EFiled: Nov 12 2009 7:12PM EST
Transaction ID 28023385
Case No. Multi-case
COURT OF CHANCERY
OF THE
STATE OF DELAWARE
JOHN W. NOBLE
VICE CHANCELLOR
417 SOUTH STATE STREET
DOVER, DELAWARE 19901
TELEPHONE: (302) 739-4397
FACSIMILE: (302) 739-6179
November 12, 2009
Thad J. Bracegridle, Esquire
Wilks, Lukoff & Bracegirdle, LLC
1300 North Grant Avenue, Suite 100
Wilmington, DE 19806
Re:
Rolin P. Bissell, Esquire
Young Conaway Stargatt & Taylor LLP
1000 West Street, 17th Floor
P.O. Box 391
Wilmington, DE 19899-0391
Lola Cars International Limited v. Krohn Racing, LLC, et al.
C.A. No. 4479-VCN
Lola Cars International Limited v. Krohn Racing, LLC, et al.
C.A. No. 4886-VCN
Date Submitted: October 20, 2009
Dear Counsel:
This letter opinion addresses the Defendants’ motions to dismiss both of these
related actions.
I. BACKGROUND1
Plaintiff Lola Cars International, Ltd. (“Lola”) is a company registered under
the laws of England and Wales specializing in the manufacture and sale of race car
1
The facts are drawn from the complaints in the two actions.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 2
chassis and parts. Defendant Krohn Racing, LLC (“Krohn”) is a Delaware limited
liability company and racing team that competes in the Grand American Rolex
Racing Series (the “Grand Am Series”).
Defendant Jeff Hazell (“Hazell”) has
managed Krohn since its inception in late 2005.
On March 5, 2007, Lola and Krohn established Proto-Auto, LLC (“ProtoAuto” or the “Company”) through the execution of a limited liability company
operating agreement (the “Operating Agreement”). Lola owns 51% of Proto-Auto,
while Krohn holds the Company’s remaining membership interests. Despite Lola’s
majority interest, the two companies agreed to equal representation on Proto-Auto’s
governing board with each member initially appointing one director.2
Krohn
appointed Hazell, and he has served in this post since the Company’s inception.
Krohn also agreed to provide Hazell’s services as Proto-Auto’s chief executive
officer as one of its primary obligations under the Operating Agreement.
Proto-Auto’s stated purpose was to acquire and sell specific “Daytona
prototype” race cars licensed by the Grand American Road Racing Association, the
sanctioning body for the Grand Am Series. To this end, the parties agreed to acquire
2
Operating Agmt. §§ 5.1, 5.2.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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a Grand Am Constructor’s License from third-party Multimatic Motorsports. The
Operating Agreement anticipated the development of the business on a sound, profitmaking basis in accordance with its business plan and budget, with the not-unusual
goal of maximizing and maintaining profits for distribution to its members. The
Operating Agreement defined Proto-Auto’s function in a generalized fashion: to
manufacture the vehicles and parts for sale, to strengthen its position in the market,
and to improve the Company’s business.3
The parties each also took on specific responsibilities: Lola agreed to evaluate,
test, and develop a Lola chassis for the prototype race car mentioned above, while
Krohn agreed to purchase and test two of these vehicles for competition in the Grand
Am Series. The Operating Agreement also required Krohn, as the party providing the
chief executive officer, to fulfill a number of budgetary and accounting duties. For
example, Krohn had to prepare an annual budget and ensure that Hazell undertook
“all reasonable endeavors” to make certain that the budget not exceed Proto-Auto’s
income.4 Krohn also had to produce monthly management accounts, which included
several financial statements, and to send these accounts to the board for review.
3
4
Id. § 3.2.
Id. § 6.2.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 4
Lastly, Krohn had to ensure that its designated chief executive officer—in this case,
Hazell—would not commit to expenditures beyond Proto-Auto’s budget.
A. The First Action5
Lola’s Amended Complaint (the “First Complaint”) in the First Action asserts
several claims against the Defendants related to their respective obligations and it
seeks various forms of relief.
Lola alleges that Krohn breached the Operating
Agreement by failing to provide Lola with vehicle test reports, as well as many of the
accounting reports described above. Krohn also has allegedly failed to pay interest
owed Lola on loans Lola has made to Proto-Auto beyond its obligation to support the
enterprise.6 In addition, Lola claims that Krohn’s engineers assembled several ProtoAuto vehicles for which they were compensated; this responsibility, however,
belonged to Lola by the terms of the Operating Agreement.7 Lastly, Lola argues that
Krohn violated the implied covenant between contracting parties to act fairly and in
5
C.A. No. 4479-VCN (filed April 6, 2009).
