Disparaging Statements Made in Litigation Support Cancellation of a Founder's Equity
Private equity transactions often feature the retention of management with either a rollover of equity or grant of incentive equity in a Delaware LLC. Often, those equity issuances require that members not make any disparaging statements about the LLC. A typical consequence of violating such requirement is the triggering of a unit repurchase option in the LLC Agreement.
What if a member makes disparaging statements about an LLC in a lawsuit against the LLC – – can the LLC repurchase the member’s units? Can a member rely on the absolute litigation privilege to shield its good faith allegations from triggering the repurchase obligation?
The answer, according to a recent Delaware Chancery Court decision, is that the LLC can repurchase a member’s equity based on disparaging statements made in litigation. In Seva Holdings Inc. v. Octo Platform Equity Holdings, LLC, a founder’s business was acquired and, as part of the transaction, he received membership interests in Octo Platform Equity Holdings, LLC (“Octo”). Under the Octo LLC agreement, a repurchase option is triggered if (among other circumstances) a member breaches his non-disparagement obligations. Here, the founder and Octo disagreed as to, among other things, how the post-acquisition company would operate. Those disagreements spilled over into the courts when the founder filed suit in Virginia state court making, as admitted by the founder, disparaging statements against Octo.
After the lawsuit was filed, Octo sent the founder a repurchase notice and repurchase agreement. The founder refused to sign. Octo then canceled the founder’s membership interests.
The founder argued that his derogatory statements could not be used to support the repurchase option. Under Delaware law, the absolute litigation privilege protects litigants from defamation liability and contractual non-disparagement claims based on statements made during litigation so that parties can freely argue their claims. The founder argued that enforcing Octo’s repurchase option runs afoul of the privilege and would impermissibly chill the founder’s litigation against Octo.
The Court disagreed. The Court held that while the litigation privilege protects litigants from liability for defamation or a contractual non-disparagement claim, it does not extend protection to triggering a repurchase provision in an LLC agreement because it touches on the internal affairs of a company agreed to by its members, which Delaware is “strongly inclined” to respect.
This is an important case for sponsors and founders alike, as statements made in litigation may have consequences outside of the courtroom!