Richards Layton & Finger

Sanders v. Ohmite Holding, LLC, C.A. No. 5145-VCL (Del. Ch. Feb. 21, 2011): Plaintiff Demonstrates Proper Purpose in Requesting Inspection of an LLC’s Books and Records

April 6, 2011

In Sanders v. Ohmite, the Delaware Court of Chancery considered whether plaintiff Max Sanders (“Sanders”), as a member of Ohmite Holding, LLC, a Delaware limited liability company (the “Company”), was entitled to inspect certain books and records of the Company pursuant to Section 18-305 of the Delaware Limited Liability Company Act (the “LLC Act”). The Company denied Sanders’s request for books and records, in part, on the grounds that Sanders was requesting books and records that pre-dated his admission as a member of the Company. The Court held that Sanders had a proper purpose for inspecting the books and records of the Company and was entitled “to inspect those books and records that are necessary for him to fulfill his purpose, regardless of whether they pre-date when he formally acquired member status.” As a result, summary judgment was granted for Sanders.

Sanders loaned James Horne (“Horne”) $2 million to purchase a 20.66% limited liability company interest in the Company. The loan was secured by, among other things, the collateral assignment of Horne’s limited liability company interest in the Company in favor of Sanders. On February 20, 1998, the Company engaged in a recapitalization which left Horne with a 15.5% limited liability company interest in the Company. In May 2000, the Company repurchased half of Horne’s limited liability company interest for $1 million, which was paid directly to Sanders in accordance with the collateral assignment agreement. Sanders and Horne believed that Horne retained a 7.75% limited liability company interest in the Company. On February 28, 2007, Horne assigned his remaining limited liability company interest to Sanders.

In October 2008, Sanders received a Schedule K-1 from the Company that indicated that Sanders owned only a 0.000775% stake in the Company, rather than the 7.75% stake he believed he owned. Sanders sought an explanation for the purported reduction in his interest in the Company, and the Company responded that the Company had required additional capital to continue its business operations and had issued additional units in July of 2003.

By a demand letter, Sanders sought books and records relating to the dilution of Horne’s limited liability company interest. The demand letter stated that Sanders sought the documents “to evaluate the value of [his] ownership interest, the status of the business and financial condition of [the Company], the performance of [the Company’s] management and the legitimacy of the dilution of [his] interests in [the Company] from 7.75% to .000775% of [the Company].” The Company denied the request in whole and asserted that Sanders was not a member at the time of the issuance and that Sanders’s actual purpose was to conduct an improper fishing expedition.

Later, the Company provided copies of tax returns and financial statements which showed that an affiliate of the Company owned 99.993101% of the Company. The Court inferred that the Company issued new voting units for an undisclosed amount of consideration. From various facts and their logical inferences, the Court concluded Sanders reasonably suspected that the Company “issued units in a related-party transaction at a deep discount.” Sanders had requested books and records of the Company to determine whether the Company had received proper consideration for the additional units issued and whether the Company was being operated exclusively for the benefit of its controlling member rather than the members as a whole.

Section 18-305 of the LLC Act states that a member of a limited liability company has the right to inspect certain books and records of such limited liability company “upon reasonable demand for any purpose reasonably related to the member’s interest as a member.” This right to books and records is subject to reasonable standards as may be set forth in a limited liability company agreement or otherwise established by the manager. The Company’s limited liability company agreement did not limit the rights to obtain books and records set forth in Section 18-305. The limited liability company agreement provided that “[e]ach member shall receive copies of any annual audited financial statements prepared for the Company promptly after receipt by the Company” and that “[o]therwise, each member’s rights to access books and records are ‘as provided in the [LLC] Act.’” Although the limited liability company agreement limited inspection rights of assignees, the Court stated that these limitations do not apply to Sanders since he was a member and not merely an assignee. Additionally, there was no evidence that the Company’s managers established any standards to govern a member’s exercise of inspection rights. The Court stated that the scope of Sanders’s inspection rights was identical to Section 18-305 of the LLC Act.

The Court analogized to corporate law and rejected the Company’s argument that Sanders could not seek books and records that related to a transaction prior to the time Sanders was admitted as a member. In the analogous corporate context, the Delaware Supreme Court has held that “[i]f activities that occurred before the [date on which the plaintiff became a stockholder] are ‘reasonably related’ to the stockholder’s interest as a stockholder, then the stockholder should be given access to records necessary to an understanding of those activities.” The Company had not provided a sufficient reason for why a different rule should apply to limited liability companies.

The Court also found that Sanders’s purposes were proper; valuing one’s ownership interest is a proper purpose. Investigating potential wrongdoing is also a proper purpose, and Sanders established a credible basis from which the Court could infer possible mismanagement that would warrant further investigation. “The dilutive issuance suggested a possible breach of the duty of loyalty.” The Court also found that each of the categories of documents that Sanders sought was “reasonably required for him to carry out an inspection for the proper purposes set forth in his demand.”