Summary
In VGS, the Court of Chancery found that the minority member and designee breached their duties of loyalty by using a flawed process to divest the controlling member of his board control and equity.
Summary of this case from Adams v. KleinOpinion
C.A. No. 17995.
Submitted: July 5, 2000.
Decided: August 31, 2000.
Stuart M. Grant and Megan D. McIntyre of Grant Eisenhofer, Wilmington, Delaware. Attorneys for VGS, Inc.
Brian A. Sullivan and Duane D. Werb of Werb Sullivan, Wilmington, Delaware. OF COUNSEL: John W. Bickel II and James S. Renard of Bickel Brewer, Dallas, Texas. Attorneys for Peter D. Sahagen and Sahagen Satellite Technology Group, LLC.
Thomas R. Hunt, Jr. of Morris, Nichols, Arsht Tunnell, Wilmington, Delaware. OF COUNSEL: William H. Jeffress, Jr., R. Stan Mortenson, Jody Manier Kris and Kelli C. McTaggart of Miller, Cassidy, Larroca Lewin, LLP, Washington, D.C. Attorneys for Defendant-Counterclaim Plaintiffs Virtual Geosatellite Holdings. Inc. and Ellipso, Inc. and Counterplaintiff-Intervenor Virtual Geosatellite LLC.
MEMORANDUM OPINION
One entity controlled by a single individual forms a one "member" limited liability company. Shortly thereafter, two other entities, one of which is controlled by the owner of the original member, become members of the LLC. The LLC Agreement creates a three-member Board of Managers with sweeping authority to govern the LLC. The individual owning the original member has the authority to name and remove two of the three managers. He also acts as CEO. The unaffiliated third member becomes disenchanted with the original member's leadership. Ultimately the third member's owner, also the third manager, convinces the original member's owner's appointed manager to join him in a clandestine strategic move to merge the LLC into a Delaware corporation. The appointed manager and the disaffected third member do not give the original member's owner, still a member of the LLC's board of managers, notice of their strategic move. After the merger, the original member finds himself relegated to a minority position in the surviving corporation. While a majority of the board acted by written consent, as all involved surely knew, had the original member's manager received notice beforehand that his appointed manager contemplated action against his interests he would have promptly attempted to remove him. Because the two managers acted without notice to the third manager under circumstances where they knew that with notice that he could have acted to protect his majority interest, they breached their duty of loyalty to the original member and their fellow manager by failing to act in good faith. The purported merger must therefore be declared invalid.
The parties tried this case from June 15, 2000 through June 23, 2000. In further detail below, I describe the case's relevant facts and explain the rationale for my ruling.
I. Facts
David Castiel formed Virtual Geosatellite LLC (the "LLC") on January 6, 1999 in order to pursue a Federal Communications Commission ("FCC") license to build and operate a satellite system which its proponents claim could dramatically increase the "real estate" in outer space capable of transmitting high speed internet traffic and other communications. When originally formed, it had only one Member — Virtual Geosatellite Holdings, Inc. ("Holdings"). On January 8, 1999, Ellipso, Inc. ("Ellipso") joined the LLC as its second Member. Several weeks later, on January 29, 1999, Sahagen Satellite Technology Group LLC ("Sahagen Satellite") became the third Member of the LLC.
In more technologically precise terms, the LLC's purpose was "to construct, launch and operate a global fixed-satellite service system employing nongeostationary satellites in subgeosynchronous elliptical orbits developing the related [ground] segment and offering the related communications services." LLC Agreement, at 15, § 4.01(a).
David Castiel controls both Holdings and Ellipso. Peter Sahagen, an aggressive and apparently successful venture capitalist, controls Sahagen Satellite.
Pursuant to the LLC Agreement, Holdings received 660 units (representing 63.46% of the total equity in the LLC), Sahagen Satellite received 260 units (representing 25%), and Ellipso received 120 units (representing 11.54%). The founders vested management of the LLC in a Board of Managers. As the majority unitholder, Castiel had the power to appoint, remove, and replace two of the three members of the Board of Managers. Castiel, therefore, had the power to prevent any Board decision with which he disagreed. Castiel named himself and Tom Quinn to the Board of Managers. Sahagen named himself as the third member of the Board.
