The opinion of the court was delivered by: Katharine S. Hayden, U.S.D.J.
Who is rich? He that is content. Who is that? Nobody.
This litigation evolved from a dispute over the value of an interest in an exclusive and lucrative investment enterprise. In 1984, a small group of high net worth individuals formed a limited investment partnership in which the general partner, William Huff, actively invested the limited partners' initial capital outlays, then passed on to them the returns those investments generated. By agreement, the partnership was converted to a limited liability company in 1994 and was slated to terminate ten years later. Limited to the group of passive investors originally invited to participate, the private venture proved wildly successful, with William Huff and the passive investors reaping steady profits year after year.
At issue in this diversity action is whether the interest of one limited partner, William Soroka (―Soroka‖), terminated sometime before the venture's 2004 end date when, as part of his estate planning, Soroka attempted to pass his interest to a trust containing a non-member beneficiary without first offering it to the rest of the membership, in violation of the group's formal agreement.
Plaintiff, W.R. Huff Asset Management Co., L.L.C. (―Huff‖),*fn1 initiated this declaratory judgment action in New Jersey Superior Court, Chancery Division, against the defendants, the William Soroka 1989 Trust (the ―Trust‖ or the ―1989 Trust‖), the Estate of William Soroka (the ―Soroka estate‖), and Kaye Woltman (―Woltman‖), in her capacity as trustee and executor of the Soroka Trust and Estate, respectively.*fn2 Specifically, plaintiff seeks a declaration that defendants are not entitled to a complete distribution of Soroka's share of Huff, and requests the return of certain distributions paid into the trust that Soroka created. For their part, defendants seek payments from Huff that they claim are still owed by way of distributions, arguing that Soroka's interest survived until the termination of the investment enterprise. According to defendants, Woltman is entitled, as executor of the Soroka estate, to a full distribution of his capital account as it stood on the termination date of the company. Additionally, the parties dispute which of two generally accepted accounting methods should govern the final distribution of Soroka's capital account.
After careful consideration and for the following reasons, the Court finds for plaintiff in part and for defendants in part.
II. JURISDICTION & PROCEDURAL HISTORY
Plaintiff filed suit in state court seeking: (1) a judgment declaring the transfer of Soroka's interest in Huff to his personal trust to be in violation of the Huff Operating Agreement (―Operating Agreement‖); (2) a determination of the balance of Soroka's capital account on the date of the purported transfer; (3) a declaration that Soroka is entitled to that balance and nothing more; (4) and costs and attorney's fees. Defendants properly removed the case to federal court on diversity grounds [D.E. # 1], see 28 U.S.C. § 1441(a); 28 U.S.C. § 1332(a), and thereafter answered and counterclaimed against plaintiff seeking an accounting of Soroka's capital account and payment of profits withheld after the first quarter of 2003. [D.E. # 2]. Additionally, defendants sought a declaration that no violation of the Operating Agreement occurred as a result of the attempted transfer of Soroka's interest, or in the alternative that plaintiff was estopped from objecting to the transfer. [D.E. # 2]. Finally, the counterclaim asked the Court to require that distributions be made to Woltman for the duration of the company's life, pursuant to the Operating Agreement. After an evidentiary hearing on the admissibility of a version of the Operating Agreement proffered by defendants, the Court conducted a bench trial.