The parties agreed to make loans to the Company if its balance sheet for any fiscal year showed
negative net assets. Lola agreed to provide 51% of the deficit and Krohn 49%. Operating Agmt.
§ 8.3. If any party fails to pay its prorated share, the other party may make up the difference and be
entitled to interest on the loan amount that exceeds its obligation. Operating Agmt. § 8.4.
7
The Operating Agreement is attached as Exhibit A to the First Complaint.
6
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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good faith when it refused to meet with Lola’s board representative in March 2009 to
discuss replacing Hazell as chief executive officer.
Lola also alleges that Hazell has breached his fiduciary duties of loyalty and
care. It argues that Hazell has mismanaged Proto-Auto, rendering the Company
insolvent and unable to fulfill its commercial purpose as stated in Operating
Agreement. Specifically, Lola claims that Hazell has failed to create and pursue an
effective marketing and sales strategy, and for this reason, Proto-Auto has secured
material income from only one source—Krohn. To make matters worse, a significant
portion of this income has come by sale of the two vehicles Krohn had agreed to
purchase when it entered into the Operating Agreement. Lola also claims that Hazell
failed to implement an internal control system to monitor inventory levels and costs,
as well as to account properly for tax and engineering expenses. For example,
Hazell’s alleged inefficient management caused Proto-Auto’s engineering costs to
rise to more than $1.2 million above the budgeted amount, and his failure to timely
pay Georgia state sales tax resulted in an assessed penalty of over $27,000.8
8
First Compl. ¶¶ 12(f), 12(h).
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 6
Lola also claims that Hazell breached his duty of loyalty by acting on Krohn’s
behalf to Proto-Auto’s detriment.
Hazell purportedly allowed Krohn to
misappropriate or underpay for parts, resulting in a gross profit on the sale of
inventory far less than what should have been realized given the number of parts
sold.9 Further, Lola charges Krohn with aiding and abetting Hazell’s disloyalty. Lola
concludes that, due to Hazell’s mismanagement and fiduciary violations, Proto-Auto
sustained approximately $2.2 million in losses from the time of its inception until
January 2009. Lola claims that Proto-Auto is now insolvent as its total liabilities
exceed its total assets by more than $2 million.
Through the First Complaint, Lola seeks several remedies. It asks this Court to
dissolve Proto-Auto on the ground that the Company can no longer realize or attempt
to realize its stated business purpose. Connected with this request for relief, Lola
asks that the Court appoint a liquidating receiver to oversee the dissolution and wind
up the company’s affairs. It also requests the Court to enjoin the Company from
taking any actions outside the ordinary course of business, and it has requested the
9
Id. ¶ 12(b) (“From its inception through February 2, 2009, the Company realized gross profits of
only $120,736 on part sales to Krohn of $1,450,076 . . . [when] it should have realized gross profits
of $715,799 on sale of parts.”).
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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appointment of a receiver pendete lite to preserve the Company’s assets; the Court
generally denied these interim injunctive requests but, instead, imposed a Status Quo
Order that continues to govern the Company. Lola also seeks damages against Krohn
and Hazell on its breach of contract allegations, both express and implied, and its
fiduciary duty claims.
B. Defendants’ Motion to Dismiss the First Complaint
Defendants moved to dismiss most of the counts in the First Complaint. They
concede that Lola sufficiently pled a claim against Krohn for breaching the Operating
Agreement, but otherwise argue that Lola failed to state a cause of action on its
remaining claims. The Defendants first challenge Lola’s request for dissolution and
the appointment of a liquidating trustee. They believe that the facts as alleged do not
support the conclusion that Proto-Auto can no longer meet, or make an effort to
attain, its business purpose. They claim that insolvency alone does not support
judicial dissolution, nor does a company’s failure to attain a profit within its first two
years of operation. They also note that the Operating Agreement provides its own
scheme for bringing and resolving member disputes, including a buy-out provision in
the event of a board deadlock. Krohn contends that, because Lola failed to state a
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 8
cause of action for dissolution, it follows that Lola’s request for the appointment of a
liquidating trustee should be denied as well.
The Defendants also move to dismiss Lola’s claims against Hazell for breach
of fiduciary duty. They argue that Lola failed to make a demand upon Proto-Auto’s
board to consider its derivative claim, and that Lola has not pled demand futility with
particularity. Specifically, the Defendants argue that Lola failed to plead sufficiently
that Hazell, as Krohn’s board designee, is not independent or disinterested and that
his decisions were not the product of valid business judgment. Because a fiduciary
duty claim cannot be brought against Hazell, Krohn argues that it cannot be held
liable on Lola’s aiding and abetting count since there is no properly pled primary
claim from which to derive liability.
