This column examines these amendments, the history behind Delaware’s prominence in the realm of corporate law, and discusses some key differences between LLCs and corporations.

In the October 14, 2021 editions of The Legal Intelligencer and the Delaware Business Court Insider Edward T. Kang, managing member of Kang Haggerty wrote “Significant Recent Changes to the Delaware Limited Liability Company Act.”

Delaware Senate Bill 114, recently enacted and effective as of Aug. 1, includes substantial additions and amendments to the Delaware Limited Liability Company Act (the LLC Act). In addition to several amendments meant to supersede recent case law, these amendments also contained further guidance regarding the operations of a Delaware public benefit LLC. This column examines these amendments, the history behind Delaware’s prominence in the realm of corporate law, and discusses some key differences between LLCs and corporations.

Despite its small size, Delaware has long been the jurisdiction of choice for the formation of many types of business entities. This dates back to the late 19th century where, in an attempt to attract commerce and compete with nearby New Jersey, Delaware enacted its first general incorporation statute. With its comparatively liberal rules relating to incorporation and corporate governance, businesses quickly flocked to Delaware and the state became a national hub of corporate law over the course of the 20th century.

This initial momentum resulted in something of a feedback loop; the more corporations based in Delaware, the easier it was to do business there, and the more sense it made for budding businesses to incorporate there. Especially, before the development of modern, instant forms of electronic communications, it was critical for businesses to be based in the immediate vicinity of other businesses.

This centralization resulted in a second feedback loop; with so many businesses interacting with each other, litigation inevitably arose. This litigation, case by case, developed into an encyclopedic compendium of almost every issue that could arise in corporate law. The sheer volume of case law created clear guidance as to the rights and duties of corporations, and this clarity created an even greater incentive to incorporate in Delaware. More than anything, businesses fear uncertainty, and the clear answers found in Delaware case law allowed corporations to make informed business decisions ex ante. In contrast with other jurisdictions, where it was common for potential litigants to arrive at opposite conclusions as to who would likely prevail, Delaware’s exhaustive case law allowed parties to reliably predict the outcome of many disputes before a suit was even brought.

Delaware has also cultivated the development of this case law through the structural framework of its court system. For instance, the Delaware Court of Chancery sits in equity and all issues of fact are decided by the presiding chancellor or vice chancellor. While trial by jury is one of the most celebrated constitutional rights afforded litigants, it has long been recognized that certain cases are just not well-suited for jury trials. These cases often involve “such long, deliberate, and critical investigation as would be impracticable to men called from their occupations,” and are thus better suited for resolution in a chancery court. See The Federalist Papers, No. 51. The nuances of corporate law can sometimes befuddle even the most capable of attorneys, and litigators would prefer that such arcane matters not be resolved by laypersons.

To these practitioners, the Delaware Chancery Court is a welcome answer to this conundrum. Renowned for its expertise, the chancellors and vice chancellors of this court specialize almost exclusively in corporate law matters. And unlike many other states with intermediate appellate courts, appeals from the Delaware Chancery Court go directly to the state supreme court. This significantly shortens the appeals process for litigants who feel the trial court may have erred, ultimately resolving these contentious business disputes as expeditiously as possible.

Just as its general corporation statute played a prominent role in developing corporate law nationally, Delaware’s LLC Act has also been disproportionately influential. The legislature and court system of Delaware have taken proactive steps to remain a leader when it comes to business entity formation, and this trend continues to the present day. While both LLCs and corporations obviously provide for limited liability, there are several key distinctions between these two types of business entities under Delaware law.

For instance, in Delaware, directors of a corporation cannot waive their fiduciary duties. Under the LLC Act, however, directors/members of companies are free to waive fiduciary duties so long as they stipulate to this in the operating agreement. The management and ownership structure of LLCs is also significantly more flexible than that of a corporation under Delaware law. Finally, there are different statutory disclosure requirements for LLCs and corporations, with the latter required to file annual reports relating to its governance and ownership. While the public disclosure requirements for LLCs and corporations remain divergent after the most recent amendments, the LLC Act was amended to standardize the test used for both corporate and LLC records inspection requests.

Like many statutory amendments, Section 18-305(g) was enacted to clarify an ambiguity encountered in the case law. The case in this instance was Murfey v. WHC Ventures, 236 A.3d 337 (Del. 2020), where the court was tasked with determining what was required for limited partners to inspect the books and records of a limited partnership in the absence of governing language in the partnership agreement. The chancery court had used the default “necessary and essential” test that Delaware courts apply to corporations, but the supreme court on appeal held that this was improper, as there was no language in the partnership agreement indicating an intention to adopt that standard.