III. STANDARD OF REVIEW & APPLICABLE LAW
As stated above, both parties seek a declaration of their respective rights vis-à-vis Soroka's interest (the ―Soroka Interest‖) in Huff. The Operating Agreement contains a choice of law clause stipulating that Delaware law shall govern the parties' substantive rights. Ex. P-1 at 1, 5, 31. Thus, the Court will apply Delaware contract law. In doing so, however, the Court applies the federal Declaratory Judgment Act in deciding whether and to what extent declaratory relief is warranted under the Operating Agreement, as interpreted using Delaware's substantive doctrines. See Fed. Kemper Ins. Co. v. Rauscher, 802 F.2d 345, 352 (3d Cir. 1986) (―It is settled law that, as a procedural remedy, the federal rules respecting declaratory judgment actions apply in diversity cases.‖). That Act states:
In a case of actual controversy within its jurisdiction . . . any court of the United States, upon the filing of the appropriate pleading, may declare the rights and other legal relations of any interested party seeking such declaration, whether or not further relief is or could be sought. Any such declaration shall have the force and effect of a final judgment or decree and shall be reviewable as such. 28 U.S.C. § 2201(a). Depending on the particular context, a declaratory judgment can either be legal or equitable in nature. See Township of Haddon v. Royal Ins. Co. of Am., 929 F. Supp. 774, 777 (D.N.J. 1996).When determining whether legal or equitable principles reign, a court must look to the historical basis for the cause of action and focus on the requested relief. Id. at 777-78. Where the remedy sought is damages, courts may rightly conclude that the relief is legal in nature. Conversely, where a party is seeking an injunction, restitution, or specific performance, the remedy is ordinarily equitable. Id.
The Court will exercise its powers in equity. While a declaratory judgment action may ultimately result in the payment of money, it is not by necessity one at law. See id. In this case, the relief sought is more aptly characterized as specific performance (or arguably, termination) of the contract. Plaintiff believes that its obligations under the group's Operating Agreement concluded upon Soroka's alleged breach and that it is entitled to purchase the Soroka Interest at the value as it stood when Soroka breached the agreement. Defendants, on the other hand, contend that plaintiff owed a continuing duty to make distributions, per the terms of the agreement, until the venture culminated in 2004. This action was initially filed in a New Jersey court of equity, both parties submitted to a non-jury trial, and thereafter urged the Court in their post-trial submissions to call upon the equities in resolving the dispute. The Court agrees that, to the extent consistent with traditional maxims of contractual interpretation, it is empowered to incorporate considerations of fairness and justice into its analysis.
The Court heard testimony from the architects of, and central participants in, the Huff investment vehicle. These key fact witnesses were: William Huff,*fn3 founder and principal investor in the company; Josephine Carbone, a long-time employee at Huff whose responsibilities included issuing quarterly checks to the members reflecting their shares in the venture's profits; Joseph Thornton, counsel for Huff and a principal drafter of the company's governing document; Stephen Bassock, a founding member of Huff; Bryan Bloom, in-house counsel at Huff; and Woltman, the executor of Soroka's estate and a defendant in this lawsuit. Mark Gallagher, C.P.A. and Michael Gavin, C.P.A. provided expert testimony for plaintiff and defendants, respectively.
While the facts adduced at trial have obviously provoked impassioned disagreement over the interpretation of the Operating Agreement and the ultimate resolution of the case, the background facts are straightforward and largely undisputed. The following factual findings are established from the trial record, consisting of trial testimony, exhibits, and stipulated facts.*fn4
A. The Original Partnership
William Huff, a talented investment advisor, testified that he left his job at a Wall Street investment advisory firm in 1984 in order to start his own investment company. (1T:24:20-25). Needing seed capital, he approached a friend, Spencer Brainard (―Brainard‖), who introduced him to several high net worth individuals, including Steven Bassock (―Bassock‖) and Arthur Paturick (―Paturick‖). (1T:25:2-14). These and other individuals executed a limited partnership agreement on December 8, 1984 (the ―1984 Agreement‖), with William Huff acting as general partner and each limited partner passively investing approximately $32,000. (1T:12:7-8). Including William Huff, ten individuals comprised the original partnership. (Ex. P-8 at 30-31). Once a quarter, the members would receive a check from the Huff partnership reflecting their respective shares in the profits William Huff's investments generated. Under the agreement, the partnership would dissolve on December 31, 2004. (Ex. P-8 at 6). William Huff testified that most of the members of the group were employed by Bassock and Paturick, and the partnership interest was intended to be a ―perk‖ of that employment. (1T:27:20-25). He further explained that Soroka was not one of these employees, however, and that he had never met the man. (1T:29:2-6). William Huff stated that unlike the other limited partners, Soroka became a member of the limited partnership through his personal friendship with Paturick. (1T:27:24-28:2; 1T:29:2-6).