Not long after the formation of the LLC, Castiel and Sahagen were at odds. Castiel contends that Sahagen wanted to control the LLC ever since he became involved, and that Sahagen repeatedly offered, unsuccessfully, to buy control of the LLC. Sahagen maintains that Castiel ran the LLC so poorly that its mission had become untracked, additional necessary capital could not be raised, and competent managers could not be attracted to join the enterprise. Further, Sahagen claims that Castiel directed LLC assets to Ellipso in order to prop up a failing, cash-strapped Ellipso. At trial, these issues and other similar accusations from both sides were explored in great detail. For our purposes here, all that need be concluded is the unarguable fact that Castiel and Sahagen had very different ideas about how the LLC should be managed and operated.
Sahagen ultimately convinced Quinn that Castiel must be ousted from leadership in order for the LLC to prosper. As a result, Quinn (Castiel's nominee) covertly "defected" to Sahagen's camp, and he and Sahagen decided to wrest control of the LLC from Castiel. Many LLC employees and even some of Castiel's lieutenants testified that they believed it to be in the LLC's best interest to take control from Castiel.
On April 14, 2000, without notice to Castiel, Quinn and Sahagen acted by written consent to merge the LLC under Delaware law into VGS, Inc. ("VGS"), a Delaware corporation. Accordingly, the LLC ceased to exist, its assets and liabilities passed to VGS, and VGS became the LLC's legal successor-in-interest. VGS's Board of Directors is comprised of Sahagen, Quinn, and Neel Howard. Of course, the incorporators did not name Castiel to VGS's Board.
On the day of the merger, Sahagen executed a promissory note to VGS in the amount of $10 million plus interest. In return, he received two million shares of VGS Series A Preferred Stock. VGS also issued 1, 269, 200 shares of common stock to Holdings, 230, 800 shares of common stock to Ellipso, and 500,000 shares of common stock to Sahagen Satellite. Once one does the math, it is apparent that Holdings and Ellipso went from having a 75% controlling combined ownership interest in the LLC to having only a 37.5% interest in VGS. On the other hand, Sahagen and Sahagen Satellite went from owning 25% of the LLC to owning 62.5% of VGS.
There can be no doubt why Sahagen and Quinn, acting as a majority of the LLC's board of managers did not notify Castiel of the merger plan. Notice to Castiel would have immediately resulted in Quinn's removal from the board and a newly constituted majority which would thwart the effort to strip Castiel of control. Had he known in advance, Castiel surely would have attempted to replace Quinn with someone loyal to Castiel who would agree with his views. Clandestine machinations were, therefore, essential to the success of Quinn and Sahagen's plan.
II. Analysis
A. The Board of Managers did have authority to act by majority vote.
The LLC Agreement does not expressly state whether the Board of Managers must act unanimously or by majority vote. Sahagen and Quinn contend that because a number of provisions would be rendered meaningless if a unanimous vote was required, a majority vote is implied. Castiel, however, maintains that a unanimous vote must be implied when the majority owner has blocking power.
Section 8.01(b)(i) of the LLC Agreement states that, "[t]he Board of Managers shall initially be composed of three (3) Managers." Sahagen Satellite has the right to designate one member of the initial board, and if the Board of Managers increased in number, Sahagen Satellite could "designate a number of representatives on the Board of Managers that is less than Sahagen's then current Percentage Interest." If unanimity were required, the number of managers would be irrelevant — Sahagen, and his minority interest, would have veto power in any event. The existence of language in the LLC Agreement discussing expansion of the Board is therefore quite telling.
LLC Agreement, at § 8.01(b)(i).
Also persuasive is the fact that Section 8.0 1(c) of the LLC Agreement, entitled "Matters Requiring Consent of Sahagen," provides that Sahagen's approval is needed for a merger, consolidation, or reorganization of the LLC. If a unanimity requirement indeed existed, there would have been no need to expressly list matters on which Sahagen's minority interest had veto power.
Section 12.01(a)(i) of the LLC Agreement also supports Sahagen's argument. This section provides that the LLC may be dissolved by written consent by either the Board of Managers or by Members holding two-thirds of the Common Units. The effect of this Section is to allow any combination of Holdings and Sahagen Satellite, or Holdings and Ellipso, as Members, to dissolve the LLC. It seems unlikely that the Members designed the LLC Agreement to permit Members holding two-thirds of the Common Units to dissolve the LLC but denied their appointed Managers the power to reach the same result unless the minority manager agreed.
