For Delaware LLCs, Contractual Freedom Overrides Equitable Defenses

Limited liability companies, as “alternative entities” under Delaware law, enjoy significantly greater freedom in ordering their internal affairs than do corporations.  The contractarian bent of Delaware law is at its height in both the legislative and the judicial treatment of LLCs.  Unlike corporations, LLCs may contract out of fiduciary duties on the part of their managers, and may control the nature and availability of remedies for breach of an LLC agreement.

Last year, the Court of Chancery invited the Delaware Supreme Court to reconsider this law in the context of an LLC agreement providing that the remedy for violating restrictions on the transfer and encumbrance of equity is incurable voidness.  XRI Inv. Holdings LLC v. Holifield, 283 A.3d 581 (Del. Ch. 2022).  A transfer or encumbrance that is incurably void is treated as if it had never occurred; it cannot be ratified or rescued by equitable defenses.  In last year’s ruling, Vice Chancellor Laster recognized that under a 2018 Delaware Supreme Court decision, equitable defenses such as acquiescence may be foreclosed when parties contract for the remedy of incurable voidness.  CompoSecure, L.L.C. v. CardUx, LLC, 206 A.3d 307 (Del. 2018).  But Vice Chancellor Laster also believed that the application of CompoSecure led to “disquieting” results in the case before him.  In lengthy dicta, the Vice Chancellor argued that the Supreme Court should revisit and overrule CompoSecure.

In a September 7, 2023 decision, the Supreme Court declined that invitation, holding that CompoSecure articulates a straightforward rule, well grounded in both legislative and decisional law, and that no policy reasons justify departing from stare decisisHolifield v. XRI Inv. Holdings LLC, – A.3d –, 2023 WL 5761367 (Del. Sept. 7, 2023).  The Supreme Court also concluded that parties to LLC agreements need not invoke any particular “magic words” to establish a remedy of incurable voidness, as long as they make their intent clear.  The result is that parties to LLC agreements continue to enjoy maximum contractual freedom in specifying remedies for breach.

Background and Holdings

Gregory Holifield was a founder of XRI Holdings, a full-stream water and recycling infrastructure company that in 2016 was recapitalized through a cash infusion from a fund affiliated with Morgan Stanley.  As part of the recapitalization, the parties entered into an LLC agreement prohibiting the transfer or encumbrance of units save in narrowly specified circumstances.  The agreement specified that transactions that violated this prohibition would be void.

Holifield borrowed widely.  At the time of the recapitalization, he borrowed $10.6 million from XRI, securing the loan with his XRI units.  Two years later, in 2018, Holifield obtained a $3.5 million loan from a mezzanine fund.  Holifield initially sought to provide the fund with a second-lien position in his units, but needed XRI’s consent to do so.  After XRI declined consent, Holifield and the mezzanine fund entered into a series of interlinked transactions in which Holifield transferred his units to a wholly owned SPV and the mezzanine fund obtained an interest in the proceeds of any subsequent sale of the units.  Holifield told XRI that he had transferred his units to the SPV but withheld many of the details of the loan transaction.

In 2020, Holifield defaulted on both the $3.5 million loan from the mezzanine fund and the $10.6 million loan from XRI.  After XRI strictly foreclosed on the units securing its loan, the mezzanine fund sued XRI in Texas, asserting an interest in the units.  A predicate question in the Texas proceeding was whether Holifield’s transfer of his units to the SPV violated the transfer and encumbrance provisions in the LLC agreement.  Because the agreement was governed by Delaware law, XRI filed a complaint against Holifield in the Court of Chancery to resolve that question.

Following a one-day trial, Vice Chancellor Laster concluded that (1) Holifield’s transfer violated the transfer restriction in the LLC agreement, (2) this rendered the transfer incurably void, i.e., not subject to equitable defenses, (3) XRI was aware of and acquiesced in the transfer, (4) CompoSecure foreclosed the equitable defense of acquiescence, and (5) because this result was “disquieting” to a court of equity, the Supreme Court should revisit CompoSecure.  The Vice Chancellor proposed an alternative framework under which LLCs would have no contractual ability to render any act incurably void.  Incurable voidness would be reserved for acts that violate limits imposed by the state—not contract provisions.

The Supreme Court declined to adopt that framework and reaffirmed CompoSecure.  The court drew on both legislative and judicial statements strongly endorsing Delaware’s contractarian principles in the alternative entity context.  Delaware’s LLC Act states that “[i]t is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”  The legislature amended the LLC Act in 2021, expressly in response to CompoSecure, but that modest modification only confirmed the continued application of CompoSecure to situations like XRI’s.  The legislature provided LLCs with a method for ratifying defective acts, but did not resurrect equitable defenses, nor provide the Court of Chancery with the power to address defective acts.  This contrasts with the legislative approach in the corporate context.

