DELAWARE TRANSACTIONAL & CORPORATE. Company Act and Limited Partnership Act. New Guidance for Series LLCs and Series LPs

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1 DELAWARE TRANSACTIONAL & CORPORATE Update LAW FALL 2007 IN THIS ISSUE Recent Changes to the Delaware Limited Liability Company Act and Limited Partnership Act...1 Fiduciary Duty Claims Against Directors of Insolvent or Near-Insolvent Companies...1 Who Holds the Assets in a Delaware Series LLC?...5 Hayes Lemmerz Case Clarifies Limits on Director Indemnification... 6 Recent Changes to the Delaware Limited Liability Company Act and Limited Partnership Act by John J. Paschetto In July the Delaware legislature made several important additions and modifications to the state s Limited Liability Company Act and Limited Partnership Act. The more significant changes clarify how the assets of a series LLC or series LP should be accounted for and the scope of activities that a series may pursue. In addition, the LLC and LP acts have been amended to require that an LLC or LP have an LLC or LP agreement (sometimes termed an operating agreement ), to prohibit the issuance of certificates for LLC interests or partnership interests in bearer form, and to permit LLC and LP agreements to bar certain organic changes. New Guidance for Series LLCs and Series LPs Since 1996 the LLC Act and LP Act have permitted the formation of separate series of members or managers (of an LLC), general or limited partners (of an LP), or interests in an LLC or LP. The series structure has enabled LLCs and LPs to limit the assets against which creditors may enforce claims. If certain prerequisites are met, creditors of a series will be unable to reach LLC or LP assets beyond the assets associated with that series, and likewise, the assets of the series will not be available to satisfy claims against the LLC or LP as a whole. (continued on p. 2) Fiduciary Duty Claims Against Directors of Insolvent or Near-Insolvent Companies by James P. Hughes, Jr. Despite Delaware s leading role in defining the fiduciary duties of corporate directors, one issue that has remained unresolved concerns the scope and nature of duties owed to creditors of insolvent or near-insolvent companies. The Delaware Supreme Court has now resolved that question in a decision captioned, North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, No. 521, 2006, 2007 Del. LEXIS 227 (May 18, 2007). The Court held that creditors of insolvent companies and solvent companies operating in the zone of insolvency may not bring direct fiduciary duty claims on their own behalf against directors. The Court, however, reaffirmed that a creditor may bring a derivative claim against directors-- i.e., a claim brought on behalf of all similarly affected claimants of a (continued on p. 4)

2 Recent Changes... (cont. from p. 1) The 2007 amendments have enlarged the types of series that may be created, have added a safe harbor regarding proper accounting for series assets, and have clarified the types of activities that a series may engage in. As amended, Section of the LLC Act and Section of the LP Act no longer implicitly require that series assets be associated with a series of members, managers, partners, or interests. Thus, a series of assets may now be established even if the LLC or LP has no other series to which the assets will be attached. LLCs and LPs should therefore find it easier to shield assets from certain creditor claims by means of the series structure. In addition, the amendments have clarified the steps that must be taken to ensure that a series structure will effectively shield assets. Previously, Sections and required that both the certificate of formation (or, in the case of an LP, the certificate of limited partnership) and the LLC or LP agreement provide for the series structure, that the LLC or LP agreement further specify that series assets are to be shielded from non-series claims, that separate and distinct records [be] maintained for each series, and that the assets associated with each series be held in such separate and distinct records... and accounted for in such separate and distinct records separately from the other assets of the [LLC or LP], or any other series thereof[.] Although series assets must still be accounted for separately, the need for separate and distinct records has been removed. More importantly, the amendments have added a safe-harbor provision regarding what will be deemed sufficient to meet the separate accounting requirement. Sections (b) and (b) now provide, in relevant part: Records maintained for a series that reasonably identify its assets, including by specific listing, category, type, quantity, computational or allocational formula or procedure (including a percentage or share of any asset or assets) or by any other method where the identity of such assets is objectively determinable, will be deemed to account for the assets associated with such series separately from the other assets of the [LLC or LP], or any other series thereof. The amendments regarding series LLCs and LPs have also added new subsection (c) to Sections and , in which the breadth of powers and activities permitted to a series is confirmed. The new subsection states that a series has the power to in its own name, contract, hold title to assets..., grant liens and security interests, and sue and be sued[,] unless otherwise provided in the LLC or LP agreement. Similarly, new subsection (c) provides that a series may carry on any lawful business, purpose or activity, whether or not for profit, with the exception of the business of banking as defined in [Section 126 of the Delaware General Corporation Law]. Finally, changes to Section of the LLC Act and Section of the LP Act have made clear