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June 4, 2018

Legal Update
Kenneth N. Thayer

Minority LLC member is entitled to equitable remedies for majority member’s breach of fiduciary duties in freeze-out merger

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Majority members of a limited liability company cannot rely upon the “exclusive remedy” provision in the Massachusetts Limited Liability Company statute (M.G.L. c. 156C) to prevent minority members from recovering certain equitable remedies in cases where the majority has breached its fiduciary duties to accomplish a merger that the minority opposed, according to the Supreme Judicial Court’s recent decision in W. Robert Allison v. Elof Eriksson. Indeed, the SJC held that trial courts have discretion to fashion equitable relief for minority LLC members wrongfully “frozen out” by majority members seeking to consolidate their control through mergers. Such relief may include rescission of the merger or, more commonly, modification of the new entity’s operating agreement to provide greater minority member protections.

Here, Robert Allison and Elof Eriksson were the founders and sole members of Applied Tissue Technologies (ATT-MA), a Massachusetts LLC. Eriksson controlled roughly 75% of the company and Allison controlled roughly 25%. Despite the ownership disparity, ATT-MA’s operating agreement provided that the addition of any new members would require their unanimous consent, and that any change to a member’s ownership interest would require that member’s specific consent.

In 2012, the company had nearly depleted its cash reserves. Eriksson and Allison could not reach agreement on how best to raise additional funds, in part because Allison refused to contribute more of his personal assets to the business and also refused to allow Eriksson to purchase more equity in the company. Eriksson hired an attorney without informing Allison, and they conducted an appraisal of the company. Following the appraisal, Eriksson offered to purchase Allison’s share of ATT-MA based upon the appraised value of the company. Allison rejected the offer.

Eriksson then formed a new entity, ATT-DE (a Delaware LLC), which had a significantly different operating agreement that did not offer the same level of protection for minority members like Allison. Rather, ATT-DE’s operating agreement provided that members owed no fiduciary duties to one another, and that minority members had no right to access company records, appoint directors, or transfer their ownership interests without board approval. Together with the company’s CEO, Karl Proppe, Eriksson caused ATT-DE to merge with ATT-MA, the result of which was ATT-MA being subsumed into ATT-DE. Thereafter, Eriksson purchased additional shares in ATT-DE to increase his ownership percentage of the new company while simultaneously diluting Allison’s. Ultimately, Allison’s ownership interest was reduced to 3.32%.

Allison brought suit in the Massachusetts Superior Court’s Business Litigation Session against Eriksson and Proppe in 2013, alleging breach of fiduciary duties, breach of contract, and related claims. Following a jury-waived trial, the judge found that Eriksson had violated his fiduciary duties to Allison by failing to notify him of the merger.  The judge then granted equitable relief to Allison, ordering changes to ATT-DE operating agreement: (1) granting all members voting rights; (2) striking the provision that eliminated members’ fiduciary duties to one another; (3) granting all members access to the company’s books and records; (4) requiring the directors to report to Allison on the business of ATT-DE and advise him of significant events. The judge also ordered that Allison’s membership interest be “grossed up” to 5% of ATT-DE, not subject to dilution without bona fide outside investment.

Both parties appealed. Eriksson argued that the trial judge should not have awarded any equitable relief to Allison because, he reasoned, M.G.L. c. 156C, § 60(b) provides an “exclusive remedy” for these situations; namely, that minority members such as Allison who oppose mergers are only entitled to resign from the LLC in the wake of the merger and receive a distribution equivalent to their ownership interest. The SJC rejected Eriksson’s argument, finding that another provision of the statute, M.G.L. c. 156C, § 63, negates § 60(b)’s exclusive remedy provision in situations where, as here, the LLC’s operating agreement creates enhanced fiduciary duties for the LLC’s members. The SJC held that Eriksson’s breach of fiduciary duties to Allison meant that he had not complied with the requirements of § 63 when merging ATT-MA with ATT-DE. The failure to satisfy § 63 meant that § 60(b)’s exclusive remedy provision did not apply to this situation, thus freeing the trial court to award equitable relief to Allison.

In other words, because ATT-MA’s operating agreement restricted Eriksson’s ability to raise new capital or dilute Allison’s shares without consent, Eriksson’s actions in merging ATT-MA with ATT-DE without Allison’s knowledge or approval constituted a breach of fiduciary duties, thus rendering § 60(b) inapplicable. Accordingly, the SJC upheld the trial court’s decision to modify ATT-DE’s operating agreement to add greater protections for Allison, such that he would be in a position similar to the one he occupied as a member of ATT-MA.

Significantly, however, the SJC denied Allison’s request to rescind the merger altogether. The Court held that it would be inequitable and not in the company’s best interest to do so, given that nearly six years had elapsed and Eriksson had made substantial capital investments in ATT-DE. The Court also remanded the trial judge’s decision to “gross up” Allison’s interest in the new company to 5%.  While recognizing that it may be appropriate to increase Allison’s percentage from the diluted 3.32%, the SJC explained that any remedy fashioned by the trial court must “reset the proper balance” between the minority member’s reasonable expectations and the majority’s “right to what has been termed ‘selfish ownership.’” Accordingly, the case is remanded to the Business Litigation Session to determine whether and to what extent Allison’s ownership interest should be increased.

This case resolves a significant question in Massachusetts LLC law, confirming that minority members who are harmed by a majority’s decision to merge the company are not limited to the “resign and distribution” remedy set forth in § 60(b), at least in cases where the majority’s actions  fail to satisfy § 63 by violating their fiduciary duties to the minority. It remains uncertain, however, what specific remedies courts can and should apply in these situations to strike the “proper balance” required by the SJC, particularly where minority members may have stronger arguments for rescinding the merger than Allison had in this case. Likewise, the decision leaves open the question of whether Eriksson’s concealment of the merger would have given rise to the same level of equitable relief absent such strong minority protection provisions as existed in ATT-MA’s operating agreement.