Jeremy M. Miller

Whether a New York limited liability company is a party to and bound by its own operating agreement has been examined in a recent decision by the New York Supreme Court, Appellate Division, First Judicial Department. The opinion distinguished New York’s Limited Liability Company Act from the Revised Uniform Limited Liability Company Act (RULLCA), ultimately delineating a bright-line rule: An LLC organized under the laws of the State of New York that has not executed its own operating agreement is not a party to, and therefore cannot be bound by, such operating agreement. Background In Wythe Berry v. Goldman, a dispute arose between two real estate entrepreneurs, Yoel Goldman and Zelig Weiss, relating to the development of a hotel in New York. Pursuant to Section 11 of the Fifth Amendment to the operating agreement of the developers’ primary operating company, Wythe Berry LLC, Goldman and Weiss agreed that any dispute arising under the operating agreement would be determined by the American Arbitration Association. Significantly, the Fifth Amendment only refers to the members — including Goldman and Weiss, in their individual capacities as members — as parties to the agreement. Accordingly, the signature block of the Fifth Amendment made no reference to Wythe Berry. When a dispute later arose in connection with financing the hotel development, Goldman commenced arbitration against Weiss and several of Weiss and Goldman’s entities, including Wythe Berry, pursuant to the arbitration clause in the Fifth Amendment. In response, the petitioner entities, including Wythe Berry, filed a petition to stay the arbitration pursuant to New York Civil Practice Law and Rules Section 7503(b), which allows courts to stay arbitration proceedings on the basis that a valid agreement does not exist. In opposing the petition, Goldman presented a contract referred to as the “Side Agreement,” wherein Weiss and Goldman agreed that the Fifth Amendment would be the governing agreement should any dispute arise between Goldman and Weiss in connection with the hotel development. Specifically, Goldman cited a provision in the Side Agreement that he argued expressed an intent to bind Weiss and Goldman, as well as certain entities registered under their names, such as Wythe Berry, to the Side Agreement. As translated from Hebrew to English, the relevant provision in the side agreement provided that “Goldman and Weiss ‘hereby acknowledge, both on our own behalf and on that of all the corporations registered under our names, whether in whole or in part, and that have any relevance or connection to the [hotel] land and building, without exception — fully acknowledge … everything that is written’ in the Side Agreement. The Side Agreement further provide[d] that the ‘main and principal agreement that shall be determinative and dispositive between us in any case of doubt, dispute, or … conflict that may perhaps arise between us … shall be … [the] [Fifth Amendment], which was signed by us on the said date.’”1 Like the Fifth Amendment, however, the Side Agreement was not executed by Wythe Berry. The lower court held that Wythe Berry had agreed to arbitrate, reasoning that the Side Agreement incorporated the Fifth Amendment’s arbitration clause and that Weiss and Goldman had acted on behalf of Wythe Berry when they signed the Side Agreement. Legal Analysis on Appeal The Appellate Division relied on a comparative analysis to illustrate how the New York LLC Act diverges from the RULLCA on the issue at hand. The appellate court explained that under the RULLCA, an LLC would be bound by its operating agreement, even if the LLC had not itself manifested assent to said agreement. Under Delaware law, for example, Section 18-101(9) of the Delaware Limited Liability Company Act explicitly provides that a “limited liability company … is bound by its limited liability company agreement whether or not the limited liability company … executes the limited liability company agreement.” In sharp contrast to Delaware’s law and the RULLCA, the court explained that under the New York LLC Act, an “operating agreement” is defined as a written agreement among the members of an LLC that concerns the business of the