Delaware Corporate and Commercial Litigation Blog - Summary & Analysis from Delaware's Supreme Court & Court of Chancery

In a post-trial decision, the Court of Chancery in Dweck v. Nasser, C. A. No. 1353-VCL (Jan. 18, 2012), found that Dweck, the former CEO, a director and 30% stockholder in Kids International Corporation (“Kids”), and Kevin Taxin, Kids’ President, breached their fiduciary duties of loyalty to Kids by establishing competing companies that usurped Kids’ corporate opportunities and converted Kids’ resources. 

The Court also found that Dweck breached her fiduciary duties by causing Kids to reimburse her for hundreds of thousands of dollars of personal expenses and that Bruce Fine, Kids’ CFO, breached his fiduciary duties by abdicating his responsibility to review Dweck’s expenses and signing off on them. 

This summary was prepared by Kevin F. Brady.

Background

The background to this case is long and complex as shown by the trial logistics – five-day trial, 930 exhibits, almost 30 fact and three expert witnesses.  As a result, I will only provide a high-level summary of the facts here. In 1993, Dweck and Nasser (Chairman and controlling shareholder of Kids) and others purchased the assets of EJ Gitano. As part of the transaction, Kids was formed and designated for tax purposes as a Subchapter S Corporation so Kids’ profits would be attributed pro rata to Kids stockholders (originally only Nasser). In 1994, Taxin joined Kids as Vice President of Sales and Merchandising, and Kids’ sales subsequently increased by a factor of five over a four-year period.  Around 1998, Dweck was issued 45% of Kids’ outstanding equity.  However, Dweck believed she was not being adequately compensated and so in October 2001, she formed Success Apparel LLC (“Success”), to operate as a wholesaler of children’s clothing.
From 2001 until 2005, Success operated out of Kids’ premises using Kids’ employees. Success drew on Kids’ letters of credit, sold products under Kids’ vendor agreements, used Kids’ vendor numbers, and capitalized on Kids’ relationships.  Then in June 2004, Dweck founded Premium Apparel Brands LLC (“Premium”), a clothing wholesaler, which also operated out of Kids’ premises, and used Kids’ employees and resources. Dweck owned 100% of Premium and served as its CEO. Between 2002 and 2005, Dweck charged almost $500K in expenses to Kids and at least $172K were personal expenses, including vacations and assorted luxury goods.  In March 2005, Dweck admitted at a stockholder meeting that she was selling “overlapping product” and competing with Kids from Kids’ premises. However, Dweck continued to work out of Kids’ offices until April 11, 2005, and Dweck and Taxin continued  to divert Kids’ business to Success.  Dweck and Taxin also arranged for a mass exodus of Kids’ employees to join Success.

Eventually there was a falling out with Nassar and Dweck accusing each other of breaching their fiduciary duties (Nassar also asserted third-party claims against Taxin and Fine).   Nasser sought damages equal to Kids’ purported going-concern value at the time of the split, which his expert values at between $70.8 million and $458.2 million.

Analysis

The Court found that Dweck, as a director and officer of Kids and Taxin as an officer of Kids, each owed a duty of loyalty to Kids and that they breached their duty of loyalty by diverting what they decided were “new opportunities” to Success and Premium.  Dweck and Taxin used Kids’ personnel and resources to pursue each opportunity, demonstrating that Kids just as easily could have pursued the opportunities in its own name. After appropriating the opportunities, Dweck and Taxin operated Success and Premium as if the companies were divisions of Kids, but kept the resulting profits for themselves.  By doing so, Dweck and Taxin placed themselves “in a position inimicable to [their] duties to [Kids].”