Lastly, the Defendants argue that Lola failed to state a claim against Krohn for
breaching the implied covenant to act in good faith. They argue that Krohn’s rights
and obligations regarding the appointment and retention of Hazell as chief executive
officer are defined by the Operating Agreement, and that Krohn is under no
obligation to consent to Lola’s demands for Krohn’s removal.
The Defendants
conclude that because this issue is expressly addressed by the contract, any
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 9
obligations arising under the implied covenant to act in good faith regarding the
matter have been necessarily precluded.
C. The Second Action10
Lola filed its complaint (the “Second Complaint”) in the Second Action, in
reliance upon Section 10.1 of the Operating Agreement—a termination clause that
may be invoked by one member after a breach of the Operating Agreement by the
other. Under this provision, the non-breaching party must notify the other party of
the breach as well as the consequences of a failure to rectify the breach.11 If the
breaching party does not cure the breach within twenty-one days, the non-breaching
party may terminate the Operating Agreement. Lola claims that Krohn materially
breached the Operating Agreement and that it served proper notice and advised
Krohn of the consequences of any failure to cure; it also contends that upon
termination of the Operating Agreement, it should be given the right to manage and
control Proto-Auto, given its majority stake.12 It cites Delaware’s Limited Liability
10
C.A. No. 4886-VCN (filed September 11, 2009).
Operating Agmt. § 10.1.
12
Second Compl. ¶ 17.
11
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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Company Act (the “Act”),13 which by default grants control of a limited liability
company to its members in proportion to their respective equity interests, with a
controlling authority inuring to those members owning a majority of such interests,
unless of course otherwise stated in the operating agreement.14 Lola argues that the
First Complaint served notice upon Krohn of its material breaches, and because at
least twenty-one days have elapsed without cure between the filing of the First
Complaint and the Second Complaint, the Operating Agreement should be terminated
and control of Proto-Auto should pass to Lola.
In the Second Complaint Lola also requested both a temporary restraining
order and a permanent injunction prohibiting Hazell and Krohn from interfering with
Lola’s control of the Company, or acting as its agents. Lola argued that Hazell and
Krohn have caused, and will continue to cause, Proto-Auto irreparable harm. In
support of its argument, Lola alleged that Krohn and Hazell had ceased all efforts to
promote or sell Proto-Auto cars.15 Krohn supposedly issued an August 2009 press
release stating its unwillingness to race Proto-Auto cars in light of its broader dispute
13
6 Del. C. ch. 18.
6 Del. C. § 18-402.
15
Second Compl. ¶ 27.
14
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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with Lola, while communicating to other customers that it would no longer sell these
vehicles. Lola also claims that Krohn potentially damaged Proto-Auto’s relationship
with the Grand-Am racing circuit by withdrawing its race cars from a circuit event in
violation of Proto-Auto’s Grand Am license and proclaiming that it would not race a
Proto-Auto vehicle in future Grand Am events.
Lola accuses Krohn of
communicating with Grand Am authorities to its exclusion, and of obstructing an
inventory audit by a neutral third party.16
It believes that Krohn’s actions, in
particular its unwillingness to sell Proto-Auto cars and its deleterious comments to
the marketplace and individual customers, damaged Proto-Auto’s reputation and
caused it to lose potential sales.
This Court denied Lola’s request for interim injunctive relief. Because it could
not reconcile the differing facts laid forth in the parties’ respective affidavits, it
concluded that a temporary restraining order would be inappropriate. Lola, at the
time, simply could not demonstrate a reasonable likelihood of success on the merits.
The Court also refused to declare a termination of the Operating Agreement pursuant
to Section 10.1; it questioned, first, whether the First Complaint informed Krohn of
16
Id.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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the consequences of its failure to cure the alleged breaches, and, second, if not,
whether it would meet the notice standard set forth in the Operating Agreement.
On October 9, 2009, Lola moved for leave to file a supplemental complaint. It
now contends that it sent Krohn a letter on September 22, 2009 giving notice that
Krohn had materially breached the Operating Agreement and stating the
consequences of Krohn’s failure to cure within twenty-one days. It argues that
allowing it to file a supplemental complaint would work a just and efficient result: a
determination of whether Krohn materially breached the Operating Agreement and
whether it cured any of these defects, if they ever existed, could and should properly
be resolved at trial of the matters addressed in the First Complaint. In the alternative,
Lola suggests that the Court should dismiss its Second Complaint without prejudice
so it may file a new complaint that incorporates the September 22 letter.