The recent amendments to Section 18-305(g), however, reversed the default rule enunciated in Murfey; that is, in the absence of language indicating otherwise in the agreement, the necessary and essential test does apply to LLCs and partnerships. In keeping with the greater flexibility afforded to LLCs, this amended section also allows members to expand or restrict the right to inspection in their operating agreement as they see fit.

Another section of the LLC Act that was amended in response to recent case law was Section 18-407. Cases like Wenske v. Blue Bell Creameries, 214 A.3d 958 (Del. Ch. Ct. 2019) had held that a conflicted general partner could not shed its disability by appointing a disinterested party to act on the matter in question. The Wenske court relied on principles of agency law in reaching this determination, specifically that principals are still deemed to control the decisions of their agents, regardless of whether actual control is exercised.

The amended Section 18-407 rejects this reasoning, and specifically allows delegation “irrespective of whether the member or manager has a conflict of interest.” In doing so, the new Section 18-407 brings the law governing LLCs in line with that of corporations, where special committees are frequently appointed to avoid conflicts of interest. That is not to say that interested members can now defeat a clear conflict of interest by appointing a nominally independent party, only that these agents will no longer be considered conflicted “solely by reason of the conflict of interest of the member or manager.”

The amendments to the LLC Act also added a new subsection, Section 18-106(e), which creates a safe harbor process for ratifying void or voidable actions taken by LLCs. This was a reaction to case law applying a more stringent standard to void or voidable transactions, and the new Section 18-106(e) significantly liberalizes the ability of LLCs to ratify such transactions, either through existing mechanisms provided for in the operating agreement or through retroactive amendments to this agreement. LLCs are able to waive any issues relating to these subsequently ratified actions and backdate them to the original transaction date, assuming that the transaction would have been valid if properly enacted to begin with.

Finally, the recent amendments also include several changes relating to public benefit LLCs in Delaware. These entities, like the more common benefit corporations, are for-profit business entities with the overt intention of furthering some social or public good. This allows the members of the LLC to balance the profit motive with the social harms and benefits of their activities. While a majority of states now have statutory benefit corporations, Delaware is one the few that extends this option to LLCs, continuing its role as a pioneer in the realm of business entity formation.

The first amendment to the public benefit LLC section of the statute relates to Section 18-1201. In the past, it was unclear how or if an LLC not initially formed as a public benefit LLC could become one. Like most actions taken by an LLC, this can now be done through whatever means specified in the operating agreements, or even by amending the operating agreement to specify a procedure for this election.

Section 18-1202(a) of this statute was also amended in several ways. First, public benefit LLCs must now explicitly indicate that they are such in their operating agreements, when this was only required in the certificate of formation in the past. This section also now requires that an LLC’s operating agreement specify what public benefits it intends to promote. In the event of an inconsistency between the certificate of formation and operating agreement, the operating agreement shall govern. Finally, these amendments now impose a duty on members and managers of a public benefit LLC to promptly amend the certificate of formation if they discover it is inaccurate.

It remains to be seen how popular public benefit LLCs will prove to be in Delaware, as even the more widely available benefit corporation is still a fairly recent invention. Inevitably these amendments, like the others discussed above, will be subject to legislative and judicial refinement in the coming years. Delaware, a state with no shortage of history when it comes to business formation, continues to show its willingness to innovate and cultivate this area of law.

Edward T. Kang is the managing member of Kang Haggerty. He devotes the majority of his practice to business litigation and other litigation involving business entities. Contact him at ekang@kanghaggerty.com.

Reprinted with permission from the October 14, 2021 edition of “The Legal Intelligencer” © 2021 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

Corporations are permitted to adjourn their physical meetings or move to a remote format, provided that certain steps are taken if the date and/or “location” (yes, virtual) are being changed.  Pursuant to § 232 of Title 8 of the Delaware Code, notice of stockholder meetings is usually given through mail, courier service, or email – but the Securities and Exchange Commission is currently allowing companies to provide certain notices via required public filings and press releases. Consequently, to effectuate the change of an annual meeting to a remote format, Delaware corporations should file this notice with the SEC and issue a press release on their websites immediately afterwards.