that an LLC A series of assets may now be established even if the LLC or LP has no other series to which the assets will be attached. or LP agreement may grant to a series of members, partners, or interests the right to seek an appraisal in the Court of Chancery in the event of an amendment to the LLC or LP agreement, the sale of all or substantially all of the entity s assets, or an organic change to the entity, such as its merger or conversion. Previously, Sections and stated that appraisal may be made available to any class or group of members, partners, or interests, without specifying series as well. LLC and LP Agreements Are Now Required The LLC Act previously stated, in Section (d), that an LLC agreement may be entered into before, after, or upon the filing of the LLC s certificate of formation (emphasis added). The use of the word may permitted the conclusion that an LLC agreement was optional. That source of potential confusion has now been removed. As amended, Section (d) provides that an LLC agreement shall be entered into or otherwise existing before, after, or upon the filing of the certificate (emphasis added). A comparable provision respecting LP agreements has been added to the LP Act, as new subsection (d) of Section If an LLC or LP agreement is not entered into, it will be implied, as indicated by amended Sections (7) and 2

3 Recent Changes... (cont. from p. 2) (12). Those sections previously defined LLC agreement and LP agreement, respectively, as any agreement... written or oral, of the [members or partners] as to the affairs of [an LLC or LP] and the conduct of its business. Following the latest amendments, they refer to any agreement written, oral or implied (emphasis added). Since an LLC or LP agreement will presumably be implied if the parties have not expressly adopted one, it is all the more important that the agreement be addressed at the planning stage. The amended definitions of LLC and LP agreement should not, however, open the way for the recognition of implied LLCs or LPs. A Delaware LLC or LP, unlike a Delaware general partnership, can be formed only upon the filing of a certificate of formation or certificate of limited partnership with the Secretary of State. (Compare 6 Del. C (a) with 6 Del. C (b) and 6 Del. C (b).) Thus, while an LLC or LP agreement itself may be implied, the underlying entity cannot come into existence without the required Secretary of State filing. Contractual Prohibition of Mergers, Conversions, and Comparable Changes The recent amendments have made clear that an LLC or LP agreement may include provisions removing the LLC s or LP s power to enter into any of a variety of major transactions. Specifically, the agreement may prohibit merging or consolidating with other entities (Sections (h) and (k)); transferring to, domesticating in, or continuing in a non-u.s. jurisdiction (Sections (h) and (h)); or converting into another type of entity (Sections (i) and (i)). By explicitly enabling LLC and LP agreements to bar those transactions, however, the legislature has not implied that other types of prohibitions are impermissible. The official synopses to the bills containing the LLC Act and LP Act amendments explain that the amendments to the above sections are not intended to imply that the [agreement] may not deny other powers to the [entity]. Additional amendments affecting mergers have clarified two points. First, a certificate of merger need not contain a consent to Delaware jurisdiction if the surviving entity is any type of Delaware partnership (previously, only limited partnerships were mentioned, among other types of Delaware entities). (6 Del. C (c)(8) and (c)(8).) Second, the merger of an LLC or LP with another entity does not constitute a dissolution of the LLC or LP (a proposition that previously was implicit in the provisions of Sections (g) and (h)). Changes Affecting Registered Agents As described in the winter 2007 issue of the Update, major revisions were made in 2006 to the provisions of the LLC Act and LP Act involving Delaware registered agents. Several additional changes were made to those provisions in the most recent amendments. The amendments have made clear that a Delaware registered agent must have a business office identical to the registered office named by the LLCs or LPs that the registered agent serves. (6 Del. C (a) and (a).) In addition, references to foreign LLCs and LPs have been added to subsections (e) and (g) of Sections and , to confirm that those subsections apply to both Delaware LLCs/ LPs and foreign LLCs/LPs doing business in Delaware. Section (b) of the LLC Act and Section (b) of the LP Act, dealing with the registered offices of foreign LLCs and LPs doing business in Delaware, have also been amended so that they now conform to Sections (a) and (a). Further Amendments Sections (c) and (b) have been amended to bar the issuance of certificates representing LLC or LP interests in bearer form. This change brings the LLC and LP acts into line with Section 158 of the Delaware General Corporation Law, which was amended in 2002 to bar the issuance of stock certificates in bearer form. As noted above, the sections of the LLC and LP acts governing appraisal actions have been amended to permit the granting of appraisal rights to series of members, partners, or interests. (6 Del. C and ) Those sections have also been amended to add continuance to the types of transactions that may trigger appraisal rights. Finally, changes to Sections and make clear that if a certificate of merger, transfer, or conversion specifies a future effective date, the certificate of formation or certificate of limited partnership of a Delaware entity that does not survive the transaction will not be canceled until the future effective date.