LLC and the conduct of its affairs.2 Moreover, because the LLC and its members exist as separate legal entities pursuant to Section 203(d) of the New York LLC Act, an LLC that does not execute its own operating agreement is not a party to such agreement. The court further explained that the New York LLC Act does not otherwise provide that operating agreements necessarily govern the relationship between an LLC and its members. Therefore, unlike Delaware and other states that have adopted the RULLCA, the operating agreement of an LLC organized under the New York LLC Act (1) can be exclusively among the members of the LLC and (2) a nonsignatory LLC is a nonparty to any such operating agreement among members.3 The Appellate Division rejected the lower court’s determination that Wythe Berry’s acknowledgment of the Side Agreement manifested an intent for Wythe Berry company to be bound by the Fifth Amendment’s arbitration clause. Rather, the appellate court determined that the more consistent interpretation of the Side Agreement is that Wythe Berry merely acknowledged that the Fifth Amendment would be the governing agreement between Goldman and Weiss, the signatories to the Side Agreement. Because Wythe Berry did not sign the Fifth Amendment and because its mere acknowledgment of the side agreement did not constitute “a clear and unequivocal manifestation of an intent to arbitrate”4 by Wythe Berry, the court determined that Wythe Berry was not bound by the arbitration provision under the Fifth Amendment. A Bright-Line Rule Emerges In Wythe Berry, the Appellate Division made one thing very clear: Under the New York LLC Act, an LLC shall not be bound by its operating agreement unless it signs the agreement separately from the members themselves. Therefore, if it is the intent of the parties that an LLC formed in New York be bound by the same contractual rights and duties as the members under the operating agreement, then it is imperative that the LLC be a signatory to its operating agreement. 1 Wythe Berry v. Goldman (230 AD3d 1081 [1st Dept 2024]). 2 New York Limited Liability Company Act Section 102(u). 3 Wythe Berry v. Goldman. (230 AD3d 1081 [1st Dept 2024]). 4 Id.

A series of recent decisions from the Delaware Court of Chancery has muddied the waters for dealmakers and lawyers, raising questions about the legality of certain longstanding market practices relating to stockholders’ agreements and the approval process for mergers. In deciding these recent cases, the court made clear that in construing the language of the Delaware General Corporation Law (DGCL), the court will apply a strict reading of the express language of the statute. In response to the uncertainties caused by the court’s recent decisions in Moelis and Activision, on March 28, the Council of the Corporation Law Section of the Delaware State Bar Association proposed certain amendments to the DGCL. These proposals are intended to conform the statute with customary market practice. Implications to Stockholder Agreements In West Palm Beach Firefighters’ Pension Fund v. Moelis & Co.,1 the court cast a shadow over the enforceability of provisions in agreements between a corporation and its stockholders that provide such stockholders with veto powers or protective voting rights that could be viewed as impinging on the authority and discretion of the board to manage the corporation. These types of agreements are widely used, especially in private equity and venture capital deal structures. At issue in Moelis were certain “Pre-Approval Requirements” in the stockholders’ agreement requiring the board to obtain the prior written consent of a founder stockholder (the founder) prior to taking virtually any meaningful corporate action, including, among others: (1) the issuance of common and preferred stock; (2) the appointment or removal of certain officers, such as the CEO, which was an office held by the founder; (3) entering into or amending any material contract; (4) adoption of a stockholder rights plan; and (5) any equity or debt commitment in an amount greater than $20 million. Read the full article here. ¹ West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., No. 2023-0309-JTL (Del. Ch. February 23, 2024).