The Court provided eminently quotable well-established law on the fiduciary duty of loyalty and the corporate opportunity doctrine:

The essence of a duty of loyalty claim is the assertion that a corporate officer or director has misused power over corporate property or processes in order to benefit himself rather than advance corporate purposes.” Steiner v. Meyerson, 1995 WL 441999, at *2 (Del. Ch. July 19, 1995) (Allen, C.).  At the core of the fiduciary duty is the notion of loyalty–the equitable requirement that, with respect to the property subject to the duty, a fiduciary always must act in a good faith effort to advance the interests of his beneficiary.” US W., Inc. v. Time Warner Inc., 1996 WL 307445, at *21 (Del. Ch. June 6, 1996) (Allen, C.). Most basically, the duty of loyalty proscribes a fiduciary from any means of misappropriation of assets entrusted to his management and supervision. Id. The doctrine of corporate opportunity represents . . . one species of the broad fiduciary duties assumed by a corporate director or officer.” Broz v. Cellular Info. Sys., 67 A.2d 148, 154 (Del. 1996).

The Court also rejected various defenses raised by Dweck and Taxin.  Dweck and Taxin tried to distinguish the new line of business they were entering into from Kids’ line of business.  However, the Court rejected that argument noting that “[w]hen determining whether a corporation has an interest in a line of business, the nature of the corporation’s business should be broadly interpreted. ‘[L]atitude should be allowed for development and expansion. To deny this would be to deny the history of industrial development.’”  Dweck also argued that Nasser gave Dweck permission to compete with Kids but the Court failed to find Dweck’s version of what occurred to be believable. 

Dweck also argued that an operating agreement which contained a so-called “free-for-all” provision authorized her to compete with Kids.  The Court rejected Dweck’s reading of the operating agreement and as to any ambiguity in the agreement, regarding the parties’ course of performance, the Court noted:

It is a familiar rule that when a contract is ambiguous, a construction given to it by the acts and conduct of the parties with knowledge of its terms, before any controversy has arisen as to its meaning, is entitled to great weight, and will, when reasonable, be adopted and enforced by the courts.  Radio Corp. of Ain. v. Phila. Storage Battery Co., 6 A.2d 329, 340 (Del. 1939).  The evidentiary record reflects that before this litigation, the parties did not believe that the essential free-for-all provision granted Dweck the right to compete with Kids. Dweck repeatedly sought to have Nasser sign the Kids stockholders’ agreement, each draft of which contained a functionally identical free-for-all provision. Nasser refused to sign the draft agreements, specifically objecting to the free-for-all provision. Before founding Success and taking the Bugle Boy opportunity, Dweck sought Nasser’s consent (albeit in a vague and ambiguous manner). She received approval only after assuring Shiboleth that her new business would not compete with Kids. If the Essential agreement operated as Dweck now contends, then she had no reason to seek Nasser’s consent.

The Court determined that with respect to the damages for usurping Kids’ corporate opportunities, Dweck, Taxin, Success, and Premium were jointly and severally liable to Kids for the lost profits Kids would have generated from business diverted to Success and Premium between January 1, 2005 and May 18, 2005, which were over $9M.  In addition, among other things, the Court found that Dweck, Taxin, Success, and Premium were also jointly and severally liable for profits generated by Success and Premium after May 18, 2005. This analysis may also be relevant in covenant not to compete cases. See, e.g., Slip op. at 36.

With respect to the mass departure of Kids’ employees and the taking of Kids’ property and files, the Court found that Dweck actively conspired with Taxin and Fine, thereby aiding and abetting Taxin and Fine’s breaches of fiduciary duty.  As a result, the Court found that Kids’ remedy for the departure-related breaches of fiduciary duty should be limited to the damages Kids suffered over and above where Kids would have been had Dweck and Taxin resigned in an appropriate manner. The Court then awarded Kids the profits generated by Success in its non-branded business for the Holiday 2005 and Spring 2006 seasons.

Liability of Officers for Breach of Fiduciary Duty (Approving Personal Expenses of Superior to be Paid by Company Funds)

Finally, with respect to the personal expenses, the Court found Dweck liable to Kids for a total of $342,366 in expenses, comprising both the $171,966 of admittedly personal expenses and the $170,400 of indeterminate expenses.  The Court also found that Fine was jointly and severally liable for those amounts because Fine co-signed for the reimbursement of Dweck’s personal expenses, and he admitted at trial that he did not perform any review of Dweck’s expenses before co-signing her reimbursement checks. See generally, Slip op. at 37-40.