Woltman testified that in 1989, the partnership offered to buy out Soroka's and two other members' interest at a profitable price. She explained that Soroka, acting on her advice, rejected the offer and continued to receive his payments. (3T:122:24-125:6). Woltman further testified that Soroka felt that he was under pressure to accept the buyout; there is, however, no dispute that under the 1984 Agreement, neither he nor any other partner was obligated to accept such an offer, and he was free to continue on as a full member in the venture. (3T:124:7-125:7).
William Huff testified that with the exception of Soroka, who was somewhat of an outsider, the investment venture was made up of a ―very, very tight-knit group of basically friends and family.‖ (1T:28:2-4). Besides the personal connections, there was a business reason for the tight circle: William Huff explained that ―given the nature of the business that [he] was doing,‖ he wanted to operate with anonymity and avoid regulatory restrictions by keeping the partnership ―close and tight.‖ (1T:28:6-29:1). This partnership structure kept William Huff insulated from his passive investors and left him in complete control over the investments. He testified further that Bassock and Paturick established themselves as ―stewards‖ of the limited partners, providing a buffer for channeling partnership business, what little there was, between him and the investors. (1T:30:13-24). His sole responsibility was to ―make money for the firm.‖ (1T:30:16-17). And he made a lot of it, increasing his and the limited partners' capital accounts many times over. (1T:12:7-9).
2. The 1984 Limited Partnership Agreement
Two provisions contained in the 1984 Agreement are directly relevant to this case. First, § 8.2(A) states:
No Limited Partner's Interest or any fraction thereof may be sold, assigned, transferred or withdrawn without first offering such Interest to the other Limited Partners at a price equal to the balance in such Limited Partner's Capital Account at that time. Any such interest or fraction thereof shall first be offered to all other Limited partners pro rata, and any such pro rata portion thereof for any Limited Partner(s) who do not elect to purchase a share shall be likewise offered to the membership pro rata. All or any portion of an Interest which a Limited Partner seeks to sell, assign, transfer or withdraw and which is not purchased by one or more of the other Limited Partners shall thereafter be offered to the General Partners pro rata, also at a price equal to the balance in such Limited Partner's Capital Account at that time. Thereafter, all or any portion of an Interest which a Limited Partner seeks to sell, assign, transfer or withdraw and which is not purchased by any other Partner shall either (i) be ―sold‖ to the Partnership by permitting such Limited Partner to withdraw from the Partnership . . . or (ii) with the consent of two-thirds of the then Limited Partners, may be sold, assigned, or transferred to any other Person other than a Partner at that time. (Ex. P-8 at 22-23). The import of this provision is self-evident: William Huff and the original investors wanted to maintain a tight circle of partners. To that end, they restricted unilateral alienation of interests by giving the partnership a right of first refusal before a member could transfer his or her interest to an outsider. William Huff testified that the original intent of the partnership was to allow a member to convey his or her interest only to a spouse or child. (1T:53:11-14). While nothing in the 1984 Agreement literally permits such a transfer to family members, William Huff testified that he had a ―handshake agreement‖ with Bassock and Paturick that such transfers would be permissible. (1T:53:21-54:11).
Second, § 10.2 of the 1984 Agreement states: ―The books of the Partnership shall be kept on an accrual basis.‖*fn5 (Ex. P-8 at 27). Despite this language, William Huff clarified at trial that the books of the partnership were actually kept on a cash basis, because given ―the nature of the business . . . accrual accounting ma[de] very little sense‖ since the partnership was a ―cash business.‖ (1T:42:18-20). He further stated that when the partnership was converted to a limited liability company in 1994 (see infra Section III.B), the Operating Agreement was specifically changed to require cash method accounting to ―reflect . . . the practice that actually happened since 1984 . . . .‖ (1T:49:9-11). The partnership also prepared its tax returns and made all quarterly distributions using the cash method. (1T:43:18-44:19). William Huff explained that the partnership did, however, keep an ongoing accounting of receivables on an accrual basis as an internal forecasting tool to reflect how much money the firm was making. (1T:43:4-17).
