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Lola Cars Int'l v. Krohn Racing, LLC, C.A. Nos. 4479-VCN, 4886-VCN (Del. Ch. Aug. 2, 2010) (V.C. Noble)

August 2, 2010

In this memorandum opinion, Vice Chancellor Noble declined to order dissolution of a Delaware limited liability company (the “Company”) when the complaining member, “Lola”, failed to prove its breach of contract and fiduciary duty claims and had an exit mechanism available to it pursuant to the Company’s operating agreement.

The Company was formed for the purpose of manufacturing and selling race cars on a “sound, profit-making commercial basis.” Although the members shared equal board representation, one member, “Krohn Racing,” held primary management responsibility over the Company. Relations among the parties deteriorated, and litigation ensued.

At trial, the Court considered Lola’s claims for breach of contract and breach of fiduciary duties against Krohn Racing and the Company’s chief executive officer, Jeffrey Hazell, (“Hazell”). Lola sought termination of the operating agreement and control of the Company, or, alternatively, an order for dissolution of the Company. Although the Court noted that Lola rightly had cause for concern regarding a loan imbalance and inventory account issues, the Court determined that such issues had been resolved or were proven “immaterial or innocent” at trial.

The Court confirmed that, absent language in a limited liability company’s  operating  agreement eliminating, restricting or otherwise modifyingfiduciary duties, a manager owes to such company traditional fiduciary duties of care and loyalty as applicable to corporate fiduciaries. In order to prove a claim of an alleged violation of a fiduciary’s duty of care, the movant must satisfy the high standard that the fiduciary “acted with gross negligence, which has been defined as ‘reckless indifference’ or conduct beyond the ‘bounds of reason.’” Here, although Hazell arguably wasted time and money, and was naive in lobbying for an exemption to a new Grand-Am regulation, Hazell’s efforts, if successful, could have saved the Company money and time going forward; the members of the Company agreed that the new regulation was not a good one; and, therefore, Hazell’s conduct “was neither reckless nor the product of gross negligence.” In addition, two significant inventory write-downs were found to not result from mismanagement by Hazell, but rather most likely from poor implementation of accounting software among affiliates, all of which the Court found to be immaterial. The Court also rejected unsubstantiated claims that Hazell sold parts to an affiliate below market value and that Hazell failed to market or sell the Company’s products to third parties. Lola maintained that Hazell failed to sell more than two cars and failed to assertively market the Company’s products because of Hazell’s alleged conflict of interest given Hazell’s interest in Krohn Racing. The Court rejected the claim of an alleged conflict because Hazell’s lack of independence and potential conflict was known at the time of the Company’s formation which lessened any concern that the Court might have regarding Hazell’s loyalties. The Court also did not find sufficient evidence at trial that Hazell caused the Company to incur expenses which instead should have been incurred by Krohn Racing.

Lola sought a declaratory judgment that the Company’s operating agreement be terminated, thereby enabling Lola to assume control over the Company. The Court rejected this claim. The operating agreement permitted termination of the operating agreement by any member upon the failure of the other member to cure a material breach thereof within a proscribed time period. The Court noted as a threshold matter that Lola failed to properly calculate the cure period which was significant because Krohn Racing attempted to cure the purported breaches prior to the end of the actual cure period. With respect to Lola’s claim that Krohn Racing materially breached the operating agreement, the Court looked to the Restatement (Second) of Contracts (Section 241) for a definition of materiality since the operating agreement was silent on this point. Applying the Restatement test, the Court found that Lola failed to prove that Krohn Racing’s alleged breaches (e.g., failure to provide certain performance data and financial information, failure to repay its share of a loan imbalance and failure to cause the Company to hold regular meetings) were material. The Court rejected Lola’s argument that Krohn Racing breached the implied covenant of good faith and fair dealing by refusing to replace Hazell as the Company’s chief executive officer because Lola failed to satisfy the high burden of proving that the replacement of Krohn should be inferred into the operating agreement when Lola could not establish most of its claims at trial and in light of the fact that Krohn Racing had been willing to consider Hazell’s replacement if Lola provided proof (e.g., audited financials) of Hazell’s  misconduct.

Krohn Racing’s counterclaims for breach of contract, liability for filing a petition for judicial dissolution and fee shifting for bad faith commencement of the parties’ litigation was dismissed, as such claims were not proven at trial, but the Court granted Krohn Racing’s motion for an injunction preventing Lola from blocking shipment of a chassis (as Lola did not have the authority to do so).

Finally, the Court denied Lola’s petition for judicial dissolution because Lola failed to prove at least some of its claims (the most troubling of which was that parts were lost or stolen because of Hazell’s gross negligence) at trial and because Lola had an exit mechanism, albeit not an ideal remedy, pursuant to the operating agreement. Therefore, the Court declined to exercise its discretion and order dissolution for a movant that (i) “simply ended up stuck in a business relationship that had not worked out to its liking,” (ii) was unsuccessful in getting the other member to change the terms of their deal, and (iii) had brought on much of the parties’ dispute itself. The Court noted that, although the members were not in a “deadlock” because day-to-day management was vested in Hazell and therefore the Company was able to operate in accordance with the Company’s limited liability company agreement, the Company was a joint venture of two members with equal board representation and therefore required the members’ cooperation in order to thrive. Accordingly, the Court expressed concern over the Company’s future; however, such concern was tempered by the exit mechanism available to the members. The Court emphasized that judicial dissolution is not a mechanism by which a disgruntled party may simply escape a bad deal at the cost of another party’s reasonable expectations.

The full opinion is available here