Castiel takes the position that while the Members can act by majority vote, the Board of Managers can act only by unanimous vote. He maintains that if the Board fails to agree unanimously on an issue the issue should be put to an LLC Members' vote with the majority controlling. The practical effect of Castiel's interpretation would be that whenever Castiel and Sahagen disagreed, Castiel would prevail because the issue would be submitted to the Members where Castiel's controlling interest would carry the vote. If that were the case, both Sahagen's Board position and Quinn's Board position would be superfluous. I am confident that the parties never intended that result, or if they had so intended, that they would have included plain and simple language in the agreement spelling it out clearly.
B. By failing to give notice of their proposed action, Sahagen and Quinn failed to discharge their duty of loyalty to Castiel in good faith
Section 18-404(d) of the LLC Act states in pertinent part:
Unless otherwise provided in a limited liability company agreement, on any matter that is to be voted on by managers, the managers may take such action without a meeting, without prior notice and without a vote if a consent or consents in writing, setting forth the action so taken, shall be signed by the managers having not less than the minimum number of votes that would be necessary to authorize such action at a meeting (emphasis added).
Therefore, the LLC Act, read literally, does not require notice to Castiel before Sahagen and Quinn could act by written consent. The LLC Agreement does not purport to modify the statute in this regard.
Those observations can not complete the analysis of Sahagen and Quinn's actions, however. Sahagen and Quinn knew what would happen if they notified Castiel of their intention to act by written consent to merge the LLC into VGS, Inc. Castiel would have attempted to remove Quinn, and block the planned action. Regardless of his motivation in doing so, removal of Quinn in that circumstance would have been within Castiel's rights as the LLC's controlling owner under the Agreement.
Section 18-404(d) has yet to be interpreted by this Court or the Supreme Court. Nonetheless, it seems clear that the purpose of permitting action by written consent without notice is to enable LLC managers to take quick, efficient action in situations where a minority of managers could not block or adversely affect the course set by the majority even if they were notified of the proposed action and objected to it. The General Assembly never intended, I am quite confident, to enable two managers to deprive, clandestinely and surreptitiously, a third manager representing the majority interest in the LLC of an opportunity to protect that interest by taking an action that the third manager's member would surely have opposed if he had knowledge of it. My reading of Section 18-404(d) is grounded in a classic maxim of equity — "Equity looks to the intent rather than to the form." In this hopefully unique situation, this application of the maxim requires construction of the statute to allow action without notice only by a constant or fixed majority. It can not apply to an illusory, will-of-the wisp majority which would implode should notice be given. Nothing in the statute suggests that this court of equity should blind its eyes to a shallow, too clever by half, manipulative attempt to restructure an enterprise through an action taken by a "majority" that existed only so long as it could act in secrecy.
DONALD J. WOLFE, JR. MICHAEL A. PITTENGER, CORPORATE AND COMMERCIAL PRACTICE P4 THE DELAWARE COURT OF CHANCERY, at vii (1998) (listing the maxims of equity). See also Westendorf v. Gateway 2000 , Del. Ch., C.A. No. 16913, 2000 WL 307369, at *5, Steele, V.C. (March 16, 2000) ("A long-standing equitable maxim states that equity looks to the intent rather than to the form"); Infinity Investors Limited v. Takefman , Del. Ch., C.A. No. 17347, 2000 WL 130622, at *5, Chandler, C. (Jan. 28, 2000) ("As equity looks to the intent rather than to the form, this Court should not permit parties to manipulate procedural rules for the purpose of avoiding resolution on the merits"); The Estate of Helen Lattimore Speare , Del. Ch., 2000 WL 130622, at *4, Brown, C. (Aug. II, 1982) (quoting the maxim and citing 2 POMEROY, EQUITY JURISPRUDENCE, § 363 — § 384 (5th ed. (1941)))
Sahagen and Quinn each owed a duty of loyalty to the LLC, its investors and Castiel, their fellow manager. Castiel or his entities owned a majority interest in the LLC and he sat as a member of the board representing entities and interests empowered by the Agreement to control the majority membership of the board. The majority investor protected his equity interest in the LLC through the mechanism of appointment to the board rather than by the statutorily sanctioned mechanism of approval by members owning a majority of the LLC's equity interests. It may seem somewhat incongruous, but this Agreement allows the action to merge, dissolve or change to corporate status to be taken by a simple majority vote of the board of managers rather than rely upon the default position of the statute which requires a majority vote of the equity interest. Instead the drafters made the critical assumption, known to all the players here, that the holder of the majority equity interest has the right to appoint and remove two managers, ostensibly guaranteeing control over a three member board. When Sahagen and Quinn, fully recognizing that this was Castiel's protection against actions adverse to his majority interest, acted in secret, without notice, they failed to discharge their duty of loyalty to him in good faith. They owed Castiel a duty to give him prior notice even if he would have interfered with a plan that they conscientiously believed to be in the best interest of the LLC. Instead, they launched a preemptive strike that furtively converted Castiel's controlling interest in the LLC to a minority interest in VGS without affording Castiel a level playing field on which to defend his interest. "[Another] traditional maxim of equity holds that equity regards and treats that as done which in good conscience ought to be done." In good conscience, under these circumstances, Sahagen and Quinn should have given Castiel prior notice.
