How to Mitigate Post-Closing Risks to Facilitate Asset Distribution and Entity Dissolution
After a transaction closes, sellers often wonder: when can all proceeds be distributed and the selling entity be dissolved? This question can be complicated, particularly where there are surviving representations, warranties, or indemnity obligations. While the Delaware Limited Liability Company Act (the “Act”) provides a framework for proper dissolution and distribution, it does not provide a one-size-fits-all answer. Ultimately, resolving this issue requires careful consideration of both existing claims and contingent claims.
The Act makes clear that a winding up limited liability company (“LLC”) “[s]hall pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional or unmatured contractual claims, known to the limited liability company.”[1] Section 18-804 of the Act provides[2]:
(a) Upon the winding up of a limited liability company, the assets shall be distributed as follows:
(1) To creditors, including members and managers who are creditors, to the extent otherwise permitted by law, in satisfaction of liabilities of the limited liability company (whether by payment or the making of reasonable provision for payment thereof) other than liabilities for which reasonable provision for payment has been made and liabilities for distributions to members and former members under § 18-601 or § 18-604 of this title;
(2) Unless otherwise provided in a limited liability company agreement, to members and former members in satisfaction of liabilities for distributions under § 18-601 or § 18-604 of this title; and
(3) Unless otherwise provided in a limited liability company agreement, to members first for the return of their contributions and second respecting their limited liability company interests, in the proportions in which the members share in distributions.
(b) A limited liability company which has dissolved:
(1) Shall pay or make reasonable provision to pay all claims and obligations, including all contingent, conditional or unmatured contractual claims, known to the limited liability company;
(2) Shall make such provision as will be reasonably likely to be sufficient to provide compensation for any claim against the limited liability company which is the subject of a pending action, suit or proceeding to which the limited liability company is a party; and
(3) Shall make such provision as will be reasonably likely to be sufficient to provide compensation for claims that have not been made known to the limited liability company or that have not arisen but that, based on facts known to the limited liability company, are likely to arise or to become known to the limited liability company within 10 years after the date of dissolution.
If there are sufficient assets, such claims and obligations shall be paid in full and any such provision for payment made shall be made in full. If there are insufficient assets, such claims and obligations shall be paid or provided for according to their priority and, among claims of equal priority, ratably to the extent of assets available therefor. Unless otherwise provided in the limited liability company agreement, any remaining assets shall be distributed as provided in this chapter. Any liquidating trustee winding up a limited liability company’s affairs who has complied with this section shall not be personally liable to the claimants of the dissolved limited liability company by reason of such person’s actions in winding up the limited liability company.
(c) A member who receives a distribution in violation of subsection (a) of this section, and who knew at the time of the distribution that the distribution violated subsection (a) of this section, shall be liable to the limited liability company for the amount of the distribution. For purposes of the immediately preceding sentence, the term “distribution” shall not include amounts constituting reasonable compensation for present or past services or reasonable payments made in the ordinary course of business pursuant to a bona fide retirement plan or other benefits program. A member who receives a distribution in violation of subsection (a) of this section, and who did not know at the time of the distribution that the distribution violated subsection (a) of this section, shall not be liable for the amount of the distribution. Subject to subsection (d) of this section, this subsection shall not affect any obligation or liability of a member under an agreement or other applicable law for the amount of a distribution.
(d) Unless otherwise agreed, a member who receives a distribution from a limited liability company to which this section applies shall have no liability under this chapter or other applicable law for the amount of the distribution after the expiration of 3 years from the date of the distribution unless an action to recover the distribution from such member is commenced prior to the expiration of the said 3-year period and an adjudication of liability against such member is made in the said action.
(e) Section 18-607 of this title shall not apply to a distribution to which this section applies.
The disjunctive “or” used here is critically important and highlights that unless all contingent claims are paid, “reasonable provision” for future known liabilities, even contingent liabilities, must be made. However, the Act does not define “contingent” claims.
Fortunately, Delaware case law provides guidance in this regard. In Capone v. LDH Mgmt. Holdings LLC,[3] the Court explained:
Several features of these statutory provisions bear emphasis. First, Section 18–804(b)(1) is clear that a dissolved LLC must provide for all claims—“including all contingent, conditional or unmatured contractual claims”—that are “known to the limited liability company.”110 One leading treatise provides an illustrative discussion of the LLC Act’s treatment of known claims:
One example of a contingent, conditional contractual claim is a right to indemnification under the limited liability company agreement; under many such indemnification provisions, the claim arises only if a covered loss occurs and becomes an entitlement only if the would-be indemnitee has satisfied an applicable standard of conduct. A contingent or conditional claim against the limited liability company must be accounted for under Section 18–804( [b] )(1) irrespective of the likelihood that it will actually “vest.” (emphasis included).
Should an LLC not make “reasonable provision,” the defect may be corrected by reviving the company for the purpose of a lawsuit.[4] Indeed, in Capone, the Court explained, “[i]f an LLC is not wound up in accordance with the LLC Act, th[e] Court ‘may nullify the certificate of cancellation, which effectively revives the LLC and allows claims to be brought by and against it.’”[5]
The Act, however, arms the aggrieved party with additional tools, including the appointment of a receiver to chase assets:
… the Court of Chancery, on application of any creditor, member or manager of the limited liability company, or any other person who shows good cause therefor, at any time, may either appoint 1 or more of the managers of the limited liability company to be trustees, or appoint 1 or more persons to be receivers, of and for the limited liability company, to take charge of the limited liability company’s property, and to collect the debts and property due and belonging to the limited liability company, with the power to prosecute and defend, in the name of the limited liability company, or otherwise, all such suits as may be necessary or proper for the purposes aforesaid, and to appoint an agent or agents under them, and to do all other acts which might be done by the limited liability company, if in being, that may be necessary for the final settlement of the unfinished business of the limited liability company. The powers of the trustees or receivers may be continued as long as the Court of Chancery shall think necessary for the purposes aforesaid.[6]
That said, sellers must be cognizant of the rules of the road regarding asset distribution and entity dissolution. Having a receiver chasing after distributed assets will not be welcome news to investors. To mitigate the risks of the Act, it is important to actively negotiate limited survival periods and limited periods of indemnification. To the extent that negotiations can circumscribe “contingent” claims, a selling entity will significantly mitigate its risks of post-closing litigation under the Act. And, ultimately, it is mission critical to make “reasonable provision” in compliance with the Act to avoid disputes down the road.
This document is not intended to, nor shall it, be considered legal advice. If you have any questions regarding your legal rights, you should address the specific matter with your attorney.
[1] Del. Code Ann. tit. 6, § 18-804 (emphasis added).
[2] Del. Code Ann. tit. 6, § 18-804 (emphasis added).
[3] Capone v. LDH Mgmt. Holdings LLC, No. CV 11687-VCG, 2018 WL 1956282, at *7 (Del. Ch. Apr. 25, 2018), judgment entered, (Del. Ch. 2018).
[4] Id.
[5] Id.
[6] Del. Code Ann. tit. 6, § 18-805.