4 Fiduciary Duty Claims... (cont. from p. 1) failing or insolvent company for breach of fiduciary duty. 1 Companies in the Zone of Insolvency With respect to direct claims against directors of companies in the zone of insolvency, the Court noted that there had been substantial scholarly debate on the subject, citing a dozen law review articles and selected papers. Id. at ** Nevertheless, the Court s analysis of why direct claims were not permitted was comparatively short and straightforward. First, citing the Court of Chancery decision below, the Court observed that creditors already enjoy a range of protections, including contract provisions, fraudulent conveyance law and covenants of good faith and fair dealing, among others. Id. at *23. Second, the Court concluded that the benefits of providing creditors with an additional layer of protection was outweighed by the uncertainty it would create for directors, particularly those navigating in the zone of insolvency. Id. at ** Indeed, when operating in the zone of insolvency, the Court observed that the duties of a director do not change: Directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners. Id. at *25. Insolvent Corporations With respect to insolvent corporations, the Court reaffirmed existing case law holding that creditors may maintain 1 The distinction between a direct claim and a derivative one is often confusing and subtle. In Tooley v. Donaldson, Lufkin & Jenrette, 845 A.2d 1031, 1036 (Del. 2004) (citations omitted), the Court posed the following question to determine whether a claim is direct: Looking at the body of the complaint and considering the nature of the wrong alleged and the relief requested, has the plaintiff demonstrated that he or she can prevail without showing an injury to the corporation? derivative suits for fiduciary breaches by directors, i.e., Production Resources Group, LLC v. NCT Group, Inc. 863 A.2d 772 (Del. Ch. 2004). However, the Court held that creditors may not bring direct fiduciary claims against directors of insolvent companies: To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. Id. at *31. The Court s decision is of particular interest because an earlier opinion by the Delaware Court of Chancery had suggested that there might be circumstances where a creditor could bring a direct claim in the insolvency context where the directors display such a marked degree of animus towards a particular creditor with a proper entitlement to payment that they expose themselves to a direct claim. Id. at *29. The Court curtly rejected this possibility: We think not. While there may well be a basis for a direct claim arising out of contract or tort, our holding today precludes a direct claim arising out of a purported breach of a fiduciary duty owed to that creditor by the directors of an insolvent corporation. Id. at ** Although some cases and commentators have suggested that direct fiduciary claims may serve to fill gaps for creditors who believe they have been specifically targeted for inequitable treatment by the directors of insolvent or near-insolvent companies, Gheewalla teaches that a direct fiduciary claim is not an available remedy.

