Article courtesy of Michael D. Robson (Greenberg Traurig)
Tissue Technology, LLC v. Tak Investments, LLC, No. 18‑1835 WL 5318271 (7th Cir. 2018)
In an investment dispute arising under an agreement to build $315 million worth of tissue mills, the United States Court of Appeals, Seventh Circuit (the “Court”), upheld a lower court decision that withheld all remedies that would transfer notes from secured lenders to parties who breached contractual obligations. The Court similarly affirmed the lower court’s decision to withhold any remedy to an entity attempting to cancel notes and take control of a business partner without fulfilling its obligations within the contract.
In 2007, Tissue Technology and other affiliated entities (“OFTI”) sold a tissue mill located in Oconto Falls, Wisconsin to a subsidiary controlled by Tak Investments (“Tak”). Tak issued four negotiable notes with an aggregate value of approximately $16 million to finance the transaction, which OFTI offered to creditors as substitute securities. The notes were accepted by creditors and the deal closed. OFTI was to pay off 10% of the principal at the end of the first year, another 10% at the end of the second year, and the remaining 80% by the end of year three. In a side agreement, the parties agreed that Tak would hire a construction firm affiliated with OFTI to build at least $315 million worth of new tissue mills, and if this occurred, Tak would not have to pay the notes. If Tak did not build the specified tissue mills and didn’t pay off the notes, OFTI could cancel the notes and acquire a 27 percent interest in Tak. In essence, if OFTI paid off the debt secured by the notes and regained possession of these instruments, and Tak refused to pay, the notes would be deemed cancelled and OFTI would receive its equity interest in Tak.
Neither party paid on the notes, nor were any mills built. After three years, OFTI attempted to gain its 27 percent equity interest in Tak, to which Tak refused. OFTI filed suit in federal district court, which held that since Tak did not own itself, it could not be compelled to issue the equity stake that OFTI demanded. In its review, the Court declared this a “misstep,” because Tak was organized under Delaware law, where the internal‑affairs doctrine serves as the source of rules about its powers. The Court went on to remark that Delaware permits an LLC to issue membership interests in itself, similar to a corporation issuing shares, even if such an action dilutes the interests of existing members. The two existing members of Tak did not assert any contractual or statutory right to prevent the issuance of new equity interests, meaning that Tak could provide OFTI with its 27% equity interest under Delaware law. However, the Court ruled on two other considerations that do prevent OFTI from enforcing the notes against Tak.
First, a hold‑harmless clause was included in the agreement, which acted to prevent OFTI from enforcing the notes against Tak, because whatever Tak gave to OFTI would be returned through indemnification. The Court believed this made practical sense because the notes were designed as a security for third parties, not to compensate OFTI. Furthermore, since OFTI failed to pay the notes, it had no enforceable rights against Tak, including the 27 percent equity interest, that it wouldn’t have to immediately return back to Tak in indemnity.
Second, the negotiability of the notes allowed OFTI to pledge the notes to lenders to replace that lender’s security interest in the tissue mill, which in turn enabled OFTI to convey clear title to Tak. Since none of the notes were returned to OFTI, the district court was correct to invoke Wisconsin’s statute that mirrors the Uniform Commercial Code, which applies to negotiable instruments and conclude that OFTI had no grounds to enforce the notes because OFTI was not the holder of the notes, was not in possession of them and was not entitled to enforce them. Again, the Court saw the business rationale in this finding, holding that the notes replaced lenders’ liens against the tissue mill, and that until the debts were repaid, the lenders needed the notes as security. If, as they demanded, OFTI could use nonpayment as a reason to cancel the notes, they would be rendered worthless to lenders, and OFTI would have practically replaced their security with nothing, while in turn reaping a substantial benefit. The Court continued by pointing out that if OFTI had paid the notes as promised, thereby retiring the loans, then it would be able to recover the notes from the lenders and enforce its equity interest, but as the record shows, OFTI failed to do so.
OFTI also attempted to argue that it did not endorse the notes, which prevents their enforcement. The Court responded to this by ruling that this only proves that the lenders who hold the notes may have the legal right to compel OFTI to endorse the notes to facilitate enforcement, but this fact in no way gave OFTI the right to cancel the notes. Due to this analysis, the Court affirmed the district court’s findings that withheld any remedy that would transfer the value of the notes from secured lenders to OFTI.