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Phillips v. Hove, C.A. No. 3644-VCL (Del. Ch. Sept. 14, 2011) (Laster, V.C.)

September 14, 2011

In this memorandum opinion, the Court of Chancery ordered the judicial dissolution and winding up of a Delaware member-managed limited liability company after finding that the member-managers were deadlocked and it was not reasonably practicable to carry on the business. The Court also held that one of the member-managers as well as an officer breached their fiduciary duty of loyalty to the limited liability company (the “LLC”) by using LLC property for their own benefit.

In 1997, Eric Phillips was the sole stockholder in Wicks’ End, Inc., a Delaware corporation, which sold candles online using the domain name wicksend.com. Approximately one year later, Phillips acquired candles.com, a first-tier generic domain name worth potentially $2-4 million. In December 2005, David Schifino, a former roommate of Phillips, and Stephen Hove, a business acquaintance of Schifino, drafted a term sheet for a Schifino-Hove investment vehicle to loan Wicks’ End $500,000 in exchange for a security interest in the candles.com domain name. Schifino and Hove initiated this deal in order to gain control of candles.com. Schifino and Hove believed that without additional capital, default would likely result, thus allowing Schifino and Hove to levy on candles.com.

On February 20, 2007, Phillips and Schifino drafted a four-page document (the “GnB Agreement”) that called for Phillips and Schifino to form a member-managed Delaware LLC (“GnB”). The  “ambiguous” GnB Agreement provided that the entity would be equally owned by Phillips and Schifino’s investment entity (the “Schifino Investment Entity,” which the Court later determined to be Firehouse Gallery, LLC (“Firehouse”)) while Phillips and Schifino would own voting membership interests. The GnB Agreement also provided that GnB would pay Phillips $50,000 in exchange for all of Wicks’ End’s assets while Firehouse would loan GnB up to $500,000 in exchange for a Domain Purchase Right. The Domain Purchase Right provided for GnB to enter into a purchase agreement with Phillips to acquire candles.com for $2 million, which would be payable at any time within five years of the creation of the GnB Agreement, or upon the sale of the entity. The GnB Agreement also provided that until the domain name was purchased or the GnB Agreement was otherwise terminated, GnB would have an exclusive license to use the candles.com domain name (the “Exclusive Domain License”). In addition, Phillips had a right to terminate this license if GnB ceased doing business or went bankrupt (the “Termination Right”). Finally, the GnB Agreement provided that if Phillips exercised his Termination Right, GnB would have no further right to purchase the domain name.

Then Schifino, presumably to add capital and increase the likelihood of default, shut Phillips out of the business operations, undertook an expensive software development project on behalf of GnB, and denied Phillips access to financial information. Then in November 2007, Hove bought out Schifino’s interest in Firehouse and took over all day-to-day operations of GnB. In April 2008, Hove, in bad faith, without actual authority, and presumably to force Phillips to sell his share in GnB, filed a bankruptcy petition on behalf of GnB in Florida. Thereafter, Phillips executed his Termination Right, and GnB obtained a temporary restraining order preventing its execution. In April 2009, Hove dismissed the bankruptcy case; litigation ensued to determine the rights of the parties.

Phillips sought declarations that (i) Firehouse was not a voting member of GnB thus giving Phillips control of the LLC; (ii) he properly terminated the Domain Purchase Right and Exclusive Domain License; and (iii) he did not agree to transfer additional candle-related domain names to GnB. Firehouse and Hove sought contrary declarations and contended that the Court lacked jurisdiction over Hove.