As proven by this case and at least one other prior Chancery opinion cited in this opinion, an officer who approves personal expenses of a superior, which are to be paid with company funds, faces an unenviable binary choice: risk losing one’s job by refusing to process the reimbursement of personal expenses as requested by the superior, or risk personal liability in a court proceeding for approving those expenses in violation of the officer’s fiduciary duty to the company. 

Commentary on Credibility

There is an important theme that the Court mentions a number of times in the opinion that has to do with witness credibility especially in fiduciary cases.  While every litigator know that a witness (and their lawyer’s) credibility is very important, it is worth a reminder now and again.  It is also important to remember that credibility does not just come into play at trial.  It starts at the very beginning of the case with the filing of the complaint and motion practice especially in  discovery disputes before the Court of Chancery.  A good example of this comes from Vice Chancellor Laster’s comments in Eagle Rock when he was dealing with a discovery dispute as to whether an individual should be trusted to identify, preserve, review, and produce relevant electronically stored information.  His larger concern went to the trustworthiness and credibility of an individual who was involved in the litigation and whether he/she should be trusted to do the right thing (in the Eagle Rock case he said that they shouldn’t be trusted to do that without a lawyer being present.)       

Postscript: Professor Gordon Smith blogged about the case here, with scholarly insights on the “free for all” clause that can attempt to eliminate a corporate opportunity claim. See DGCL Section 122(17).

On January 13, 2012, the Court of Chancery issued non-binding guidelines or “best practices” to help lawyers and their parties handle common and sometimes complex  procedural issues that arise in litigation before the Delaware Court of Chancery. 

Kevin F. Brady, who is a member of the Court of Chancery Rules Committee, prepared this summary.

The 18-page Guidelines cover a variety of topics from as simple as hearing protocols, courtesy copies, contacting Chambers and scheduling expedited or summary proceedings to more expedited subjects such as expert report and confidentiality agreements.  The Guidelines also include sample forms for such proceedings as scheduling a preliminary injunction, a Rule 12(b)(6) motion or cross-motions for summary judgment. 

The Guidelines, available for download here, include procedures that the Court would prefer to see.  For example, with respect to expert reports, the Guidelines state:

In general, the Court prefers that parties stipulate to limit expert written discovery to the final report and materials relied on or considered by the expert. Counsel should be aware that the Court understands the degree of involvement counsel typically has in preparing expert reports. Cross-examination based on changes in drafts is usually an uninformative exercise.

With respect to the pleadings, the Guidelines state: “An answer should repeat the allegations of the complaint and then set forth the response below each allegation. Otherwise the Court has to look back and forth from answer to complaint to see what is being denied.”

One of the more important guidelines issued by the Court provides instruction to the legions of non-Delaware lawyers who coordinate with local Delaware lawyers to litigate cases in Chancery. About these working relationships, the Court gives the following specific direction:

Role of Delaware Counsel

a. The concept of “local counsel” whose role is limited to administrative or ministerial matters has no place in the Court of Chancery. The Delaware lawyers who appear in a case are responsible to the Court for the case and its presentation.

b. If a Delaware lawyer signs a pleading, submits a brief, or signs a discovery request or response, it is the Delaware lawyer who is taking the positions set forth therein and making the representations to the Court. It does not matter whether the paper was initially or substantially drafted by a firm serving as “Of Counsel.”

c. The members of the Court recognize that Delaware counsel and forwarding counsel frequently allocate responsibility for work and that, in some cases, the allocation will be heavily weighted to forwarding counsel. The members of the Court recognize that forwarding counsel may have primary responsibility for a matter from the client’s perspective. This does not alter the Delaware lawyer’s responsibility for the positions taken and the presentation of the case.

d. Non-Delaware counsel shall not directly make filings or initiate contact with the Court, absent extraordinary circumstances. Such contact must be conducted by Delaware counsel.

e. It is not acceptable for a Delaware lawyer to submit a letter from forwarding counsel under a cover letter saying, in substance, “Here is a letter from my forwarding counsel.”

Finally, there are some interesting comments with respect to what counsel should include in Compendiums and Appendices.  The Guidelines show that this is an opportunity to point the Court to exactly what counsel want the Court to review.  There is also a humorous comment where the Guidelines tell counsel they don’t have to include everything in a compendium – “Avoid the Manhattan Phonebook. If a submission is huge, uncomfortable to hold, and likely to fall apart, please break it into separate usable volumes.”