With 2023 off to a rocky start for entrepreneurs and startups due to rising interest rates, inflationary pressures and the collapse of highly recognized banks for venture-backed companies – such as Silicon Valley Bank (SVB), Signature Bank and other financial institutions with a greater appetite to do business with these types of riskier companies – the market saw both a pullback by venture capital firms, limiting follow-on equity rounds for the weaker companies in their portfolio as well as a sharp decline in the availability of venture debt. The simultaneous pullback in both the equity and debt markets for these early- and growth-stage companies has left many of these companies in a precarious position, focused on capital preservation and, in some cases, survival, with many ending up in a fire sale or shutdown mode. There was a great deal of uncertainty as to what the future held in terms of venture debt after the upheaval in the banking market. For the remainder of 2023 and beyond, it initially seemed unlikely that traditional banks, including those remaining banks that targeted the startup world, would be the source of venture debt due to the riskier nature of these loans (which generally would not meet their underwriting criteria) as well as more uncertainty and unpredictability in the growth prospects of many of these companies, given the instability in the financial markets for both debt and equity. However, recent trends suggest that there may be more banks than expected that have jumped in to fill the void, with HSBC and Stifel starting to offer new financing alternatives (both institutions picked up former SVB team members) and CIBC and First Citizens Bank (which acquired SVB) continuing to make and honor existing loans. It will be interesting to see how HSBC targets the market, as it recently launched a venture banking practice, but the growing consensus is that loans will start at $1 million post-Series A. To understand venture debt as it is today, one must understand its history. Venture debt became prominent in the 1970s and 1980s with the rise of SVB and similar lending institutions willing to accept more risk and do business with high-growth startups. Many of the great companies that we all know of today were, in part, the product of venture debt. Venture debt seemed to peak during what is known as the pre-dot-com era (mid/late 1990s). During this period, venture debt financing topped out at around $5 billion. This was until 2001 when events took place that led to the bursting of the dot-com bubble and the crash of the markets in the early 2000s. This crash led to many venture capital firms exiting the market and others becoming much more conservative and risk averse. Things again started to look up in the mid-2000s, but the market was again crushed by the crash of 2008. Much as in the 2001 crash, lenders became significantly more risk averse or they exited the market completely. Venture debt only works if there is venture capital (equity behind it), and much of the exit of venture debt in these prior financial crises was tied to the lack of new equity investment. As the market came back with a vengeance in recent years, lenders had again become more flexible in their lending habits, and the venture debt market grew tremendously. However, the rapidly rising interest rates, inflationary pressure, volatile public markets and other macroeconomic factors, including the collapse of SVB and other banks as noted above, that converged in late 2022 and early 2023 led many to speculate that venture debt markets would tighten significantly – and they did, in fact, do so for the first half of 2023. But there does seem to be a light at the end of the tunnel, although likely with more conservative terms and underwriting. What Is Venture Debt, and How Does It Work? What is venture debt? So, what is venture debt? At a high level, venture debt is similar to any other kind of debt. It is a loan from a bank or a nonbank lender to early-stage companies that have previously completed round(s) of venture capital equity funding. Most of the time, these companies have strong growth potential but little to no marketable collateral such as cash, real estate or liquid investments with which the lender can secure its obligations under the loan, making them risky candidates for conventional bank loans. When they lend, venture debt lenders, as opposed to conventional banks, focus more on a company’s growth potential and equity backing than its cash flow and profits. Additionally, venture debt can be attractive to early-stage companies, as it can be used as a complement to equity financing that will not dilute existing equity ownership or change management control in the company. Who are the lenders? Venture debt lenders and equity investors are very different. In a nutshell, equity investors, such as venture capital firms and high net worth individuals, infuse a certain amount of capital into a company in exchange for an equity ownership interest in the company. Equity investors hope to achieve a big return on their investment once the company matures and declares and issues dividends and/or there is a sale event, among other liquidity events. They usually get a preferred return of capital and perhaps an accruing dividend on that capital that is paid when and if there is a liquidity event, but they generally do not have a set timetable or the equivalent of a maturity date nor a guaranteed repayment obligation from the company as to either return of invested capital or a certain return on their investment. To the contrary, when venture debt lenders enter into a credit facility, the lender expects to be repaid every cent that is lent plus interest. This is no different from a residential mortgage company demanding that you repay your entire mortgage plus interest, but the venture debt lender does not have a lien on your residence as security for the loan. How does venture debt work? As an initial matter, before a venture debt lender agrees to lend to an early-stage company, the lender generally will assess the company’s business plan, financials and growth potential to determine whether they will proceed with a