First, the Court of Chancery concluded that Firehouse was a voting member and not an assignee of Schifino. After analyzing the “ambiguous” GnB Agreement, the Court found that Schifino invested in GnB through Firehouse, not individually, thus giving Firehouse a 50% voting interest and creating a deadlock between it and Phillips.

econd, the Court held that GnB continued to hold the Domain Purchase Right and the Exclusive Domain License because the Bankruptcy Code prevented Phillips from executing his Termination Right. Citing 11 U.S.C. Section 541 (c)(1)(B) and 349(b)(3) of the Bankruptcy Code, the Court stated that when a bankruptcy petition is filed, the “debtor’s property ‘becomes property of the [bankruptcy] estate . . . notwithstanding any provision in an agreement.’” When a bankruptcy case is dismissed, the property of the estate is revested “in the entity in which such property was vested immediately before the commencement of the case.” Therefore, the Court held that when Hove filed the bankruptcy petition, Phillips could not terminate those rights. When Hove dismissed the bankruptcy case, GnB and its assets returned to the pre-bankruptcy status quo. As such, GnB continued to hold the Domain Purchase Right and Exclusive Domain License at the time of Phillips’ lawsuit notwithstanding the failed attempt to execute the Termination Right.

Third, the Court concluded that Phillips transferred all candle-related domain names to GnB. The GnB Agreement provided that GnB would pay Phillips $50,000 for “all of Wicks’ End’s assets,” which, the Court concluded, included the candle-related domain names.

Fourth, the Court analyzed whether Phillips and Hove breached their fiduciary duties to GnB and its members.  Hove argued that he was not subject to the jurisdiction of the Delaware Court of Chancery. The Court, however, held that it had jurisdiction over Hove because he took control of GnB’s day-to-day operations.  Under Section 18-109(a) of the Delaware Limited Liability Company Act (“DLLCA”), implied consent jurisdiction extends to “a person, whether or not a member of a limited liability  company, who, although not a manger as defined in Section 18-101(10) of this title, participates materially in the management of the limited liability company.” The Court held that through Hove’s operation of GnB’s day-to-day business, he participated materially in the management of GnB, thereby consenting to suit in Delaware.

The Court then held that both Hove and Phillips owed traditional fiduciary duties to GnB and its members. The Court stated that, unless limited or eliminated in the LLC agreement, the member-managers of a Delaware LLC owe traditional fiduciary duties to the LLC and its members. The Court stated that Phillips owed fiduciary duties to GnB and its members because he was a member-manager and the GnB Agreement did not limit or eliminate fiduciary duties. The Court also held that Hove owed fiduciary duties to GnB and its members because he became president and took control over day-to-day operations.
 
The Court then concluded that both Hove and Phillips breached their fiduciary duty of loyalty. Quoting In re USACafes, L.P. Litig., 600 A.2d 43, 48 (Del. Ch. 1991), the Court stated that the “principle of fiduciary duty, stated most generally, [is] that one who controls property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner.” Here, Phillips used GnB’s principal asset, candles.com, for his own benefit and competed with GnB by continuing to operate Wicks’ End, a violation of the GnB Agreement. Hove, on the other hand, took control of GnB’s cash and inventory and sold products from GnB’s inventory through a competing online candle business that he established. As a result, the Court concluded that both Phillips and Hove breached their duty of loyalty and ordered them to account to GnB for the profits they earned from their disloyalty.

Finally, the Court ordered the dissolution and winding up of the LLC because it was not reasonably practicable to continue to operate its business. Under Section 18-802 of the DLLCA, “[o]n application by or for a member or manager the Court of  Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the limited liability company agreement.”  Here, Phillips and Firehouse were coequal owners and managers of GnB and their agreement was required for GnB to take action. The Court found that a deadlock existed because of the great deal of animosity between the two parties and their inability to agree on basic issues. Citing Fisk Ventures, LLC v. Segal, 2009 WL 73957, at *4 (Del. Ch. Jan. 13, 2009), the Court said that if a deadlock “cannot be remedied through a legal mechanism set forth within the four corners of the operating agreement, dissolution becomes the only remedy available as a matter of law.” The GnB Agreement provided that any deadlocked decisions would be decided by a board of directors. Here, because the parties never agreed on the composition of a board of directors and animosity precluded doing so, there was no effective mechanism to break the deadlock. As such, the Court held that it was not reasonably practicable to carry on the business of GnB and ordered its dissolution.

The full opinion is available here