Fiduciary Duty Claims of Start-up Co-Founder Denied

A recent Delaware Court of Chancery opinion analyzed claims that are not uncommon: one of two founders of a start-up, that failed to launch, claimed that the other co-founder breached fiduciary duties by launching another start-up venture with a third-party who then pursued the business plan of the original start-up, but without the original co-founder.  In McKenna v. Singer, C.A. No. 11371-VCMR (Del. Ch. July 31, 2017), the court disagreed that the original co-founder of the original start-up entity had any right to an interest in the separate start-up venture later launched with a different third-party.

Background

The first 40 pages of this 69-page opinion offers detailed facts which are necessary to understand the court’s reasoning. The comprehensive background details explain why one co-joint venture partner decided not to do business with the other.  As an aside, one of the co-joint venture partners who was not a part of the eventual launching of the start-up formed with another third-party, exhibited a chronic failure to promptly reply to emails, as well as consistently dilatory behavior and failure to follow-up on tasks that were assigned to him as part of the due diligence for the start-up that was eventually launched with another third party.  That type of languid behavior did not endear him to the other entrepreneurs.

Key Takeaways

This opinion features iconic articulations of the basic elements of a fiduciary duty claim and eminently quotable descriptions of the fiduciary duties owed by directors or others serving in a fiduciary role to constituencies in a business venture. See Slip op. at 47.

Also useful for the toolbox of any corporate or commercial litigator is the application by the court of a fiduciary duty analysis to a former co-joint venture partner who decided to consummate the joint venture start-up deal with a third-party.

Of practical and widespread application is the court’s analysis of the unclean hands doctrine that barred relief based on the improper conduct by the party requesting relief. Slip op. at 41-42.  That is, but for the material misrepresentations of the plaintiff, the original joint venture partner never would have agreed to form a start-up entity.

Similarly helpful for commercial litigators is the court’s discussion of the duty of disclosure, if any, in an arm’s length negotiation, Id. at 43, as well as the standard for usurpation or misappropriation of a corporate opportunity. Id. at 48.

In sum, the court reasoned that the fiduciary relationship on which the request for relief rested was conceived in an unholy manner, due to the several material misrepresentations by the plaintiff that was requesting damages for the breach of an alleged fiduciary duty – – one that was never properly consummated due to the unclean circumstances created by the misdeeds of the plaintiff.

Chancery Refuses to Apply Garner Exception to Attorney/Client Privilege

A recent Delaware Court of Chancery decision is essential reading for anyone who seeks to apply the exception to the attorney/client privilege known as the Garner exception. Salberg v. Genworth Financial, Inc., C.A. No. 2017-0018-JRS (Del. Ch. July 27, 2017). Garner is known to corporate litigation practitioners as an exception to the general prohibition on the production of privileged communications between attorney and client.

Key Principles

The Garner exception applies in certain circumstances where corporate fiduciaries who are defending claims brought against them by those to whom the fiduciary duty is owed, based on the application of a multitude of factors in which it is determined by the court that the documents otherwise withheld, should produce otherwise privileged documents.

The court in this opinion makes it clear that the application of the Garner exception is factually determinative, and even if all of the various factors apply, whether or not a fiduciary exception to the privilege will be recognized is within the discretion of the court.

The context of this case was a Section 220 demand made more complicated because it was preceded by a derivative action which was still pending at the time of this Section 220 case. During the pendency of the previously filed derivative action, a merger of Genworth was announced.  The Section 220 case sought records regarding the valuation of the pending derivative action as part of the decision to merge.

One of the factors that made it more challenging in this case for the application of the Garner exception, was the acknowledgement by the parties that they were seeking, at least arguably, in the Section 220 action, documents that they would not otherwise be entitled to obtain in the pending derivative action against the same company.

This opinion is must reading for anyone seeking to have a complete and nuanced understanding of the Garner fiduciary exception to the attorney/client privilege.  The court also discusses Delaware Rule of Evidence 502(b) in the context of the analysis, as well as the Delaware Supreme Court’s Section 220 decision in Wal-Mart Stores, Inc., in 2014, highlighted on these pages here, which endorsed the application of Garner, which had been applied for many years previously by the Court of Chancery.

In addition to the nine factors that the Garner case requires to be considered as informing the court about whether “good cause” exists, the Delaware courts have identified three of those as having particular significance. See footnotes 18 and 19.  Even though the Garner factors, including the three that the Delaware courts focus on, were arguably met, the biggest problem that the claimants faced in this case, and a key reason for the court’s decision, was that they were seeking to obtain in a Section 220 action what they otherwise would not be able to obtain through the previously filed and still pending derivative action.

The court emphasized that even if all of the Garner factors apply, they are not “talismanic” and that the court must use its discretion based on the unique circumstances of every case.  The court in this case was troubled that the documents sought would contain the mental impressions and assessments of the defendants and their counsel in the derivative action regarding the strengths and weaknesses of the derivative claims.  The company’s board would be understandably concerned that the production of those sensitive documents would give the plaintiffs an unfair advantage in the derivative action.  The general articulation of the Garner fiduciary exception recognizes that:

“Where the corporation is in suit against its stockholders on charges on acting inimically to stockholder interests, protection of those interests as well as those of the corporation and of the public requires that the availability of the privilege be subject to the right of the stockholders to show “good cause” why the privilege should not apply.” See footnotes 10 and 11.

The exception is intended to be difficult to satisfy and generally does not entitle the party to the mental impressions about trial strategy of the lawyers regarding the lawsuit at issue. In sum, the court refused to apply the Garner exception in this case.