D. Defendants’ Motion to Dismiss the Second Complaint
Defendants have also moved to dismiss the Second Complaint pursuant to
Court of Chancery Rule 12(b)(6). They argue that Lola’s allegations must stand as
pled, and they maintain that the First Complaint did not serve proper notice upon
Krohn of its obligation to cure its alleged breaches and of Lola’s authority to
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 13
terminate the Operating Agreement in the event such breaches have not been
remedied. They also argue that Lola failed to state a cause of action: although a
member may terminate the Operating Agreement pursuant to Section 10.1, it does not
follow that the terminating member is thereafter entitled to manage and control the
company. Instead, the Defendants argue that termination of the Operating Agreement
pursuant to section 10.1 triggers dissolution. They ask that the Second Complaint be
dismissed with prejudice.
II. ANALYSIS
The Court will not dismiss the First Complaint, but it will dismiss the Second
Complaint, although without prejudice. From the facts as alleged, there is good
reason to believe that a potentially irreconcilable conflict exists between the parties.
Such a conflict would likely render Proto-Auto unable to pursue its business
objectives as stated in the Operating Agreement. Indeed, it is possible that this has
already come to pass. The First Complaint therefore states a claim for dissolution;
Lola has also sufficiently pled its claims for both breach of fiduciary duty and the
implied covenant to act in good faith for the reasons explained below. The Second
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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Complaint, however, fails to allege compliance with the Operating Agreement’s
notice provision. Thus, it was filed too soon.
A motion to dismiss for failure to state a claim under Court of Chancery
Rule 12(b)(6) will be granted “[i]f the Court determines with reasonable certainty that
there is no set of facts which would entitle the plaintiff to relief.”17 This Court will
assume the truth of all well-pled facts as alleged, and will draw all inferences in a
light most favorable to the plaintiff.18 To survive this motion, a plaintiff must plead
enough facts to suggest plausible, ultimate entitlement to the relief sought.19 As an
important ancillary matter, the Court may also consider documents presented to it
outside the pleadings when such documents are integral to, and incorporated within,
the complaint.20
A. Dissolution
The Defendants first move to dismiss Lola’s request for judicial dissolution.
Section 18-801 of the Act provides, without qualification, that a limited liability
17
Palese v. Del. State Lottery Office, 2006 WL 1875915, at *2 (Del. Ch. June 29, 2006).
DeSimone v. Barrows, 924 A.2d 908, 928 (Del. Ch. 2007).
19
Id. at 929.
20
Vanderbilt Income & Growth Assocs. v. Arvida/JMB Managers, Inc., 691 A.2d 609, 613 (Del.
1996). Without any objection from the parties, the Court considers the Operating Agreement to be
an incorporated document.
18
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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company may be dissolved and its affairs wound up upon “the entry of a decree of
judicial dissolution.”21 Specifically, upon application by a member or manager, this
Court may decree the dissolution of a limited liability company “whenever it is not
reasonably practicable to carry on the business in conformity with a limited liability
company agreement”22
The Defendants claim that, upon the facts as alleged, this Court cannot
conclude that it is no longer reasonably practicable for Proto-Auto to carry on its
business in accord with its Operating Agreement. In particular, the Defendants focus
on Lola’s averments that Proto-Auto is insolvent, has two members who apparently
can no longer cooperate, and its allegations concerning Hazell’s breach of his
fiduciary duties and Krohn’s breach of the Operating Agreement. They argue that
each of these facts, standing alone, or in concert, cannot support a finding that ProtoAuto can no longer carry on its business based upon the statutory reasonable
practicability standard, which they interpret to mean that the business “has been
abandoned or that its purpose is not being pursued.”23
21
6 Del. C. § 18-801(a)(5).
6 Del. C. § 18-802.
23
Defs.’ Opening Br. (First Compl.) at 12.
22
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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To hold that judicial dissolution is appropriate only when the business has been
abandoned would belie the language of the Act.24 Section 18-802 makes clear that
the standard to be applied in this context is whether the Company can carry on its
business with reasonable practicability in conformity with its operating agreement.
The Court in Fisk laid out three factual scenarios this Court should consider when
ordering judicial dissolution under Section 18-802’s reasonable practicability
standard: 1) whether the members’ vote is deadlocked at the Board level; 2) whether
there exists a mechanism within the operating agreement to resolve this deadlock; and
3) whether there is still a business to operate based on the company’s financial
condition.25
The Fisk court explained that none of these factors is individually
conclusive, nor must each be found for a court to order dissolution. Rather they
provide guidance to the ultimate inquiry of whether the company can continue to
pursue its stated business purpose with reasonable practicability.26
24
See Fisk Ventures, LLC v. Segal (Fisk I), 2009 WL 73957, at *3 (Del. Ch. Jan. 13, 2009) (finding
that a party need not show complete frustration to satisfy the judicial dissolution standard set forth
in § 18-802).