Although Delaware law already does generally provide that corporations are allowed to hold stockholder meetings remotely, these provisions (e.g. the board of directors has the discretion to decide upon a remote meeting) must be in the corporation’s organizational documents. Consequently, the Tenth Amendment contains crucial provisions for those corporations whose organizational documents may not have been as explicit on these issues. The other provisions of 8 Del. C. § 211, such as the “reasonable measures” to verify the presence and participation of stockholders/proxyholders, as well as record-keeping, have not been changed by the Tenth Amendment.

The United States Court of Appeals for the Third Circuit affirmed the Delaware District Court’s July 16, 2013 decision by further solidifying the most basic requirements for filing a derivative and direct claim. The plaintiff, Robert Freedman, as a stockholder, failed to make a pre-suit demand to Viacom’s Board of Directors in his derivative claim. Also, the plaintiff failed to state a cause of action in his direct claim against the defendant. As such, the District Court dismissed the case, which the Third Circuit affirmed.

On May 30, 2007, Viacom, a publicly traded entertainment corporation incorporated in Delaware, approved of a plan, the Senior Executive Short-Term Incentive Plan, which capped the eligibility of awards by executives at $51.2 million a year.  The compensation exceeding $1 million paid by a corporation to senior executives is not generally a deductible business expense under federal tax law; however, it could be deductible by adopting a specific compensation plan approved by both the board of directors and a shareholder vote.  Therefore, to make these awards tax deductible, Viacom tied provisions to its bonuses to the achievement of specific goals that related directly to its financial success. In 2012, following Treasury Regulations 26 C.F.R. § 1.162–27(e)(4)(vi) that require corporations to obtain stockholder approval every five years, Viacom’s board brought another compensation plan to its shareholders for a vote. Per Delaware law, Viacom provided shareholders the option of purchasing Class A Stocks, containing voting privileges, and Class B Stocks, that did not give shareholders the right to vote.

Robert Freedman purchased Class B Stocks of Viacom. Upon the implementation of the 2012 plan, Freedman filed a complaint in the Delaware District Court including both a direct and derivative claim. In his direct claim, Freedman alleged that the Committee failed to comply with the procedure by including non-financial qualitative factors to determine the percentage of bonus an executive would receive. Also, the 2012 plan violated 26 U.S.C § 162(m) by withholding the ability of Class B shareholders to participate in the vote, for he contends that a federal tax law requires, in allowing executive compensation over $1 million to be tax deductible, that the compensation be awarded with the inclusion of all shareholders, with or without voting rights. He sought over $36 million in damages, injunctive relief to prevent the enforcement of the 2012 Plan, and a new vote that would include Class B shareholders in the adoption of a new plan. Between 2007 and 2011, Freedman makes the point that the executives received an excess compensation of approximately $36 million.

The Internal Revenue Code, more specifically 26 U.S.C § 162(m), however, does not provide for voting rights to a stockholder holding a non-voting share. Continuing, §162 also does not mention any language of voting rights or the process of shareholder voting, but it only details the taxability of business expenses. Because Delaware corporate law expressly provides for the ability for corporations to sell stock without limitations, including non-voting shares of stock, the Viacom board was within its rights to exclude Class B stockholders from voting on the Plan.

Freedman also contends in his derivative claim that the shareholders were unjustly enriched due to the excessive payment that its executives received. Thus, the decision to allow certain bonuses was not a “valid exercise of business judgment” since Sumner Redstone (Board of Directors Chairman) owns 79.5% Class A shares, he argues it would be inevitable that such a compensation plan would be approved and adopted.

The Third Circuit agreed with the factual allegations of Freedman, and did interpret the complaint with favor towards Freedman. Before filing a derivative claim on behalf of a corporation, as Freedman sought to do, however, the plaintiff is required to first make a demand to the corporation’s board of directors. If the plaintiff does not first make this demand, the plaintiff must provide reasonable doubt why such a demand would be useless per Fed.R.Civ.P. 23.1(b)(3). Specifically, it must create reasonable doubt about whether the “directors are disinterested and independent” or “the challenged transaction was otherwise the product of a valid exercise of business judgment.” (citing Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984)).  Since Freedman did not make a pre-suit demand to the Board of Directors or present sufficient allegations explaining why a demand would have been futile, the Third Circuit said the District Court was correct in dismissing the derivative claim.

With this decision, the Third Circuit made a clear message to future corporate litigators on what minimum requirements must be met before bringing a substantive derivative claim.