As the Court stated in its announcement:

The goal of the guidelines is to help litigants deal with each other and the Court in a more constructive, less contentious, and therefore more efficient and just manner. … All the members of the Court recognize the guidelines as sound and members of the Court will endeavor to avoid the chambers-specific approach that results in litigants having to address the idiosyncratic preferences of multiple members of the same court.  All of us on Chancery recognize how challenging it is for lawyers to address complex cases especially in view of evolving issues such as electronic discovery, said Chancellor Leo E. Strine, Jr.  By developing these practice guidelines with the invaluable help of our Rules Committee, we hope to make our Bar’s life a little easier and to enable all of us to concentrate more on the merits, rather than procedural jousting. This will get cases resolved less expensively and faster.

The Guidelines are the product of a joint effort between the judges of the Court of Chancery and the Court’s Rules Committee, which is comprised of experienced Delaware practitioners.  Please note that this is not the end of the guidelines for the Court of Chancery.  The Rules Committee is working on other rules and procedures, so stay tuned for more information.

Shiftan v. Morgan Joseph Holdings, Inc., C.A. No. 6424-CS (Del. Ch. Jan. 13, 2012), read opinion here.

Issues Addressed:

(i)         Whether the Court may consider in an appraisal action a contractually required redemption event in the certificate of incorporation, scheduled to occur six months after the merger, in determining the fair value of the stock;

(ii)        Whether the automatic redemption provision was subject to an “excess cash” requirement in the certificate of incorporation.

Short Answers:

(i)         The Court concluded that it was appropriate to consider the automatic redemption for purposes of the appraisal analysis even though the merger occurred several months before the right was triggered.  The Court distinguished this redemption right from cases in which the Court has refused to consider speculative possibilities in rendering an appraisal opinion, or where preferred stockholders were contractually told how their shares would be treated in the event of a merger;

(ii)        The Court also found that the automatic redemption was not subject to an “excess cash requirement” under the certificate.  The certificate of incorporation was plain that there were two types of redemptions for preferred stock.  In addition, although the Court found that the certificate was unambiguous, parol evidence also supported the conclusion in favor of the petitioners.  The Court especially noted that Morgan Joseph chose not to file a Rule 56(f) affidavit or to submit any conflicting parol evidence.

Background

The defendant in this case, Morgan Joseph Holdings, Inc., is an investment bank in which the petitioner held Series A Preferred Stock.  The petitioners bought their preferred stock when Morgan Joseph was founded in 2001 to help provide the initial funding for the company.  In December 2010, Morgan Joseph merged with another investment bank called Tri-Artisan Capital Partners, LLC.  The new Series A Preferred Stock which was governed by a new certificate of incorporation, was offered in exchange for Morgan Joseph’s old Series A Preferred Stock.  Instead of exchanging their Series A Shares, the petitioners in this action demanded appraisal under 8 Del. C. § 262. 

The certificate of incorporation included a provision for an automatic redemption of the Series A Preferred Stock at $100 per share which would have been triggered six months after the merger.  The petitioners claimed that because their stock was to be mandatorily redeemed six months after the merger, the Court should take into account the $100 per share redemption value provided for in the certificate in determining the fair value of the Series A Preferred Stock.

Short Summary of Court’s Reasoning

The Court emphasized that “the core mandate of Section 262 requires this Court to award the petitioners the ‘fair value of their shares.’” (emphasis in original) (citing 8 Del. C. § 262(h)).  The Court also emphasized that in the case of an appraisal of preferred stock, the Court must look at the contract rights granted to the shares being appraised under the relevant certificate of incorporation or designation in determining fair value.  In this case, the Court reasoned that the unique contractual feature of the automatic redemption given to the Series A Preferred Stock under the certificate had to be considered in rendering the final appraisal decision.

This decision was made in the context of a motion for partial summary judgment.  The material facts were not disputed, but rather, there was a different interpretation about how the certificate of incorporation provisions should be interpreted in connection with the automatic redemption clause and its impact on the analysis of the fair value in this appraisal proceeding.