25
Id. at *4.
26
See id. (asking whether the board deadlock prevented the company from furthering its stated
business purpose).
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
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All three of the circumstances laid out in Fisk are at issue here. For one, Lola
and Krohn are allegedly deadlocked over whether to replace Hazell as chief executive
officer.27 The Operating Agreement provides a buy-out mechanism in the event of a
member dispute; this self-help disentanglement provision, however, is entirely
voluntary.28 Lastly, there is doubt as to whether Proto-Auto can continue to operate
in its current financial condition. Lola argues that the Company is insolvent insofar
as its liabilities significantly exceed its assets. The Defendants counter that these
liabilities largely represent loans required to be made by its members in the event that
Proto-Auto’s balance sheet shows negative net assets for a given year and that, under
the Operating Agreement, the members are limited in their ability to demand
repayment.29 Turning back to the Act once again, the relevant inquiry is not whether
the Company cannot possibly continue its business in accord with the Operating
Agreement, but rather whether to do so would be reasonably practicable. The fact
that Proto-Auto’s members have extended it significant additional working capital
27
Deadlock may be an understatement as Krohn has allegedly refused even to consider the matter.
Operating Agreement § 10.2 (“If a dispute relating to the affairs of the Company cannot be
resolved within 15 days of such dispute arising either party may serve a written notice that it intends
to implement the deadlock procedure set out in this clause.”) (emphasis added).
29
Defs.’ Opening Br. (First Compl.) at 20-21.
28
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
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raises an inference that it is no longer reasonably practicable for the Company to exist
even if these loans, if granted on a continual basis, could stave off ultimate business
failure. Thus, Lola’s allegations can satisfy two of Fisk’s three criteria.
Stepping aside from the particular factors articulated in Fisk, there are
important other facts alleged that allow for a reasonable conclusion that Proto-Auto’s
dissolution would be appropriate. The Company’s primary purpose is to develop and
manufacture race cars for sale in the Grand Am market with the long-term goal of
continually strengthening and expanding its position in this market. Lola was tasked
with designing and manufacturing the vehicles, while Krohn was responsible for
testing the vehicles and, of perhaps of greater importance, providing Hazell as ProtoAuto’s chief executive officer. The Operating Agreement does not specify who is to
be responsible for marketing and selling the vehicles, but it is not unreasonable for
one to assume that duty belonged to Hazell as, not only the chief executive officer,
but also one of two named officers in the Operating Agreement.30 In addition,
Hazell’s services were expressly agreed to be provided by Krohn in the Operating
30
The other is the secretary. Operating Agmt. § 5.2. Moreover, Hazell would appear to have
extensive contacts within the Grand Am Series community. Indeed, the Operating Agreement
tasked the chief executive officer with handling “relationships with [racing] competitors, including
driers, teams, team formation . . . .” Operating Agmt. § 5.4(c).
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
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Agreement—perhaps as Krohn’s primary obligation—which speaks to Hazell’s
central role in Proto-Auto’s management..
The First Complaint alleged Hazell’s failure to manage properly Proto-Auto’s
business, which included the lack of vehicle sales. More importantly, Lola claimed
that Hazell managed Proto-Auto more for Krohn’s benefit than for the Company’s,
and that Krohn refuses even to consider Hazell’s replacement. Lola’s allegations of
mismanagement and disloyalty, coupled with Proto-Auto’s poor performance and
Hazell’s apparent entrenchment as chief executive officer allow for the conclusion
that it is no longer reasonably practicable for Proto-Auto to continue its stated
business purpose. In fact, it is difficult to imagine how any company can attain
commercial success with, as alleged here, a careless and disloyal chief executive.
The Defendants also argue that the Operating Agreement clearly defines the
circumstances upon which it may be terminated and that, because such circumstances
do not include judicial dissolution, that option is necessarily precluded. Assuming for
current purposes that judicial dissolution under § 18-802 may be precluded
contractually, the fact that this particular Operating Agreement merely contains
several self-termination options and does not expressly provide for judicial
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
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dissolution does not make that statutory remedy unavailable. Each of the termination
provisions contained in the Operating Agreement is permissive and may be triggered
at a member’s election. Moreover, the Operating Agreement nowhere requires that a
member terminate the Operating Agreement solely in accord with its stipulated
termination provisions.
exclusive.
