United States: Special Litigation Committee Must Be Comprised Of Board Members

John O'Toole writes:

In Obeid v. Hogan, C.A. No. 11900-VCL, 2016 WL 3356851 (Del. Ch. June 10, 2016), the Court of Chancery was confronted with the issue of whether a non-manager/non-director could function "as the sole member of...parallel special litigation committees" created by two Delaware LLC's.  Writing for the Court, Vice Chancellor Laster ultimately held that the LLC's in question, Gemini Equity Partners (the "Corporate LLC") and Gemini Real Estate Advisors (the "Manager-Managed LLC"), were not empowered to delegate power to special litigation committees not composed of directors or managers, respectively.

Both the Corporate LLC and the Manager-Managed LLC are engaged in the real estate management business, "jointly manag[ing] over $1 billion in real estate assets."  William T. Obeid, Christopher S. La Mack, and Dante A. Massaro (the "Members"), each hold one-third membership interests in both the Corporate LLC and the Manager-Managed LLC.  The Members serve as the directors of the Corporate LLC and as the managers of the Manager-Managed LLC.

The controversy in question arose when Obeid, the Plaintiff here, was "removed [by La Mack and Massaro] as President and Operating Manager of the Manager-Managed LLC" and sued in North Carolina state court.    Obeid then sued La Mack and Massaro in New York state and federal courts, both directly and derivatively on behalf of both entities, alleging a number of subversive business dealings.

After multiple unsuccessful attempts to resolve the derivative claims brought by Obeid, La Mack and Massaro purported to designate a retired federal district court judge as the sole member of special litigations committees for both the Corporate LLC and the Manager-Managed LLC.  The judge was not a member of either LLC, nor was he a manager or director of either LLC. Obeid, quite predictably, objected.   La Mack and Massaro then voted to remove Obeid as a director of the Corporate LLC.

Obeid brought this action in January 2016, seeking a declaration that a non-manager/non-director cannot serve as the special litigation committee for either the Corporate LLC or the Manager-Managed LLC.  He also sought a declaration invalidating his removal as a director of the Corporate LLC.

The Court's analysis began with a threshold determination that relevant corporate law applies to the Corporate LLC.  As "virtually any management structure may be implemented through [an LLC's] governing instrument," the Members elected to manage the Corporate LLC as if it were a corporation.  In drafting the Corporate LLC's operating agreement, the Members created a manager-managed LLC, the manager of which is a board of directors.  The Members also included language allowing for board action by committees of directors.  As such, the Corporate LLC's governance structure reflects the board centric governance model embodied by §§ 141 (a) and 141(c) of the Delaware General Corporation Law ("DGCL").

After determining that the "corporate traits in the Corporate LLC Agreement call[] for applying corporate law precedents," Vice Chancellor Laster looked to "corporate law analogies" in determining whether the Corporate LLC could "empower a special litigation committee comprising a single non‑director."  The Court found Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) particularly relevant in discussing boards' roles in managing derivative claims and the extent to which such management might be done by special litigation committees.  In Zapata, the Delaware Supreme Court held that directors' power to manage derivative claims on behalf of corporations is a product of § 141(a) of the DGCL, which provides that "[t]he business and affairs of every corporation...shall be managed by...a board of directors."  The Court then held that committees of directors created pursuant to § 141(c) of the DGCL necessarily must be comprised entirely of directors, as "[a] committee of directors is the only vessel that is capable of receiving and exercising the full authority of the board...."

Here, Vice Chancellor Laster held that "Zapata applies fully to the special litigation committee that the Corporate [LLC] purported to establish."  Despite the Corporate LLC's argument that § 18-407 of the Delaware LLC Act condones the delegation of power to manage derivative claims to a non-director, Vice Chancellor Laster faithfully applied the rule of Zapata to the actions of the Corporate LLC.  The Court supplemented its application of Zapata by looking to §§ 18-1001 and 18-1003 of the Delaware LLC Act, which together "indicate that only the duly authorized decision-making body of the entity, be it the members or the managers, can make the necessary decision[s]...[to] control...derivative litigation."

Thus, the Court granted summary judgment to Obeid, holding that given the governance structure defined in the Corporate LLC's operating agreement, a non-director cannot "function as a one-man special litigation committee on behalf of the Corporate LLC."

The Court then turned its attention to the issue of whether a non-manager can serve as the special litigation committee of the Manager-Managed LLC.  Vice Chancellor Laster stated that "the governance structure of the Manager-Managed LLC...exhibits corporate features, albeit not so pervasively as the Corporate LLC."  Thus "the reasoning that governed the Corporate LLC [could] apply equally to the Manager-Managed LLC."  The Court, however, ultimately felt it unnecessary to undertake a Zapata analysis as to the Manager-Managed LLC, as certain "sections of the Manager-Managed LLC Agreement, read as a whole, evidence a distinction between matters relating to the ordinary course of business of the LLC and more significant matters that must be handled by the managers."

Reading the Manager-Manager LLC's operating agreement against § 18-407 of the Delaware LLC Act, which "validates...ordinary course of business delegations," Vice Chancellor Laster determined that the operating agreement "intended to limit the ability of managers to delegate their core governance functions."  Given such limitation, the Court held that the Manager-Managed LLC's operating agreement "do[es] not permit an issue as serious as the exercise of authority over derivative claims to be delegated to a non-manager."  In so holding, the Court declared that a non-manager cannot serve as a one-man special litigation committee on behalf of the Manager-Managed LLC.

The Court ended its opinion with an easily-reached finding that the Plaintiff was validly removed as a director of the Corporate LLC.  The Court determined that his removal was effected in a manner consistent with the requirements of the Delaware LLC Act, the DGCL, and the Corporate LLC's operating agreement.

John O'Toole is a summer associate, resident in the firm's Wilmington office.

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