VGS, Inc. v. Castiel

Brief Fact Summary.

David Castiel (Plaintiff) formed VGS, Inc. (Defendant) as a one-member limited liability company (LLC).  The one member was Virtual Geosatellite holdings.  Two other entities, Sahagen Satellite and Ellipso, Inc., later became member/shareholders of the LLC.  Castiel named himself and Tom Quinn to the board of managers, and Sahagen named himself as the third member.  Sahagen and Quinn then decided to restructure VGS (Defendant) in such a manner that Plaintiff would become a minority shareholder.  They effectuated the restructuring without giving notice to Plaintiff.

Synopsis of Rule of Law.

A limited liability corporation agreement requires managers to fulfill their duty of loyalty by acting in good faith to one another.

Facts.

VGS, Inc. (Defendant) was controlled by David Castiel (Plaintiff), a single individual who formed VGS (Defendant) as a one-member limited liability company (LLC).  Afterwards, two more entities, Sahagen Satellite and Ellipso, Inc., became members of the LLC.  The LLC agreement formed a three-member board of managers with broad authority to govern the LLC.  Castiel (Plaintiff), the individual owning the original member, was authorized to name and remove, two of the three managers and also acted as CEO.  Castiel named himself and Tom Quinn to the board of managers, and Sahagen named himself as the third member.  Sahagen and Quinn became disappointed with Plaintiff’s leadership. Sahagen eventually convinced Quinn to help him strategically move to merge the LLC into a Delaware Corporation in secret.  Quinn, the appointed manager, and the disaffected third member, Sahagen, did not inform the Plaintiff, an ongoing member of the LLC’s board of managers, about their strategic move.  Following the merger, the Plaintiff found himself demoted to a minority position in the new corporation.  Plaintiff brought suit in equity to set aside the merger, arguing that, even though a majority of the board acted by written consent, if Plaintiff had received notice beforehand that his appointed manager contemplated action against his interests, he would have immediately tried to remove him.  Plaintiff contended that because his two fellow managers (Sahagen and Quinn) acted without notice to Plaintiff under circumstances where they were aware that with notice he could have acted to protect his majority interest, they breached their duty of loyalty to him by failing to act in good faith.

Issue.

Does a limited liability corporation agreement require managers to fulfill their duty of loyalty by acting in good faith to one another?

Held.

(Steele, V. Chan.)  Yes.  A limited liability corporation agreement requires managers to fulfill their duty of loyalty by acting in good faith to one another.  In this situation, by not giving Plaintiff notice of their plan, Sahagen and Quinn (hence VGS, Inc.) (Defendant) failed to discharge their duty of loyalty to Castiel and exercise their duty of good faith toward him.  Section 18-404(d) of the LLC Act states, in part, that the managers of the LLC company may take actions without a vote if a consent in writing, setting for the action taken, is signed by the managers having at least the minimum votes necessary to authorize such action at a meeting.  Therefore, the LLC Act, read literally did not require notice to Plaintiff before Sahagen and Quinn could act by written consent.  However, this observation does not complete the analysis of Sahagen’s and Quinn’s actions.  Sahagen and Quinn knew what would happen if they informed Castiel (Plaintiff) of their intention to act by written consent to merge the LLC into VGS, Inc.  Plaintiff would have tried to remove Quinn and block the planned action.  The purpose of allowing action by written consent without notice is to enable LLC managers to take quick, efficient action in situations when a minority of managers could not block or adversely affect the course set by the majority, even if the minority were notified of the proposed action and objected to it.  The legislators did not intend to enable two managers to deprive, secretly and underhandedly, a third manager who represented the majority interest in the LLC of a chance to protect that interest by taking an action that the third manager’s member surely would have opposed if he was aware of it.  Equity looks to the intent rather than to the form.  Here, in this hopefully unique situation, this application of the maxim requires construction of the statute to permit action without notice only by a constant or fixed majority.  It cannot apply to an false, imaginary majority which would implode if notice were given.  Nothing in the statute suggests that a court of equity should blind its eyes to a shallow, too clever by half, manipulative attempt to restructure an enterprise through an action taken by a “majority†that existed only if it could act in secrecy.  Even though a majority vote of the LLC’s board of managers could properly effect a merger, Sahagen and Quinn failed to discharge their duty of loyalty to Plaintiff in good faith when they failed to provide advance notice of their merger plans under the unique circumstances of this case and the structure of this LLC agreement.  And so, the acts taken to merge the LLC into VGS, Inc. were invalid, and the merger is ordered rescinded.

Discussion.

In the VGS case, managers Sahagen and Quinn each owed a duty of loyalty to the LLC, its investors, and Castiel (Plaintiff), the third manager.  Plaintiff owned a majority interest in the LLC and also sat as a member of the board.  As majority investor, he protected his equity interest in the LLC through the mechanism of appointment to the board rather than by the mechanism of approval, as sanctioned by statute, by members owning a majority of the LLC’s equity interests.  Instead of relying on the default position of the statute, which requires a majority vote of the equity interest, the agreement permitted the action to merge, dissolve or change to corporate status by a simple majority vote of the board of managers.  The drafters rather made the critical assumption that the holder of the majority equity interest had the right to appoint and remove two managers, seemingly guaranteeing control over a three-member board.  When they acted in secret and provided no notice, Sahagen and Quinn failed to discharge their duty of loyalty to Plaintiff in good faith, fully recognizing that these rights were Plaintiff’s protection against actions contrary to his majority interest.  The Chancery Court, in this case, took the position that the managers owed Plaintiff a duty to give him prior notice, even if he would have interfered with a plan that they honestly believed to be in the best interest of the LLC.  Instead, the managers launched a preemptive strike that secretly converted Plaintiff’s controlling interest in the LLC to a minority interest in VGS (Defendant), without giving Plaintiff a level playing field to defend his interest.  A traditional adage of equity holds that equity regards and treats actions done which in good conscience ought to be done.  And so, under these circumstances, the court held that Sahagen and Quinn should have given Castiel (Plaintiff) prior notice.