Chancery Court Blocks Former Judge From Serving On LLC Special Litigation Committees
By: Scott E. Waxman and Trevor M. Gates
In Obeid v. Hogan, No. CV 11900-VCL (Del. Ch. June 10, 2016), the Delaware Court of Chancery prevented a former federal judge from serving as the sole member of parallel special litigation committees formed to assess derivative actions because he was not a director or manager of the respective limited liability companies (“LLCs”). In reaching this decision, the court followed corporate precedent in interpreting an LLC agreement because of the LLC’s “corporate-style governance structure.” The court concluded an LLC board of directors could therefore delegate authority to a committee to take control of a derivative action, under certain circumstances, but that authority could not be delegated to a non-director/non-member in this instance.
The case involved two Delaware LLCs that jointly managed over $1 billion in real estate assets, including eleven hotels and twenty-two commercial properties. Prior to this litigation, plaintiff William Obeid managed the day-to-day operations of the hospitality division, and non-parties Christopher La Mack and Dante Massaro managed the day-to-day operations of the commercial division.
The LLC agreement for Gemini Equity Partners, LLC (the “Corporate LLC”) established a governance structure paralleling that of a corporation in which power over the entity was vested in a board of directors (the “Corporate Board”). Obeid, La Mack, and Massaro each held a one-third interest in the Corporate LLC and together comprised the Corporate Board.
The LLC agreement for Gemini Real Estate Advisors, LLC (the “Manager-Managed LLC”) established a governance structure in which power over the entity was vested in its managers. Obeid, La Mack, and Massaro each held a one-third interest in the Manager-Managed LLC and served as the entity’s only three managers.
On July 1, 2014, La Mack and Massaro voted to remove Obeid as President and Operating Manager of the Manager-Managed LLC and contemporaneously filed an action in North Carolina state court asserting claims against Obeid relating to his duties as Operating Manager of the company. In August 2014 and March 2015, Obeid filed lawsuits against La Mack and Massaro in New York state and federal courts alleging La Mack and Massaro had started competing companies using company assets and were improperly selling company properties to a competitor in return for side benefits. Obeid asserted claims directly based on his rights as a member of the entities and derivatively on behalf of the entities themselves. The New York state claims were eventually brought into the federal proceeding, and the North Carolina action was stayed in deference to the New York action.
On August 24, 2015, La Mack and Massaro hired Judge Hogan, a retired federal judge who had served for over forty years, including as Chief Judge of the United States District Court for the District of Oregon, to serve on the parallel special litigation committees that were designed to “investigate, analyze and make a recommendation whether to pursue the derivative claims on behalf of [the LLCs].” Judge Hogan is not a director of the Corporate LLC or a manager of the Manager-Managed LLC, and no formal resolutions were approved by the companies that would establish parallel special litigation committees. On September 22, 2015, La Mack and Massaro also held a telephonic special meeting of the members of the Corporate LLC and voted to remove Obeid as a director.
In November 2015, Obeid learned that La Mack and Massaro had hired Judge Hogan. By letter dated December 28, 2015, Judge Hogan introduced himself to La Mack, Massaro, and Obeid and stated that he planned to seek a stay of the New York action to permit him to perform his work as the sole member of the parallel special litigation committees. On January 12, 2016, Obeid filed the instant action primarily seeking a declaratory judgement that Judge Hogan could not serve as the sole member of the two parallel special litigation committees and separately that Obeid’s removal as director of the Corporate LLC was improper.
With respect to Judge Hogan’s ability to act as special litigation committee for the Corporate LLC, the court applied the analysis from Zapata Corp. v. Maldonado and held that because Judge Hogan was not a director of the Corporate LLC he could not serve as the sole member of the special litigation committee. At the outset, the court noted that the Delaware LLC Act and Delaware case law support the ability of parties to use an LLC agreement to define the character of a company and its members. In this case, the Corporate LLC agreement “substantially recreate[d] the governance structure of a Delaware corporation using language drawn from the corporate domain.” Specifically, it established a board-centric governance model tracking that of a corporation. Thus, the court looked to corporate precedent to guide its decision-making.
In Zapata, the Delaware Supreme Court addressed whether a board of directors could assert control over a derivative action after a stockholder had obtained the right to represent the corporation and had proceeded beyond the pleading stage. In answering that question affirmatively, the court held that the board “retained all of its corporate power concerning litigation decisions” even though a derivative action typically calls into doubt a board’s independence and disinterestedness (as it did in this case). Rather, the court noted the problem is simply one of member disqualification and not a lack of power (i.e., that “interested” directors may not participate in certain decisions). The court further held that the board could delegate that authority to a committee under certain circumstances. Specifically, “a committee can exercise all of the authority of the board to the extent provided in the resolution of the board.” Notably, the committee’s determination what to do with a litigation asset may still be subject to judicial examination of equitable considerations, such as the “independence and good faith” basis of the committee’s decision and whether that decision falls “within a range of reasonable outcomes that a disinterested and independent decision maker . . . could reasonably accept.”
In this case, Obeid had proceeded past the pleading stage in the New York action and thus had gained the authority to pursue derivative claims. Separately, La Mack and Massaro were “interested” in the challenged transactions. Therefore, the Corporate Board could reassert its authority over the derivative claims only if it reestablished “an independent and disinterested actor that was capable of wielding the full authority of the Corporate Board.” Here, the Court of Chancery, following Zapata, stated a committee of directors was “the only vessel . . . capable of receiving and exercising the full authority of the [Corporate Board]” and that the delegation of authority to a non-director would “risk an improper abdication of authority.” By delegating to a non-director, La Mack and Massaro attempted to improperly form a “quasi-committee.”
The court also noted that since Zapata Delaware corporations have formed many special litigation committees to address derivative claims, but that neither the leading treatises nor the parties themselves cite “a single occasion in which a Delaware court has approved the use of a special litigation committee staffed by a non-director, or even intimated that such a committee would pass muster.”
The court then turned to the Manager-Managed LLC and initially stated that it seemed likely the reasoning applicable to the Corporate LLC would also compel the same result for the Manager-Managed LLC. The court, however, instead pointed to specific provisions within the Manager-Managed LLC agreement that, when read as a whole, demonstrated “that the drafters of the Manager-Managed LLC Agreement intended to limit the ability of managers to delegate their core governance functions,” as opposed to matters relating to the ordinary course of business. Thus, the court similarly found Judge Hogan could not serve as the sole member of the special litigation committee for the Manager-Managed LLC because he was not a manager.
Finally, the court rejected Obeid’s argument that his removal from the Corporate Board was improper. The court noted that the default rule in the Delaware LLC Act is that decisions of members holding a majority interest is ordinarily controlling, and here the Corporate LLC agreement did not sufficiently provide otherwise. Thus, the court found that La Mack’s and Massaro’s two-thirds interest in the profits of the Corporate LLC gave them the necessary ability to remove Obeid as a director.