loan and, if so, how much funding they will provide. Because lenders in this space assume a greater risk when loaning to unproven companies, as compared to traditional loans to established companies, it goes without saying that lenders want to be protected and compensated accordingly. For example, venture debt normally follows a round of venture capital (e.g., equity or subordinated debt) funding as a form of support for the lender’s extension of credit. Instead of securing its obligations through the company’s assets as a traditional bank does, it instead uses the amount of venture capital funding previously supplied as a source of validation. This is in part due to the overall theory behind venture debt; lenders place significant value on their trusted relationships with the venture capitalists behind the companies, which are often clients of the lender. Not only does the equity funding provide comfort to the lender in the form of support for the borrower from its existing or new investors, but the available loan amount also is set based on the previous round of venture capital funding. Normally, loans are limited to 25% to 35% of the most recent round of equity funding and are relatively short term (one to three years). These venture debt loans typically have an interest rate higher than the traditional loans we would customarily think of, due in large part to the speculative nature of the business that is borrowing the funds and the need to compensate the lender for the additional risk. In addition to higher interest rates to compensate the lender for its risk, venture debt is usually coupled with warrants to purchase the borrower’s equity to provide additional upside for the lender, assuming the company achieves future success. The total value of warrants issued to a venture debt lender is between 5% and 20% of the principal loan amount. These warrants are usually a right to buy the last round of priced equity and generally have a term of one to 15 years. Finally, venture debt lenders aim to protect themselves with certain operating covenants in the loan agreement by including affirmative and negative covenants that place limits on the borrower’s activities. However, as compared to a more traditional asset-based loan, the number of covenants included may be minimal and limited to just a few financial covenants. These financial covenants normally lay out conditions that the borrower must fulfill or avoid to maintain the relationship with the lender. Financial covenants are normally limited to the borrower promising to maintain a positive growth rate and/or maintain a certain level of liquidity. Venture lenders also historically required that borrowers maintain 100% of their cash balances with the bank acting as a lender. When depositors became aware of SVB’s problems, they quickly tried to withdraw their funds, even if it put their loans in jeopardy. This was, in part, a major issue during the collapse of SVB. Therefore, newer venture debt models appear to be more flexible, with some lenders willing to limit the deposit requirement to a lower percentage of cash or a fixed amount tied to the loan balance to cover debt service for a period of time. Relevance in 2023 In the first half of 2023, venture debt deals declined a whopping 38% across the board, going from $20.07 billion in 2022 to only $6.34 billion in 2023. This most likely can be attributed to the failure of SVB and the lack of larger banks and venture debt funds stepping up to fill SVB’s void, rising interest rates, and uncertainty in the markets. However, more recently, we have seen alternative lenders and other banks step in to try to fill this void. In the meantime, only time will tell how the venture debt market will react to the current macroeconomic environment.

One of the most important yet overlooked aspects of any commercial or corporate transaction involves confidentiality obligations. Often, parties gloss over the scope of the covenants, treat them as boilerplate using precedent without thinking through the details, such as what information needs to be protected in the particular transaction at hand, who should be subject to the restrictions, what limitations need to be imposed on the use of any disclosed information and sometimes, forget to include the covenant or enter into a separate confidentiality agreement altogether. This is especially true for venture capital, private equity and related fundraising transactions where companies may have numerous stockholders with varying or conflicting interests. For expediency and cost savings, early-stage venture capital deals typically involve the use of standardized forms, such as the Series A financing documents published by the National Venture Capital Association (NVCA). The NVCA forms include typical information and inspection rights which give at least significant investors broad-based access to confidential information regarding the company. Therefore, the NVCA forms do include a confidentiality provision protecting information received by investors in this context. Having said this, lawyers should still review these documents carefully and consider the specifics of the company and transaction, for example, the types of investors involved (e.g., funds vs. strategic investors), as there may be different sensitivities based on the nature of the investor. However, not all early-stage venture capital transactions use the NVCA forms, and many later-stage venture and private equity deals use bespoke sets of agreements prepared by individual law firms. And, even when precedential forms have been supposedly fine-tuned over time, they may not have adequate provisions for confidentiality in the context of the specific transaction. Further, there may be certain investors not covered by the provisions of the NVCA forms or other primary transaction documents (either because they don’t meet the threshold set forth in the documents to qualify for information rights in such documents or they are investing through another type of instrument, such as a convertible note). In such cases, it is customary for such investors to request information rights, rights to inspect company records and access