5 Who Holds the Assets in a Delaware Series LLC? by Norman M. Powell According to records of the Delaware Secretary of State, more than 96,000 Delaware limited liability companies ( Delaware LLCs ) were formed in Delaware LLCs are increasingly the entity of choice for operating companies, and figure prominently in a great many structured finance transactions as so-called special purpose entities. The Delaware Limited Liability Company Act, 6 Del. C , et seq. (the Delaware LLC Act ) facilitates the formation of Delaware LLCs with attributes carefully crafted to meet the needs of a given application, and is regularly revised so as to best assure that Delaware LLCs can be crafted to meet the ever-developing needs of the marketplace. For a number of years, the Delaware LLC Act has permitted the formation of Delaware LLCs with separate series of members, managers, and limited liability company interests. As regards assets of a given series, who is the debtor within the meaning of Article 9 102(a)(28)? In the legislative session ended June 30, Delaware s General Assembly passed Senate Bill 96 ( SB 96 ) amending the Delaware LLC Act. SB 96 was signed into law by Governor Minner, and took effect on August 1, Among other things, SB 96 provides a number of options for the holding of assets associated with a series. These options provide maximum flexibility, and so accommodate the needs of a great many constituencies. Inevitably, some options are better suited to some applications than others. This article considers the interplay between the Delaware LLC Act provisions relating to series and perfection of security interests by filing under Article 9 of the Uniform Commercial Code ( Article 9 ). Those dealing with the creation and perfection of security interests in assets associated with a series of a Delaware LLC must be particularly careful in identifying their debtor (that is, the person having an interest in the collateral at issue, within the meaning of Article 9 102(a)(28)), and answering each question that follows from that threshold issue. In the years since (revised) Article 9 took effect, most of us have become comfortable that a Delaware LLC is a registered organization within the meaning of Article 9 102(a)(70). Thus, a Delaware LLC is located in Delaware under Article 9 307(e), and a financing statement identifying a Delaware LLC as debtor must feature the Delaware LLC s name (only) in box 1a as indicated in Article 9 503(a)(1) and be filed in Delaware pursuant to Article But things may be very different if we re considering assets associated with a series. As revised by SB 96, Section of the Delaware LLC Act provides in relevant part as follows: (b)... Assets associated with a series may be held directly or indirectly, including in the name of such series, in the name of the limited liability company, through a nominee or otherwise. (c) A series established in accordance with subsection (b) of this section... shall have the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interests, and sue and be sued. As regards assets of a given series, who is the debtor within the meaning of Article 9 102(a)(28)? Possibilities would seem to include the Delaware LLC itself, the series, and a nominee. If the Delaware LLC itself is the debtor, Article 9 would seem to require its ordinary filing against and naming the Delaware LLC as debtor, in the Delaware LLC s location (that is, Delaware). Matters unique to the series might be addressed in the collateral description, or in box 10 (miscellaneous) of the financing statement addendum, as appropriate. If a nominee is the debtor, one must consider whether that nominee is an organization, a registered organization, an individual, or something else. An effective filing against the assets of the corresponding series would be filed in such nominee s location (which may not be Delaware) (continued on p. 6)

6 Who Holds the Assets... (continued from p. 5) as determined under the applicable subpart of Article and name the nominee (only) in box 1a (or box 1b, if applicable) in deference to the applicable subpart of Article If the series is the debtor, again one must consider whether it is an organization, a registered organization, or something else. Organization is defined in Uniform Commercial Code Article 1, Section 201(25), as a person other than an individual. Person, in turn, is defined in Uniform Commercial Code Article 1, Section 201(27), as an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint It would seem that the Article 9 definition of registered organization does not fit series of a Delaware LLC - there isn t necessarily any public record maintained by the Delaware Secretary of State showing a given series to have been organized (let alone its name). venture, government, governmental subdivision, agency, or instrumentality, public corporation, or any other legal or commercial entity [emphasis added]. Is it sufficiently clear whether a series is a legal or commercial entity? Article 9 appears to contemplate that debtors to which it applies are either individuals or organizations (see, e.g., Section 9 307(b)), with some organizations belonging in the subcategory registered organization. It would seem that the Article 9 definition of registered organization