I make no ruling here as to whether I believe the merger and the resulting recapitalization of the LLC was in the LLC's best interests, nor do I rule here regarding the wisdom of Castiel's actions had he in fact been able to remove Quinn before the merger.
WOLFE PITTENGER, supra, at § 2-3(b)(1)(i), citing 2 JOHN NORTON POMEROY, A TREATISE ON EQUITY JURISPRUDENCE § 363 et seq. (5th ed. (1941)).
Many hours were spent at trial focusing on contentions that Castiel has proved to be an ineffective leader in whom employees and investors have lost confidence. I listened to testimony regarding delayed FCC licensing, a suggested new management team for the LLC, and the alleged unlocked value of the LLC. A substantial record exists fully flushing out the rancorous relationships of the members and their wildly disparate views on the existing state of affairs as well as the LLC's prospects for the future. But the issue of who is best suited to run the LLC should not be resolved here but in board meetings where all managers are present and all members appropriately represented, and/or in future litigation, if it unfortunately becomes necessary.
Likewise, the parties spent much time and effort arguing over the standard to be applied to the actions taken by Sahagen and Quinn. Specifically, the parties debated whether the standard should be entire fairness or the business judgment rule. It should be clear that the actions of Sahagen and Quinn, in their capacity as managers constituted a breach of their duty of loyalty and that those actions do not, therefore, entitle them to the benefit or protection of the business judgment rule. They intentionally used a flawed process to merge the LLC into VGS, Inc., in an attempt to prevent the member with majority equity interest in the LLC from protecting his interests in the manner contemplated by the very LLC Agreement under which they purported to act. Analysis beyond a look at the process is clearly unnecessary. Perhaps, had notice been given and an attempt then made to block Castiel's anticipated action to replace Quinn, the allegedly disinterested and independent member that Castiel himself had appointed, the analysis might be different. However, this, as all cases must be reviewed as it is presented, not as it might have been.
III. Conclusion
For the reasons stated above, I find that a majority vote of the LLC's Board of Managers could properly effect a merger. But, I also find that Sahagen and Quinn failed to discharge their duty of loyalty to Castiel in good faith by failing to give him advance notice of their merger plans under the unique circumstances of this case and the structure of this LLC Agreement. Accordingly, I declare that the acts taken to merge the LLC into VGS, Inc. to be invalid and the merger is ordered rescinded. An order consistent with this opinion, resolving the current claims of the parties is attached.
ORDER
For the reasons set forth in this Court's opinion entered in this case on August 31, 2000, it is ORDERED that:
1. The purported merger of Virtual Geosatellite LLC (the "LLC") into VGS, Inc. is invalid and is therefore rescinded, and
2. VGS, Inc. is enjoined from continuing to assert ownership or control over the LLC's property including its funds and its license application at the FCC, and
3. Judgment is entered against plaintiff and counter defendant VGS, Inc. and in favor of David Castiel, Virtual Geostellite Holdings, Inc. and Ellipso, Inc., defendants and counterclaim plaintiffs.
4. Judgment is further entered in favor of Virtual Geosatellite LLC, counterclaim plaintiff intervenor and against counterclaim defendants VGS, Inc., Sahagen, Quinn, Howard and Sahagen Satellite Technology Group, LLC.
5. The requests for attorneys' fees by David Castiel, Virtual Geosatellite Holdings, Inc., and Ellipso, Inc. are taken under advisement until briefed and supported by appropriate affidavits.
SO ORDERED this 31st day of August, 2000.
________________________________ Vice Chancellor (by designation)