to management in a side letter. It is important to make sure that side letter rights also are subject to adequate confidentiality and non-use restrictions. In addition to contractual rights, Delaware corporations need to keep in mind that under Section 220 of the Delaware General Corporation Law (the DGCL), stockholders of a Delaware corporation have the statutory right to access corporate books and records for a “proper purpose.” The term “proper purpose” is not expressly defined in the DGCL, but cases involving such demands generally arise in the context of allegations that a stockholder desires to value its interest in the company or has a credible basis to believe there is wrongdoing or mismanagement at the company or a breach of fiduciary duties by officers or directors. This was seen in a recent Delaware case1 (Rivest v. Hauppauge Digit., Inc.) in which the court permitted the disclosure of nonpublic information to a stockholder of a public corporation who exercised his Section 220 rights and did not afford confidential treatment to the corporation’s books and records. This case involved an individual plaintiff seeking to value his shares in a corporation that went “dark” for a number of years, did not make any public disclosures and ignored the requests of the plaintiff for financial and other information concerning his investment. The court stated that there is no presumption of confidentiality as it relates to a Section 220 demand, and the relevant facts and circumstances at hand would be weighed in determining whether or not to afford confidential treatment. The court went through a thorough and detailed analysis of the harm that could be imposed on the corporation for not affording confidential treatment of the corporation’s financial information, including that such information could be used by competitors of the corporation and could put the corporation out of business. On the contrary, the court also detailed the benefits of allowing the plaintiff to obtain such financial information without confidential treatment, including that the plaintiff was seeking basic financial information to value his shares, which falls within the criteria for a proper purpose for a Section 220 demand. In determining not to afford confidential treatment to the disclosed information and permitting the plaintiff to inspect the corporation’s financial records, the court stated that “Rivest has established a significant interest in obtaining financial statements for closed periods free of any confidentiality restriction [and] [t]he Company has not made a showing sufficient to outweigh Rivest’s interest and warrant a two-year confidentiality restriction.” While the company at issue in Rivest v. Hauppauge Digit., Inc. was a public company, in a recent transaction in which we were involved, a venture capital-backed company was pursuing a sale transaction and had a strategic investor who was potentially interested in acquiring the company. The company received a written request from such stockholder, purportedly in the context of wanting to monitor its investment. The request (which was not a formal Section 220 demand) was for various information pursuant to such stockholder’s information rights in an investor rights agreement. The information requested was highly sensitive because of the ongoing negotiations of the sale, certain prior communications with such stockholder indicating such stockholder was not necessarily supportive of the sale, and the fact that this stockholder had a commercial relationship with the company. In that matter, the investor was subject to adequate contractual confidentiality and non-use restrictions on the information, but in the absence of such limitations, this could have been highly problematic because disclosure could have violated agreements with the potential acquirers and could have led to leaks of information on a highly confidential transaction and potentially disrupted the closing of the sale. The absence of such restrictions could have allowed the recipient to share the information or use the information for a purpose other than monitoring its investment. If this stockholder had sought to make a Section 220 demand, the existence of the confidentiality provision in the agreement would likely have led a court to provide confidential treatment to any disclosed information – however, in future transactions, we have already made a note to make sure we explicitly extend these provisions to any demand, not just the information provided under the investment documents. Statutory information rights can be waived, and the investor rights agreement published by the NVCA does include an optional provision for the waiver of statutory information rights, though we don’t typically see investors agreeing to such a provision. Therefore, when statutory information rights are intact and not expressly waived, any contractual confidentiality obligation needs to take into account not only information provided pursuant to contractual information rights but also information provided in other contexts, such as statutory information rights. Further, it is critical, especially in private companies, to include strong confidentiality obligations in investment documents whether or not such documents provide stockholders with explicit rights to disclosure of, or access to, confidential and proprietary information, in order to protect such information from unwanted use and/or disclosure beyond the particular stockholder and for proper purposes. Such agreements should clearly define the types of information protected, the defined purposes for which such information may be used and the parties with whom such information may be shared (e.g., a venture capital or private equity fund may request the right to share certain limited information with its partners for valid reporting purposes). In the absence of such pre-existing agreement at the time of the demand (often made without court intervention), companies should also keep in mind that it is customary to ask for a confidentiality agreement before sharing such information. 1See Rivest v. Hauppauge Digit., Inc., 2022 WL 3973101, at * 1 (Del. Ch. Sept. 1, 2022).