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Capone v. LDH Mgmt. Holdings, LLC, C.A. No. 11687-VCG (Del. Ch. April 25, 2018) (Glasscock, V.C.)

April 25, 2018

In this decision, the Delaware Court of Chancery found that a limited liability company was aware of potential, non-frivolous claims against the company at the time of its dissolution, and because the company failed to create a reserve to cover the potential claims, the Court nullified the company’s certificates of cancellation.

Defendant Castleton Commodities International LLC, formerly known as Louis Dreyfus Highbride Energy LLC (“LDH”) is a commodities trading company. In 2009 LDH formed Defendant LDH Management Holdings LLC (“Management Holdings”).  Plaintiffs Capone and Scheinman served as the company’s head trader and general counsel, respectively, before their termination. Both Capone and Scheinman held units in Management Holdings, and pursuant to the Management Holding’s LLC agreement, Management Holdings redeemed Capone and Scheinman’s units for the units’ “Fair Market Value” (as defined in the LLC agreement) as of December 31, 2010, the date Capone and Scheinman were fired.

During this time, in the fall of 2010, LDH was exploring a sale of a large portion of its assets and a potential buyer allegedly emerged willing to pay close to $2 billion. However, before Capone and Scheinman were terminated, LDH performed its own valuation of the assets as part of an issuance of a new series of units (the “December 23 valuation”). They used four different valuation methodologies and estimated the assets were worth $1.43 billion as of December 31, 2010. Capone and Scheinman took issue with several aspects of the December 23 valuation, including that LDH management used higher discount rates and lower EBITDA multiples than they had used in pervious valuations used in connection with.

In early 2011, Capone reached out to LDH executives expressing concern that the fair market value of the assets were set exceedingly low in light of the bids that were coming in around that time. Capone wrote that if the assets were undervalued, it would be “devastating” to his redeemable units and he would “perhaps formally question” the valuation. Scheinman also expressed concern; according to an email between LDH management labeled “PRIVILEGED & CONFIDENTIAL ATTORNEY WORK PRODUCT,” a LDH executive indicated that Scheinman wanted to discuss the valuation issue. In March 2011, LDH sold the assets for $1.925 billion, and the following month, LDH redeemed Capone and Scheinman’s units according to the December 23 valuation of $1.43 billion. Capone and Scheinman continued to reach out to LDH management to expressing confusion regarding the discrepancy of the two valuations. Capone discussed the valuation with a LDH executive over the phone, and Capone testified that he told the executive that the Defendants were “acting in bad faith” under the LLC agreement and that “he had breached, very clearly.”

In December 2012, LDC was acquired by a third-party investor and Management Holdings was cancelled. During the wind down process, the Defendants did not notify the Plaintiffs of the cancellation, and the Defendants did not reserve funds for Plaintiffs’ potential claims relating to the breach of the LLC agreement. In May 2015, the Plaintiffs sued Management Holdings in New York for, inter alia, breaching the LLC agreement, alleging the Defendants failed to determine in good faith the fair market value of the assets considering the difference between the December 23, 2010 valuation of $1.4 billion and the March 2011 asset sale price of $1.925 billion.

Plaintiffs then commenced this action in November 2015 to nullify the cancellations. Plaintiffs claimed the Defendants violated Section 18-804(b)(1) of the LLC Act by cancelling Management Holdings without setting aside a reserve for the Plaintiffs’ breach of contract claims, even though the Defendants knew, or should have known, that the claims were likely to arise.  Defendants claim that their failure to set aside funds for the potential action was proper because the Plaintiffs’ claims were “meritless.” The parties cross-moved for summary judgment.

The Court granted the Plaintiffs’ motion and denied the Defendants’ motion.  First, the Court found that the Defendants were on notice of the Plaintiffs’ potential claims. Capone objected the December 23 valuation of the assets and confronted LDH management, stating that he was worried that the fair market value of the assets were exceedingly low, “especially in light of the bids for the [assets] that came in” just a few days before. He communicated his concerns numerous times with LHD management, specifically telling a LDH executive that if the assets were indeed undervalued, he would need to review and “perhaps formally question.” He spoke with a LDH manager on the phone an accused the Defendants of acting in bad faith and stating he thought they had breached. While Scheinman was not as vocal as Capone, an email between the LDH management indicating Scheinman had expressed his concern with the valuation of the assets was sufficient to put the Defendants on notice of the Plaintiffs’ potential claims.

The Court then found that the Defendants failed to set aside reasonable provisions to address the potential claims. The Court disagreed with the Defendants’ defense that they reasonably thought the claims were “meritless.” The Court explained that had a delusional individual threatened to sue the company for payment connected with his employment, but in fact had never worked for the company, the potential claims would obviously be frivolous and reserving zero dollars for that claim would be proper. Similarly, if a claim is procedurally bared by, e.g., the statute of limitations, then the claim would be legally frivolous. However, even a relatively weak claim may justify a reserve, especially where, as in this case, the claim raises the prospect of a large damage reward. The Court emphasized that its task was not to decide the merits of the underlying breach of contract claim. Rather, it was tasked to determine the reasonableness of Management Holdings’ reserves at the time of the dissolution. The Defendants’ reserve of zero dollars for the Plaintiffs claim was not reasonable; the dissolution, therefore, violated Section 18-804(b)(1) and the Court nullified the cancellation.

The full opinion is available here