does not fit series of a Delaware LLC - there isn t necessarily any public record maintained by the Delaware Secretary of State showing a given series to have been organized (let alone its name), and the Delaware LLC as a whole is issued a single organizational ID number. On balance, then, this particular option for holding series assets may leave Article 9 secured parties without the degree of certainty and confidence to which they ve become accustomed. As suggested above, having determined who is the debtor with respect to the relevant assets and having had such debtor effectively grant the desired security interest, interested parties must determine the proper characterization of such debtor for purposes of determining where to file a financing statement against it, and determine its name and other information for purposes of completing such financing statement. If the debtor is the Delaware LLC itself, these questions are easily answered. If the debtor is a nominee, these questions should be easily answerable by consideration of the relevant attributes of that nominee under Article 9. But if the debtor is the series, questions remain as to the characterization of the debtor and thus its location for purposes of Article (that is, where to file), and what name, organizational ID number (if applicable Delaware does not require organizational ID numbers on financing statements), and other identifying information to provide on a financing statement (that is, what to file). Hayes Lemmerz Case Clarifies Limits on Director Indemnification by James J. Gallagher A recent case in the Delaware Court of Chancery involving corporate indemnification of directors has explored the allocation of liability between co-indemnitors and the lawfulness of certain forms of indemnification. The six plaintiffs in the case were former outside directors of the defendant, known at the time of their service as Hayes Lemmerz International, Inc. In September 2001, Hayes announced that its reported financial results for certain preceding periods would need to be restated. Following that announcement, Hayes stockholders and bondholders brought suits against the Hayes directors and officers. Those suits were later settled with respect to the outside directors for $27.5 million. Of that amount, $20.3 million was paid by carriers of Hayes s directors & officers (D&O) insurance, while the remaining $7.2 million was paid in part by two of the outside directors and in part by the investor that had designated the other four outside directors. The six directors subsequently sued Hayes for indemnification of the $7.2 million settlement payment that was not covered by the D&O insurance. Hayes moved for partial summary judgment on several issues, including (i) whether directors

7 may sue for indemnification when the loss they seek to have reimbursed was actually incurred by a third party, and (ii) whether a corporation may agree to reimburse directors for fees incurred in unsuccessful indemnification lawsuits. Levy v. HLI Operating Company, Inc., 924 A.2d 210 (Del. Ch. 2007). In May 2007, the court granted Hayes s motion for partial summary judgment. The court held, first, that the directors who had been designated to the Hayes board by an investor (Joseph Littlejohn & Levy Fund II, L.P., or JLL Fund) were not proper plaintiffs, because JLL Fund, not its director-designees, had incurred the settlement costs for which indemnification was sought. As the court explained, JLL Fund s limited partnership agreement obligated it to indemnify its designees to the Hayes board. Since JLL Fund had in fact paid the share of the settlement amount owed by its director-designees, the proper claim was not one for indemnification brought by those directors, but one for equitable contribution brought by JLL Fund (a co-indemnitor with Hayes). The court therefore granted summary judgment for Hayes on the indemnification claims asserted by JLL Fund s director-designees. Importantly, while discussing JLL Fund s contribution claim, the court summarized with approval the holding of a prior Chancery Court case involving the relative liabilities of two co-indemnitors, Chamison v. Healthtrust, Inc., 735 A.2d 912 (Del. Ch. 1999), aff d, 748 A.2d 407 (Del. 2000). In Chamison, the court had held that Delaware law does not recognize a primary-secondary hierarchy among corporate indemnitors. As the Hayes court put it, the necessary starting point for analyzing such a situation is a presumption that both indemnitors are equally liable for any indemnifiable amounts. While the Hayes court ultimately did not reach the issue of how indemnification liability would in fact be allocated between Hayes and JLL Fund, its analysis of Chamison strongly suggests a lesson for drafters of indemnification provisions. In situations where the drafter does not want a corporation to be equally liable with a potential co-indemnitor (such as when an investment fund designates a director to a portfolio company), the drafter should specify clearly that indemnification will be paid only to the extent that losses are not indemnifiable by a co-indemnitor. directors for the expense of bringing an indemnification action that is ultimately unsuccessful. As noted above, Hayes had argued, and the court agreed, that