B. The 1994 Conversion to Limited Liability Company Status
In 1994, William Huff circulated a memorandum to the limited partners expressing concern with the partnership's ―potential exposure to third party suits and other asset protection issues.‖ (Ex. P-11 at 1). The memorandum stated that limited partners are commonly named as parties in a lawsuit, and that if a factfinder were to determine that their level of activity in the business was that of a general partner, their ―limited‖ liability would be ―porous.‖ (Id.). Additionally, the memorandum stated that the 1984 Agreement was out of date with respect to the law of indemnification, exculpation, and advancement. (Id.). To respond to these concerns, the memorandum proposed that the limited partnership be converted to a limited liability company, a particular corporate designation that had recently been recognized by the New Jersey Legislature. (Id. at 2).
This conversion, the memorandum continued, would provide greater protection to the members because they would be treated more like ―shareholders of a corporation‖ in terms of liability exposure. (Id.). The memorandum then outlined the major revisions to the organization. A few of the most significant and relevant proposed changes in the memorandum were: (1) the new agreement exculpated all members from liability in every situation permitted by law; (2) the indemnification provisions were updated to then-current legal standards; (3) members would be able to transfer their interests to family members and affiliates (like family trusts); and (4) cash method accounting would be substituted to reflect the actual practice of the company. (See id. at 2-5). The memorandum closed by stating, ―We want to emphasize that none of the changes affects the distribution or equity interest rights of the business.‖ (Id. at 5). The proposal was unanimously ratified and the limited partnership was successfully converted into the Huff LLC on July 27, 1994. (Ex. P-7).*fn6
2. Provisions of the Operating Agreement
The Operating Agreement contains several provisions which frame the central dispute between the parties. These provisions, all contained within Article Eight, entitled ―Transferability of Member's Interests,‖ are reproduced and discussed below.
Section 8.1, a preamble of sorts, states:
(A) Each Member hereby represents and warrants to each General Manager and to the Company that his acquisition of his Interest is made as principal for his own account for investment purposes only and not with a view to the resale or distribution of such interest.
(B) Each Member agrees that he will not sell, assign, pledge, hypothecate, place in trust or otherwise transfer(―Transfer‖) his Interest or any fraction thereof as otherwise permitted under this Agreement unless the Interests have been registered under the Securities Act, or such Transfer is exempt from such registration and, in any event, he will not Transfer his Interest or any fraction thereof to any Person who does not similarly represent and warrant and similarly agree not to Transfer such Interest or fraction thereof to any Person who does not so represent and warrant and agree. Any such attempted Transfer in violation hereof is void. (Ex. P-1 at 22-23) (emphasis added).
Section 8.2, labeled ―Restrictions on Transfers of Interests,‖ lies at the heart of the parties' dispute; it places additional constraints on the alienability of membership interests. Section 8.2(A) states:
No member's Interest or any fraction thereof may be transferred or withdrawn without first offering such interest to all of the other members at a price equal to the balance in such member's capital account at that time. Any such interest or fraction thereof shall first be offered to all of the other members pro rata, and any such pro rata portion thereof for any members who do not elect to purchase a share shall be likewise offered to the remaining members pro rata. All or any portion of an Interest which a Member seeks to Transfer or withdraw and which is not purchased by any other Member shall either: (i) be Transferred to the Company by permitting such Member to withdraw from the Company pursuant to Article Seven of this Agreement; or (ii) with the consent of the General Managers and of Members holding two-thirds of the Interests, which consent may be withheld in their complete discretion, may be Transferred to any other Person other than a Member for any price, provided that in determining the requisite consent, there shall be excluded the Interest of the transferring Member and, if such Member is also a General Manager, the consent of such General Manager. (Id. at 23-24) (emphasis added). This provision reincorporates the material aspects of § 8.2(A) of the original partnership agreement, and thus preserves the restrictions on free alienation of interests and the group's desire for exclusivity. The very next provision of the Operating Agreement, however-§ 8.2(B)-is not contained in the original agreement. It reads:
Notwithstanding the foregoing, Section 8.2(A) shall not apply to the assignment by a Member of his right to share in profits with respect to his Interest to a spouse or lineal descendant (each, a ―Family Member‖), a trust for the benefit of one or more Family Members, or a partnership comprised solely of Family Members; provided, however, that such assignee shall not be admitted to the Company as a Member unless the consent requirements set forth in clause (ii) of Section 8.2(A) shall have been satisfied (except as provided in Section 8.3(A)).
