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R&R Capital, LLC v. Merritt, C.A. No. 3989-CC (Del. Ch. Sept. 3, 2009)

September 3, 2009

In this case, the Delaware Court of Chancery found the removal of the manager of nine Delaware LLCs (the “Entities”) for cause valid and ordered the appointment of a receiver to dissolve and wind up the Entities. The plaintiffs and the defendant, Linda Merritt (“Merritt”), were members of the Entities, and Merritt was also the manager of the Entities. The parties’ working relationship greatly deteriorated over time, and in August 2008, the plaintiffs gave Merritt notice of her termination as manager of the Entities. The plaintiffs and the defendant both moved for summary judgment, with the plaintiffs seeking a declaratory judgment that Merritt’s removal as a manager was valid and the defendant seeking the opposite ruling.

The operating agreement of each of the Entities’ (the “Operating Agreements”) permitted the plaintiffs to remove Merritt as manager for “cause.” The Operating Agreements defined “cause” as meaning, among other things, that the manager shall have “(a) engaged in fraud or embezzlement [or] (b) committed an act of dishonesty, gross negligence, willful misconduct, or malfeasance that has a material adverse effect on the Company or any other Member….”

The plaintiffs claimed that they had sufficient cause under the Operating Agreements to remove Merritt as manager due to the underlying facts of a Pennsylvania District Court action between the plaintiffs and the defendant in which the Pennsylvania District Court found that Merritt had made fraudulent and material misstatements in connection with her sale of a horse to the plaintiffs. A New York Court later reviewed the same facts for a different claim without reaching a final judgment on the transaction at issue in this matter. Merritt argued that the plaintiffs could not establish cause from these facts based on three arguments, all of which the Delaware Court of Chancery rejected.

First, Merritt argued that res judicata barred the plaintiffs from bringing their removal claim because the New York Court had already decided the matter. The Delaware Court of Chancery rejected this argument on the grounds that the New York Court’s decision was not final, particularly with respect to the facts as they related to the removal action. According to the Delaware Court of Chancery, without a final judgment, res judicata could not bar the issue of fraud as cause for removal. The Delaware Court of Chancery rejected Merritt’s collateral estoppel and judicial estoppel claims on the same grounds.

Second, Merritt argued that each of the Entities’ Operating Agreements required that the Entities suffer a material adverse effect as a result of her fraud to establish cause for removal, and she claimed that the plaintiffs could not show such effect. The Delaware Court of Chancery rejected this argument, finding that because the “material adverse effect” language appears only in subsection (b) of the definition of “cause,” it applies only to that subsection and not the section as a whole, and therefore was not applicable to subsection (a) or a removal based on fraud. The Court further reasoned that even if it accepted Merritt’s interpretation, the plaintiffs could in fact establish cause because there was a clear material adverse effect on another member (i.e. the plaintiffs).

Third, Merritt raised a procedural argument that the notice of her removal was ineffective because no court had established cause prior to her receipt of notice. The Delaware Court of Chancery rejected this argument based on the plaintiffs’ belief, as stated in their notice of removal, that the facts adjudicated in the Pennsylvania and New York actions established cause.

The Delaware Court of Chancery therefore entered summary judgment in favor of the plaintiffs and against the defendant, finding that Merritt was validly removed as manager. In addition, because Merritt remained a member of the Entities despite her removal as manager and the members could no longer co-exist in a functional working relationship, the Delaware Court of Chancery ordered the appointment of an independent receiver to dissolve and wind up the Entities.

The full opinion is available here