Thus, the Court cannot conclude that these terms are
It simply cannot be true that a number of nonexclusive, permissive
termination clauses in the Operating Agreement can preclude judicial dissolution as
provided for in the Act.31
B. Lola’s Derivative Claims and Demand Excusal
The Defendants have also moved to dismiss Lola’s fiduciary claims on the
ground that Lola has failed to plead demand futility with particularity as required by
Section 18-1003 of the Act. This provision mandates that, in any derivative action
brought by a member of a limited liability company, the complaint states with
particularity the plaintiff’s effort to either require the limited liability company’s
31
Indeed, the Act provides for dissolution upon “the happening of events specified in a limited
liability company agreement” in addition to a number of events specified in the statute, including
the end of the limited liability company’s term, at any time there are no members, and, of course,
upon judicial dissolution. 6 Del. C. § 18-802(a)(2).
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manager to initiate suit or explain why such effort was not made.32 Since this
provision originates with Court of Chancery Rule 23.1, which governs corporate
derivative suits, this Court has relied upon corporate precedent to interpret § 181003’s meaning and application, especially concerning whether demand is properly
excused.33
In the corporate derivative context, demand will be considered futile and thus
excused when the particularized factual allegations contained in the complaint create
a reason to doubt that 1) “the directors are disinterested and independent [or that]
2) the challenged transaction was otherwise the product of a valid exercise of
business judgment.”34 When dealing with a two-member board of directors, this
Court has previously held that a finding of interestedness on the part of one director
32
6 Del. C. § 18-1003.
See VGS, Inc. v. Castiel, 2003 WL 723285, at *11 (Del. Ch. Feb. 28, 2003) (“[C]ase law
governing corporate derivative suits is equally applicable to suits on behalf of an LLC.”).
34
Wood v. Baum, 953 A.2d 136, 140 (Del. 2008) (citing Aronson v. Lewis, 473 A.2d 805, 814 (Del.
1984)). There is some debate over whether the test articulated in Rales v. Blasband, 634 A.2d 927
(Del. 1993), applies to this action instead of the test prescribed in Aronson. The Rales test
essentially eliminates inquiry into the second Aronson prong and focuses entirely upon the first.
Because the First Complaint sufficiently alleges that Hazell is interested in the litigation, demand
has been excused under both tests, and thus determining which one applies is unnecessary.
33
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
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will excuse demand on the board.35 A director may be considered interested in the
litigation that might be the subject of pre-suit demand if that litigation threatens a
materially detrimental effect upon the director but not the company or its
shareholders.36 When making this determination, this Court requires a particularized
showing that the director faces a substantial likelihood of personal liability, and not
simply the mere risk of damages.37
Lola’s claims against Hazell for breach of the duties of care and loyalty are
plainly derivative, and thus Section 18-1003 applies. Because Lola did not make a
demand upon Proto-Auto’s board, the inquiry then turns to whether it alleged demand
excusal with particularity. The Defendants rely heavily upon this Court’s opinion in
Spellman v. Katz to support their argument that Lola failed to meet the particularized
pleading standard; however, the First Complaint stands in stark contrast to the
pleadings put before the Court in Spellman. In that case, the Court held that the
35
Beneville v. York, 769 A.2d 80, 82 (Del. Ch. 2000). The Court in Beneville recognized that the
“central question” in determining demand excusal is whether there “is a sufficient number of
impartial directors who can cause the corporation to act favorably on a demand by bringing suit.”
Id. Thus, where the directors of a two-director board have equal voting power and one is interested,
demand should be excused because that one interested director alone has the power to preclude
litigation.
36
Rales, 634 A.2d at 936.
37
Id.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 23
counterclaim plaintiff failed to plead a substantial risk of adverse litigation
consequences with particularity.38
The Court concluded that the counterclaim
plaintiff simply did not put forward sufficient facts to support his claim, and instead
merely concluded that the counterclaim defendant’s behavior had cost the company
significant savings without explaining how those savings would have been
achieved.39
The Court is persuaded that Lola has satisfied the particularized pleading
standard to allege that Hazell is interested under the Rales test. Lola claims that
Hazell faces a substantial risk of liability, detailing his alleged mismanagement, lack
of oversight, and disloyalty. Without delving into the facts of the First Complaint, it
should be emphasized that it pleads with particularity Hazell’s failure to maintain
appropriate inventory levels, pay state taxes in a timely fashion, and perhaps most
importantly, his use of Proto-Auto assets for Krohn’s benefit in violation of his duty
38
See Spellman v. Katz, 2009 WL 418302, at *6 (Del. Ch. Feb. 6. 2009) (finding that the plaintiff
failed to “articulate any particularized facts supporting his claim and thus ha[d] not satisfied his
pleading obligations”).