The Supreme Court recognized that “the consequences of a void act are severe,” and that void acts can have a “‘domino effect,’ in which one defective corporate act can infect subsequent acts.”  More generally, the court recognized a “tension between the role of equity in Delaware law and the principle of freedom of contract in the alternative entity sphere.”  Ultimately, however, “[n]othing in Delaware law or public policy prohibits parties to an LLC agreement from contracting for incurable voidness.”

The Supreme Court next considered whether parties contracting for incurable voidness need to use particular “magic words” to secure that remedy.  Holifield had never argued that the words in the LLC agreement—“shall be void”—were ambiguous.  The Court of Chancery, however, had suggested that “the mere use of the word ‘void’” could render a noncompliant act incurably void, and had criticized that result.  The Supreme Court accordingly addressed that concern, holding that use of the word “void” alone will not invariably establish the remedy of incurable voidness.  The word “void” may be unambiguous in some contexts and ambiguous in others; as with any matter of contract interpretation, context is critical.  The Supreme Court also rejected Holifield’s proposal that it adopt a “contractual language formulation” in which parties must use the term “null and void ab initio.”  The Supreme Court held that any unambiguous language suffices.

Finally, the Supreme Court reversed the Vice Chancellor’s ruling that XRI was foreclosed from (1) recovering breach of contract damages in the form of expenses incurred in defending against and settling the mezzanine fund’s Texas action, and (2) recouping attorneys’ fees advanced to Holifield under the indemnification provisions of the LLC agreement.  The Supreme Court remanded as to both issues, instructing the Court of Chancery to determine the amount of damages XRI incurred in the Texas action and to make factual findings under the contractual recoupment provision, which required a finding of willful or grossly negligent breach.  In connection with the latter issue, the Supreme Court considered the Vice Chancellor’s view that equity tipped sharply in Holifield’s favor.  The Supreme Court’s assessment was quite different:  “[W]e are not convinced that the result in XRI’s favor is ‘disquieting’ and ‘inequitable.’” The court pointed to questionable conduct on Holifield’s side, noting that Holifield had gone to lengths to withhold from XRI the details of his arrangement with the mezzanine fund.  And while the Vice Chancellor had faulted XRI for purported delay in establishing that Holifield’s transfer to the SPV was void, the Supreme Court stated, “[I]t seems reasonable that, having reserved its rights, XRI would not take action until Holifield defaulted in 2020.”

Takeaways

  1. Delaware LLCs continue to have maximum contractual freedom to specify remedies for breach, including the breach of transfer and encumbrance prohibitions. That freedom—and in particular the freedom to elect the remedy of incurable voidness—is critical in the alternative entity context.  Unlike corporations, LLCs and their investors have a strong interest in restricting membership and hence control to people and entities with whom they choose to do business.  This is the “pick your partner” principle.  Protecting that interest by means of incurable voidness provisions can be particularly important when improper transfers or encumbrances risk putting ownership in the hands of an LLC member’s creditors, whose goals are almost certain to diverge from those of other members.
  2. More broadly, the Delaware Supreme Court continues to recognize that alternative entities have greater contractual freedom than corporations in ordering their internal affairs. This can have ramifications not only for the issue of incurable voidness but also for any issue in which an LLC agreement limits members’ rights and managers’ obligations, including the elimination of fiduciary duties.  This is both a boon to LLCs and a reason for caution on the part of those who choose to invest in them.  Investors who look for legal or equitable protection outside the four corners of an LLC agreement are bound to be disappointed.
  3. In drafting incurable voidness provisions, LLCs and their members need not use any particular linguistic formulation. To avoid ambiguity, prudent drafters may choose to use terms like “incurably void,” “void ab initio,” or “void and of no force or effect whatsoever.”  Substantive provisions are even more important in avoiding ambiguity, including provisions that an LLC may not record a noncompliant transfer on its books or recognize the transferee in a noncompliant transfer as the owner of units.

Sidley represented XRI in both the Court of Chancery and the Supreme Court.  Yolanda Garcia, Angela Zambrano, Margaret Allen, Robert Hochman, and Robin Wechkin were Sidley’s appellate team.  Abrams & Bayliss partners A. Thompson Bayliss and Eric Veres were co-counsel.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.