration clause in the limited liability company agreement did not supersede allocation provisions in the prior agreements.
In 2003, Zubin Mehta and Gregory Shalov formed Finger Lakes Capital Partners, LLC (“Finger Lakes”) to sponsor investments in portfolio companies. Lyrical Partners, L.P. (“Lyrical”) provided the majority of the capital for these investments. In 2004, Mehta, Shalov, and Lyrical executed a binding term sheet (the “Term Sheet”) addressing the ongoing business relationship between Finger Lakes and Lyrical. Under the Term Sheet, Lyrical received a 25% ownership interest in Finger Lakes and was entitled to a percentage of portfolio company management fees that would otherwise go to Finger Lakes.
Finger Lakes sponsored, and Lyrical provided capital for, investments in five portfolio companies. For each portfolio company, Finger Lakes formed a separate Delaware limited liability company (each, an “LLC”) as a special purpose vehicle for the investment. Lyrical received Class A membership interests in each LLC and Finger Lakes received Class B membership interests. The limited liability company agreement for each LLC contained a distribution provision (the “Distribution Provision”) setting forth a three-stage distribution waterfall. In the first and second stages, each member would receive a return of its invested capital and a preferred return on its invested capital. In the third, a large percentage of the remaining profits would be allocated to the Class A member (i.e., Lyrical), and a smaller percentage would be allocated to the Class B member (i.e., Finger Lakes). Each LLC agreement also contained a standard integration clause stating that the agreement superseded all prior agreements with respect to the subject matter of the agreement.
Over time, Lyrical provided additional money to the portfolio companies upon Finger Lakes giving Lyrical the right to claw back from the profits of any successful portfolio companies the amount of losses Lyrical suffered from investments in other portfolio companies (the “Clawback Agreement”).
After one of the portfolio companies (“Revolabs”) achieved a successful liquidity event, Finger Lakes and Lyrical disagreed over how to distribute the proceeds. In a prior partial judgment on the pleadings (the “Prior Litigation”), the Court held that the proceeds should be distributed in accordance with the Distribution Provision, and the parties proceeded to trial to establish their obligations under the Term Sheet and the Clawback Agreement.
Lyrical had invested in Revolabs and received Class A membership interests. Unlike in other deals, Shalov and Mehta personally invested in Revolabs, but they failed to issue themselves an appropriate number of Class A membership interests reflecting their investment. Finger Lakes argued that the Court should reform the Distribution Provision in the Revolabs LLC agreement so that Lyrical would not receive Class A distributions for profits earned on the capital that Shalov and Mehta invested in the deal. Although the Court acknowledged that the parties had mistakenly failed to account for the investment by Shalov and Mehta, the Court declined to reform the provision due to the doctrine of judicial estoppel, which prevents a litigant from advancing an argument that contradicts a position previously taken. In the Prior Litigation, Finger Lakes had argued that the Distribution Provision was clear and unambiguous.
Addressing the allocation of the Revolabs proceeds in light of the integration clause, the Court held that the Revolabs LLC agreement did not supersede the Term Sheet or the Clawback Agreement. The Court found that the LLC agreement would supersede any prior agreements concerning the investment in Revolabs. The LLC agreement did not supersede provisions in the Term Sheet addressing matters such as Lyrical’s 25% interest in Finger Lakes and the management fee split. Additionally, Finger Lakes had continually treated the Term Sheet as if it were still binding. Similarly, the LLC agreement did not supersede the Clawback Agreement, which applied across all of the portfolio company investments.
As a result of these findings, and because the amount of losses Finger Lakes owed Lyrical under the Clawback Agreement exceeded Finger Lakes’ share of the Revolabs distribution, Finger Lakes was not entitled to receive anything from Revolabs other than its first stage return of capital and second stage preferred return. Under the Term Sheet, Lyrical was entitled to 25% of the Revolabs management fees. Although Shalov had worked for Revolabs, the Court found Finger Lakes’ characterization of the Revolabs management fees as compensation to be pretextual. The Court held that Lyrical had not acquiesced to Finger Lakes retaining Lyrical’s percentage of the management fees because Finger Lakes had not kept Lyrical informed of the ongoing fees.
Finger Lakes also sought to recover its fees and expenses incurred in the litigation under indemnification provisions in the Revolabs LLC agreement. The Court held that indemnification was not available because the issues in the litigation concerned not the terms of the LLC agreement, but the terms of the Term Sheet and the Clawback Agreement.