JLL Fund s director-designees were not proper plaintiffs. Therefore, since the indemnification claims of those directors had failed, Hayes further argued that the directors were not entitled to reimbursement of their legal fees (i.e., fees on fees ). The directors maintained in response that they were entitled to fees on fees because their indemnification agreements with Hayes provided that Hayes would reimburse their fees regardless of whether Indemnitee ultimately is determined to be entitled to such indemnification[.] Hayes in turn argued that that provision was unenforceable as contrary to Delaware law. The court agreed with Hayes. Examining caselaw, the relevant statute, and public policy, the court held that a contract provision which mandates indemnification for fees on fees in unsuccessful litigation is invalid[.] Prior decisions, the court found, stood for the proposition that indemnification to the fullest extent authorized by Delaware law could entail reimbursement of fees on fees only to the extent that the indemnitee had succeeded in the underlying indemnification action. This rule was also implied by Section 145 of the Delaware General Corporation Law (the DGCL), which enables Delaware corporations to indemnify their directors and officers. Specifically, Section 145(e) states that, when a corporation pays a director s expenses in advance of a final determination that the expenses are indemnifiable, the director must provide an undertaking to repay the advanced amount if he or she is ultimately found not to be entitled to indemnification. Finally, the court held that an agreement to reimburse a director for fees incurred in an unsuccessful indemnification action contravenes notions of sound public policy previously noted by [the] court. Such an agreement would give directors a perverse incentive to bring non-meritorious suits against their corporations for indemnification, a practice that the law should not encourage. The court therefore held the indemnification agreements invalid insofar as they purported to require indemnification of fees on fees respecting an unsuccessful indemnification action, such as the one before the court. In a second key holding of the 2007 Hayes decision, the court ruled that a Delaware corporation may not indemnify 7

8 About the Update The Delaware Transactional & Corporate Law Update is published semi-annually by the Business Planning and Transactions section of Young Conaway Stargatt & Taylor, LLP. Young Conaway, based in Wilmington, Delaware, is among the state s largest law firms, with over 100 attorneys in 10 practice sections that include bankruptcy, corporate, intellectual property, employment law, tax, banking and real estate practices. The Business Planning and Transactions section handles matters arising at every stage in the formation, growth and development of corporations, limited liability companies, limited partnerships, statutory trusts and other types of entities, including those formed as special purpose entities in securitization and other structured transactions. The section s attorneys combine experience in Delaware corporate law, alternative-entity law, tax, commercial transactions and bankruptcy reorganizations. To receive a complimentary subscription to this publication, please send an with your contact information to info@ ycst.com or visit our web site at To opt out of an subscription, please send your name and address with unsubscribe to bpt newsletter in the subject line to info@ycst.com Members of the Business Planning and Transactions Section Craig D. Grear, Partner. Mr. Grear has made numerous presentations nationally and internationally on a variety of Delaware business law topics, including alternative entities and Delaware holding companies. He is a 1989 graduate of Georgetown University Law Center. (302) cgrear@ycst.com James P. Hughes, Jr., Partner. Mr. Hughes has litigated numerous matters in the Delaware Court of Chancery and served as in-house counsel at an Internet company. He is a 1992 graduate of the University of Pennsylvania Law School. (302) jhughes@ycst.com James J. Gallagher, Associate. Mr. Gallagher has written about issues including indemnification and fiduciary duties in the alternative-entity context. He is a 2004 graduate of the University of Pennsylvania Law School. (302) jgallagher@ycst.com John J. Paschetto, Partner. Mr. Paschetto has contributed to several books on corporate takeovers and the limitation of director liability. He is a 1998 graduate of Harvard Law School. (302) jpaschetto@ycst.com Norman M. Powell, Partner. Mr. Powell writes and speaks regularly at conferences and training programs on topics including alternative entities and secured transactions, and serves on the Commercial Financial Services, Legal Opinions, and Uniform Commercial Code Committees of the Business Law Section of the American Bar Association. He is a 1989 graduate of Villanova University School of Law. (302) npowell@ycst.com The Brandywine Building 1000 West Street, 17th Floor Wilmington, DE This update is intended for informational purposes only and should not be considered legal advice. Please consult an attorney regarding your specific situation. Receipt of this update does not constitute an attorney-client relationship.