The Court conducted an extensive analysis of the language in the certificate of incorporation and applied contract interpretation principles, including the principle of contract interpretation which says that ambiguous terms should be construed against the drafter.  The Latin phrase for that contract interpretation principle is contra proferentem.  See footnotes 17 through 26.

This 23-page opinion also provides helpful analysis regarding the construction of the rights granted to preferred stockholders in a certificate of incorporation or a certificate of designation.

In Hosanna-Tabor v. EEOC (download here), the U.S. Supreme Court yesterday recognized a defense that churches may assert against claims by some employees based on anti-discrimination laws, such as a minister that claims she was discriminated against on an issue that comes within the scope of the church’s religious beliefs. Professor Bainbridge comments on this important ruling here; The Wall Street Journal reports on the U.S. Constitutional basis in the opinion (that also cites to the Magna Carta) here, and employment lawyer Daniel Schwartz provides insights here.

Burtch v. Revchem Composites, Inc., f/n/a Revchem Plastics, Inc. (In re Sierra Concrete Design, Inc.), Adv. Case No. 10-52667 (CSS) (Bankr. D. Del., Jan. 4, 2012), read opinion here.

Tara Lattomus of Eckert Seamans prepared this summary.

Issue Addressed

Whether a creditor sued in a preference action was entitled to summary judgment based upon the ordinary course of business and subsequent new value defenses?

Short Answer

The defendant’s motion for summary judgment was denied in part and granted in part.  The defendant failed to establish a sufficient course of business to establish the ordinary course of business defense.  However, invoices issued after the preference payments entitled the defendant to some credit for the new value defense.

Background

This opinion did not contain many details about the underlying dispute.  Instead, Judge Sontchi took the opportunity to explain the theories behind bankruptcy law, in general, and preference law, specifically.  He began with the concept that outside of the bankruptcy context creditor recoveries are based on the principle of “first come, first served.”  However, in the bankruptcy context, this principle may be harmful to creditors as a whole.  The bankruptcy proceeding ends the individual collection efforts of specific creditors in favor of maximizing the return to all similarly situated creditors.  Preference law supports the theory behind bankruptcy because it allows a debtor to recover any payments made to its creditors in the 90 days prior to the filing of the bankruptcy case.  So, in other words, preference law is meant to deal with those creditors who see a bankruptcy filing on the horizon and step up their collection efforts in order to receive full payment on their claims before the case is filed.

Analysis

Because not all creditors who receive payments in the 90 days prior to bankruptcy are pursuing a debtor with this motivation, there are certain defenses to a preference action that are very fact specific.  The two most common defenses are the ordinary course of business and new value defenses.

The ordinary course of business defense protects payments “that are made in ordinary course on debts incurred in ordinary course according to ordinary business terms.”  The ordinary course of business defense can be established either by reference to the course of dealing between the two parties or by the industry standard.  Specifically, a creditor must prove that the payments received during the preference period were consistent with payments it received prior to the preference period or that the payments it received were consistent with the industry standard.

The subsequent new value defense “protects creditors who provide new credit [to the debtor] after an old invoice is paid off.”  In order to establish the subsequent new value defense a creditor must establish two elements:  (1) after receiving the transfer the creditor must have advanced new value to the debtor on an unsecured basis; and (2) the debtor must not have fully compensated the creditor for the new value as of the bankruptcy filing.  The judge explained that in order to undertake this analysis one must consider the net result after looking at the new value the creditor extended to the debtor after the preference payments but that any credit for new value should not be in excess of the preference exposure.

In this case, Judge Sontchi ruled that the creditor and the debtor had an insufficient pre-preference period relationship to establish an ordinary course of business.  The pre-preference period consisted of 17 checks covering approximately 68 invoices over an 11 month period.  The Court ruled that this was insufficient evidence to establish an ordinary course of business.  The creditor also failed to present sufficient evidence to establish an industry standard.  However, the judge did find that the creditor was entitled to certain credits for new value thereby reducing its preference exposure.  As a result, the motion for summary judgment was denied in part and granted in part.