In Capone v. LDH Management Holdings, LLC,[1] the Court of Chancery considered the legal principles involved in nullifying an LLC’s certificate of cancellation due to its failure to set aside reasonable provisions as required by the Act.[2] Vice Chancellor Glasscock’s April 2018 opinion created a broad standard for what qualifies as a “reasonable provision” and revived a dissolved DLLC, reopening the door for pending litigation in New York. [3] Ultimately, Capone not only redefines “reasonable” to encompass a nearly limitless scope of potential actions, but the court also hints at the potential for claims to be brought individually against the managers of a dissolved LLC.[4]

Factual and Legal Background

Capone involves two former, high-level employees[5] of an LLC challenging the valuation used in a call of their equity. Per the terms of the LLC Agreement, the valuation was conducted prematurely, and failed to consider offers for the sale of company assets which occurred shortly after the valuation date. The valuation of the entity was considerably lower than the value of just the assets sold mere weeks later,[6] without any evidence whatsoever to indicate that the assets materially increased in value between the valuation and their sale.[7]

Ruling on cross-motions for summary judgment, Vice Chancellor Glasscock held for the Plaintiffs, finding that the management of the LLC was aware of the claims at the time of dissolution and improperly failed to reserve reasonable funds to address them because they wrongly considered those claims meritless. As a result, the court ruled that the “LLCs were dissolved in violation of Section 18-804(b)(1), and the certificates of cancellation should be nullified.”[8]

The Law and the Court’s Analysis

The court considered the case in terms of (1) a violation of the provisions of the Act, and (2) a breach of contract for violating the LLC Agreement.

The controlling provision of the Act is Section 18-804(b) which requires all LLCs to make reasonable provision to provide compensation for any current or possible future claims against the entity of which they have knowledge. [9] Additionally, “Section 18-804(b)(3) requires that an LLC undergoing the wind-up process must make such provision as will be reasonably likely to be sufficient to provide compensation for” potential legal claims that are “based on facts known to the LLC, [and] are likely to arise or to become known to the LLC within 10 years after the date of dissolution.”[10] In determining what constitutes a “reasonable provision,” the court considers “several factors, including the potential amount of such a claim and the likelihood of it actually becoming a liability for which the company must answer.”[11] In other words, provision must be made for any and all claims for which the LLC or management have notice, which the Act defines as “actual knowledge” rather than “constructive knowledge.”[12]

Although there are instances that may justify setting aside a reserve of zero dollars, in Capone the court limited those instances to (1) “where the claim is procedurally barred,” or (2) “where the claim itself is legally frivolous.”[13] A claim is not considered frivolous if its chances of success are unlikely, but rather only where the claim “lacks even a good faith, arguable basis in law.”[14] These strict standards imply a limited flexibility for dissolving LLCs. In Capone, the court unequivocally concluded that the management of the LLC was aware of specific accusations alleging improper methods and breach of contract in connection with the valuation of the LLC Units a year and a half before its dissolution. Because of the LLC’s failure to set aside provision for these known claims, the dissolution violated the Act, therefore justifying the nullification of the certificate of cancellation.

The LLC violated the LLC Agreement in two ways. First, the Agreement called for valuation of gross asset value to be performed on December 31 of the year prior to sale. However, in this case, the LLC performed the valuation on December 23, over a week before the relevant date defined in the Agreement.

Second, the LLC Agreement required management to “adjust the Gross Asset Value of LDH’s assets immediately prior to the sale in good faith.”[15] As the court notes, there is no evidence on the record to indicate that the assets materially increased in value between the time of valuation and the sale. The Plaintiffs successfully argued that the LLC Agreement’s “good faith valuation could not ignore market evidence suggesting” that the assets were worth far more than the valuation implied and thus the value should have been adjusted prior to the redemption of their Units.[16]

Conclusion

The court held that the LLC’s certificate of cancellation should be nullified due to its violations of both the Act and the Agreement. Because the LLC failed to provide a reasonable reserve for the Plaintiffs’ non-frivolous claims at the time of dissolution, the entity was reinstated, and the litigation for substantive claims continues in New York.