39
Id.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 24
of loyalty. In fact, Lola details with specificity the amount of profits lost in parts and
inventory that it contends Hazell undersold or allowed Krohn to misappropriate.40
Lola’s board consists of only two directors with equal voting power: Hazell
and Lola’s representative. Because these directors share equal control over the board,
Lola need only show that only one is interested and therefore may prevent litigation.
Hazell faces a substantial risk of liability under the facts as alleged; for this reason, he
may be considered interested, and thus Lola has satisfied the demand excusal
standard.41
C. Breach of the Implied Covenant of Good Faith and Fair Dealing
Lola alleges that Krohn breached the implied covenant of good faith and fair
dealing by unreasonably withholding its consent for removing and replacing Hazell
as Proto-Auto’s chief executive officer, which thereby harmed Lola’s interests in the
40
See supra note 9. Lola is unable to document exactly which parts were misappropriated or sold
under value due to Hazell’s failure to implement an accurate reporting system for inventory, and
because of Krohn and Hazell’s alleged refusal to submit to an internal audit. First Compl. ¶ 12(b).
41
Hazell perhaps could also be said to lack independence. He has served as the manager of Krohn’s
racing team since 2005; however, there are no particularized allegations as to the importance of this
status to Hazell. Because Hazell’s interest in this litigation has been sufficiently pled, an inquiry
into his independence is unnecessary.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 25
Company. Contracts under Delaware law42 contain an implied covenant among and
between the parties to act fairly and in good faith.43 This covenant restrains a
contracting party from engaging in arbitrary or unreasonable conduct that has the
effect of frustrating the contract’s overarching purpose and denying the other party
the benefit of its bargain.44 The Court, however, may not substitute its own notions
of fairness for the terms of the agreement reached by the parties, and will therefore
only invoke the implied covenant when the contract does not expressly address the
subject at issue.45 Instead, the Court will impose obligations upon the contracting
parties under the implied covenant only when the contract is silent to the disputed
topic, and where “it is clear from the contract that the parties would have agreed to
that term had they thought to negotiate the matter.”46
The Defendants argue, correctly, that the implied covenant may not apply to
matters covered by the contract.
42
They contend that the Operating Agreement
The parties agreed that the Operating Agreement would be governed by Delaware law. Operating
Agmt. § 19.2.
43
Fisk Ventures v. Segal (Fisk II), 2008 WL 1961156, at *10 (May 7, 2008).
44
Id.
45
Superior Vision Servs. v. Reliastar Life Ins. Co., 2006 WL 2521426, at *6 (Del. Ch. Aug. 25,
2006).
46
Fisk II, 2008 WL 1961156, at *10.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 26
expressly “mandates that Hazell shall be CEO” and “specifically addresses” his
retention.47
Indeed, the Operating Agreement grants Krohn exclusive power to
replace Hazell when he resigns on his own volition.48 For these reasons, they argue
that Lola has no right to remove Hazell, and that Krohn has no obligation to assent to
Lola’s demands. Krohn reasons that if Lola wanted to the right to remove Hazell, it
could have bargained for that right when the parties established the Company.
Krohn mischaracterizes Lola’s implied covenant claim, which rests upon
Krohn’s failure even to consider Hazell’s termination or to attend board meetings to
that end, and not upon Krohn’s obligation (or lack thereof) to assent to Lola’s
demands. This is especially so when one considers the damage that Hazell has
allegedly inflicted upon Proto-Auto’s ability to market and sell vehicles, which in
turn has allegedly frustrated Lola’s purpose for entering into the Operating
Agreement. Although Krohn may indeed be under no obligation to agree to Hazell’s
termination, the Court, in the context of this motion to dismiss, may draw a
47
Defs.’ Reply Br. (First Compl.) at 22; Defs.’ Opening Br. (First Compl.) at 25.
See Operating Agmt. § 3.7 (making Krohn “responsible for providing to the company free of
charge . . . the services of Jeff Hazell, or a suitably qualified replacement of Mr. Hazell should Mr.
Hazell determine not to continue in such duties, as Chief Executive Officer”) (emphasis added).
48
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 27
reasonable inference that Krohn acted inappropriately and in bad faith by failing to
consider Lola’s request to have Hazell removed.
D. Lola’s Second Complaint and Whether it Should be Dismissed with Prejudice
The Court will dismiss the Second Complaint, but without prejudice. Court of
Chancery Rule 15(aaa) allows a party to respond to a motion to dismiss under
Rule 12(b)(6) or Rule 23.1 by amending its complaint, but such amendment can come
no later than when that party’s answering brief is due to be filed. The Rule goes
further to state that, in the event a party fails to file an amended complaint, and the
Court thereafter finds that the Complaint should be dismissed, the dismissal is to be
with prejudice.