(Id. at 24) (underline in original; italics added for emphasis). Joseph Thornton (―Thornton‖), Huff's in-house counsel at the time of the conversion to an LLC, who played a key role in drafting the Operating Agreement, referred to this section as the ―the principal change . . . [that] allow[ed] for . . transfers to family members, trusts for the benefit of families, etc.‖ (2T:7:3-5). Despite the assignment language, the engineers of the conversion to LLC status evidently believed that § 8.2(B) was the provision that permitted familial transfers, which William Huff had referenced in his memorandum proposing the conversion to an LLC.
The next section, § 8.3, dealing with transferees, contains two relevant subsections. First, § 8.3(A), which did not appear in the 1984 limited partnership agreement, states:
Upon the Incapacity*fn7 of a Member, his executor, administrator, trustee, committee, guardian, conservator, or receiver of his estate, as the case may be, shall have all the rights of a Member for the purpose of settling or managing his estate, receiving distributions of profits and/or losses from the Company and, subject to Section 8.2, such power as the Incapacitated member possessed to Transfer all or any part of his Interest and to join with such Transferee in satisfying conditions precedent to such assignee becoming a Substituted Member. (Ex. P-1 at 24-25). Under this paragraph, an executor of a deceased member steps into the shoes of the member himself and retains all rights that the decedent had with respect to his membership in the company. These reserved rights include, subject to § 8.2, the power to transfer the member's interest. (2T:53:16-54:3). Upon a member's death, then, § 8.3(A) controls and the interest resides in the executor. (2T:54:13-22). Thornton agreed with this assessment during his testimony regarding Arthur Paturick death (discussed more fully infra):
Q: So between the time Mr. Paturick died and the time the interest was transferred to his estate, where was the interest?
Q: No. Is there anything under the agreement where it says the -- where the interest was?
A: It resides in the executor.
Q: And the executor has the right to receive profits and losses and also to wind up the affairs of the estate, correct?
Q: And we had testimony yesterday from Ms. Carbone that the checks to the Paturick estate continued, that's exactly what this provision provides for, that the executor can receive profits and losses?
Second, § 8.3(D) deals with the conditions precedent to a valid transfer. It provides:
The Company will recognize any purported Transfer of all or any fraction of the Interest of a Member if the provisions of this Article 8 shall have been complied with and there shall have been filed with the Company a written and dated notice of such Transfer, executed and acknowledged by both the Transferor and the Transferee and such notice (i) contains the acceptance by the Transferee of all of the terms and provisions of this Agreement and (ii) represents that such Transfer was made in accordance with this Agreement and all applicable laws and regulations (including suitability standards). Any Transfer shall be recognized by the Company as effective on the date such notice is filed with the Company. (Ex. P-1 at 25). Thornton also acknowledged during his testimony that no transfer occurs, death or otherwise, until the requirements of §§ 8.1 and 8.3(D) have been satisfied:
Q: [Y]ou did understand . . . that notwithstanding the language in § 8.2(B), the interest to be formally transferred to the estate of the member had to be formally ...