Background
In 2021, private equity firm OceanSound Partners acquired Digital Management Holdings (DMI), an IT services company founded by Jay Sunny Bajaj. Bajaj rolled over $58.9 million of equity into the newly created OSP Razor Holdings LLC, while OceanSound retained an 82% majority interest. The company is taxed as a partnership for federal income tax purposes.
In 2022, despite operating at a $10 million loss, the company allocated approximately $6.628 million in taxable income to rollover members including Bajaj—creating “phantom” tax liability. The operating agreement required quarterly tax distributions to members “subject to having cash available after taking into account reasonable reserves as determined in the good faith discretion of the Board.” In August 2023, after management presented detailed cash flow forecasts showing significant upcoming obligations (earnout payments, bonuses, debt service), the board unanimously voted—with Bajaj voting in favor—not to make distributions due to insufficient available cash. By August 2025, when Bajaj filed suit, no distributions had been made.
Bajaj alleged the majority owner withheld distributions as a pretext to force a buyout of rollover members at a discount price. He sought specific performance compelling distributions and damages for breach of contract.
The Court’s Holding
Vice Chancellor David rejected Bajaj’s breach of contract claim, entering judgment for defendant. The court found that Bajaj failed to prove the board acted in bad faith. The operating agreement provides a highly deferential good faith standard under which the board is “conclusively presumed” to act in good faith if a majority of directors subjectively believe their decision is in the company’s best interests.
Applying this standard, the court found the board made the required “predicate” determination that cash available after reasonable reserves was insufficient for distributions. The documentary record—including detailed 13-week cash flow forecasts prepared by management and reviewed by the board—supported the board’s conclusion. Management projected significant upcoming obligations: $9 million in earnout payments, $8 million in employee bonuses, substantial debt service, and acquisition integration costs. The court found these projections were realistic and formed a rational basis for the board’s decision.
The court rejected Bajaj’s alternative arguments: that the company should have incurred additional debt (already heavily leveraged at $265 million); that the board improperly treated distributions as optional (the board applied the contractual standard correctly); and that directors falsified records (no evidence supported this claim). The court noted that Bajaj himself voted for the August 2023 board resolution declining distributions.
Key Takeaways
- Pass-through entity members may owe taxes on phantom income even when the entity operates at a loss; tax distribution obligations are subject to contractual provisions requiring available cash and board discretion.
- Delaware courts enforce highly deferential “good faith” standards in LLCs that contractually shift fiduciary duties; boards are conclusively presumed to act in good faith based on subjective beliefs if supported by rational decision-making.
- Boards must make documented “predicate” determinations about cash availability, and realistic financial projections form a sufficient basis to defer distributions despite phantom tax liability to members.
- Contractual flexibility allowing majority-controlled entities to defer tax distributions is enforceable even when it disadvantages minority rollover members, provided financial analysis supports the determination.
Why It Matters
This decision reinforces that private equity sponsors can manage portfolio company liquidity by deferring tax distributions during periods of financial stress, even when minority rollover members face phantom tax liability without cash to pay it. The highly deferential good faith standard, combined with proper documentation of financial analysis, effectively insulates board decisions from judicial review. For rollover equity holders, this underscores the significant risks of pass-through entity structures when financial performance deteriorates.
The case illustrates structural misalignment in PE acquisitions: Bajaj bore phantom tax liability while OceanSound did not, yet OceanSound’s board majority controlled cash distribution decisions. Although Benavides allegedly offered to buy rollover equity at $.50 on the dollar, the court did not find this constituted bad faith. For practitioners negotiating acquisition agreements, the decision emphasizes the critical importance of carefully defining tax distribution mechanics, carving out specific funding obligations, and limiting board discretion in the operating agreement—rather than relying on Delaware’s default fiduciary standards.