Rule 15(aaa), however, gives this Court authority to dismiss a
complaint without prejudice, but only for good cause shown when dismissal with
prejudice would not be just under the circumstances.
Here, Lola chose to answer Krohn’s motion to dismiss instead of amending the
Second Complaint. This complaint, as filed, should be dismissed for failure to state a
claim. In the Second Complaint, Lola claims that the First Complaint, filed May 20,
2009, constituted proper notice upon Krohn in accordance with Section 10.1 of the
Operating Agreement.
Because Krohn purportedly failed to cure the material
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 28
breaches described in the First Complaint, Lola claims it now has the right to
terminate it. Section 10.1 allows a member to terminate by written notice if the other
party materially breaches the Operating Agreement, and is advised in writing of the
breach and the consequences of failure to rectify the breach. The First Complaint
fails to serve as proper notice under this provision because it did not state the
consequences of failure to cure the alleged breaches. Indeed, in the First Complaint,
Lola specifically sued for damages upon the alleged breaches, not for termination
pursuant to Section 10.1 of the Operating Agreement.
Lola’s September 22, 2009, letter, on the other hand, provides proper notice as
required by Section 10.1.49 The September 22 letter advises Krohn of its material
breaches by reference to an earlier letter sent on September 10, 2009.50
The
September 10 letter lists five alleged breaches,51 and the September 22 letter properly
49
September 22, 2009, Letter, Ex. C to Pl.’s Answering Br. (Second Compl.).
The September 10 letter has been filed as Exhibit B to the Second Complaint.
51
Specifically, Lola advised Krohn that it had materially breached the Operating Agreement by
1) failing to furnish Lola with track and performance data as required by Section 3.7(b) of the
Operating Agreement; 2) failing to furnish Lola with proposed budgets, comparative analysis of
projected and actual accounts or profit and cash flow forecasts for Proto-Auto as required by
Article 6 of the Operating Agreement; 3) failing to furnish Lola with Proto-Auto financial
statements in a timely fashion as required by Section 6.6 of the Operating Agreement; 4) failing to
cause Proto-Auto to repay Lola its disproportionate share of the members’ loan imbalance as
50
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 29
served notice of these breaches by reference. The September 22 letter also advised
Krohn that if it failed to cure the breaches within twenty-one days “of this letter,” it
would consider the Operating Agreement terminated. By specifying the material
breaches and informing Krohn of the consequences of failing to remedy, the
September 22 letter meets the Operating Agreement’s notice standard.
Dismissing the Second Complaint without prejudice and allowing Lola to file a
complaint anew that relies upon the September 22 letter as notice will work a just
result. The Operating Agreement grants both Lola and Krohn the contractual right to
terminate in the event the other party commits a material breach. By dismissing with
prejudice, the Court would arguably deprive Lola of this bargained-for right. Such a
right promotes efficiency by preventing one party from being trapped in a business
arrangement that may have suddenly taken a turn for the worse.
The question of whether Krohn has materially breached the Operating
Agreement was also raised in the First Complaint, and is bound in part with the final
determination of whether Proto-Auto should be dissolved. For this reason, the factual
required by Section 11.3 of the Operating Agreement; and 5) failing to cause Proto-Auto to hold
regular meetings of its Board as required by Section 5.3 of the Operating Agreement.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 30
resolution of the issues raised by the Second Complaint will likely be resolved at trial
of the matters raised in the First Complaint with or without the later-filed action.
Dismissing without prejudice and allowing Lola to file a new complaint will do little
to change the calculus of the now-pending trial.
The Defendants argue as a final point that even if the Court were to find the
Operating Agreement terminated pursuant to Section 10.1, it does not follow that
Lola should be granted control of the Company. For this reason, the Defendants
maintain that Lola is simply not entitled to the relief requested by the Second
Complaint and it therefore failed to state a cause of action. The Defendants may be
correct that Lola is not entitled to control of the Company if the Operating Agreement
is terminated pursuant to Section 10.1; however, this does not mean that Lola failed
to state a claim. The main issue tendered by the effort to gain dismissal of the Second
Complaint is whether or not the Operating Agreement will terminate by virtue of
Krohn’s material breaches, and not the specific relief that might accrue to Lola
following that determination.
Lola Cars Int’l Limited v. Krohn Racing, LLC
C.A. Nos. 4479-VCN and 4886-VCN
November 12, 2009
Page 31
III. CONCLUSION
For the foregoing reasons, Defendants’ Motion to Dismiss the First Complaint
is denied, and Defendants’ Motion to Dismiss the Second Complaint is granted, but
without prejudice.
IT IS SO ORDERED.
Very truly yours,
/s/ John W. Noble
JWN/cap
cc: Register in Chancery-K