Lawyer Not Barred from Testifying as Witness

The latest Chancery decision in hotly contested litigation captioned In re Oxbow Carbon LLC Unitholder Litigation, Consol., C.A. No. 12447-VCL, (Del. Ch. July 28, 2017), addresses several issues that are of practical importance for all trial lawyers. Several prior Delaware decisions in this case that have been highlighted on these pages  provide additional background.  Among the key principles addresses in this decision is the application of Rule 3.7(a) of the  Delaware Lawyers’ Rule of Professional Conduct, which generally bars a lawyer from acting as an advocate at the same trial in which the lawyer is likely to be a necessary witness – – with three exceptions.  After a careful application of the rule to the facts of this case, the Delaware Court of Chancery reasoned that, on balance, the lawyer involved should not be prevented from testifying, although his testimony would be approached with care.

Court’s Analysis

The opinion explained that the lawyer involved was present during the trial but that he was not acting as an advocate to the extent that he did not have a speaking role. This was intentional because it was expected that he might be needed as a rebuttal witness.

Importantly, the court emphasized that his testimony would not undermine the fairness of the proceedings, especially because it is a bench trial and the court fully understood the difference between the role of a fact witness and the role of a counsel for one of the parties. The court provided ample citations to authority including the well-known Delaware Supreme Court decision entitled Appeal of Infotechnology, Inc., 582, A.2d 215, 221 (Del. 1990), which generally stands for the principle that a non-client litigant only has standing to enforce a rule of professional conduct such as an alleged conflict “when he or she can demonstrate that the opposing counsel’s conflict somehow prejudiced his or her rights.”  Moreover, the court is aware that rules of professional conduct are sometimes used as a tactical weapon to seek inappropriately to disqualify opposing counsel. See footnotes 22 through 24.

Trial Practice Tips from the Court

This opinion also features a practical commentary from the court with insights on trial practice regarding the order that witnesses are called, and the preference of calling a witness only once when he will be both an adverse witness and a witness favorable to the other party. The alternatives in calling an adverse witness for a party’s case in chief, involve the court deciding whether or not the party calling the adverse witness will question the party first as part of his case-in-chief.  In this case, the court decided to permit counsel to conduct a direct examination first, followed by the cross examination by the adverse party.  This approach allowed the party who has the burden of proof to determine the order of witnesses by calling adverse witnesses for its case-in-chief.  But that party here did not have the opportunity to question an adverse witness from the outset as a hostile witness.  Instead, counsel for the witness had the opportunity to present the witness first, after which opposing counsel would cross-examine.  The court preferred this approach as a more efficient use of trial time, although it deprives the party with the burden of proof of calling and questioning a hostile witness from the outset.

The author of this opinion also explained that generally he prefers to give the party with the burden of proof the ability to first question – – even an adverse witness, but in this case because both sides had asserted interrelated claims and defenses where they each technically bore the burden of proof, there was less ability to view one side as having the burden such that they should also receive the tactical advantages that accompany that burden.

Lastly, the opinion included a useful discussion of Delaware Rule of Evidence 615 regarding sequestration of witnesses and the ability of the court at the request of a party to order witnesses excluded from the trial so that they can hear the testimony of other witnesses – – with the exception of a party who was a natural person, or an officer or an employee of a party which is not a natural person, or a person whose presence is necessary to the presentation of the cause.

Stock Transfer Restrictions Explained

A recent decision of the Delaware Court of Chancery needs to be consulted by anyone who seeks to fully understand the prerequisites under the Delaware General Corporation Law for effective restrictions on the transfer of stock. Henry v. Phixos Holdings, Inc., C.A. No. 12504-VCMR (Del. Ch. July 10, 2017).

The prerequisites under DGCL Section 202 include actual knowledge of the restrictions and consent by the stockholder to the stock transfer restrictions.  The court explained in this useful decision why the requirements of Section 202 were not met based on the facts of this case, and why those restrictions cannot be retroactive unless additional requirements are satisfied.

A longer discussion of this case will be published as part of my regular column for the National Association of Corporate Directors’ publication called Directorship.

Relief Granted for Fraudulent Conveyance

The Court of Chancery recently addressed claims for fraudulent conveyance, and relief available for such claims, in Duffield Associates, Inc. v. Lockwood Brothers, LLC, C.A. No. 9067-VCMR (Del. Ch. July 11, 2017). Court of Chancery Rule 9(b) requires that averments of fraud or mistake shall be stated with particularity, as compared to other claims which may be averred generally.

The court described the elements of Section 1304 of the Delaware Uniform Fraudulent Transfer Act, and referred to remedies available to creditors defrauded by debtors who transfer assets improperly. In this case, there was no genuine issue of material fact as to insolvency.  This opinion has practical application in its description of the prerequisites for establishing a fraudulent transfer under the statute and for providing a reminder that any court of equity has “broad latitude” in crafting a remedy appropriate to the circumstances of a fraudulent transfer.  Those remedies are cumulative and non-exclusive.

In this case, the court granted the remedies sought of constructive trust, a full accounting of the proceeds of distributions, and a disgorgement of any profits or proceeds from the transfers.

 

More on ABA Model Rule of Professional Conduct 8.4(g)

Much has been written about the new Model Rule of Professional Conduct that the American Bar Association (ABA) adopted in August 2016. My ethics column in the November/December 2016 edition of The Bencher, the national publication of the American Inns of Court, explained how the new ethics rule, which the various states can decide to adopt–or not–expands in an amorphous manner the concepts of discrimination and harassment. That article quoted from law professors who teach legal ethics and constitutional law, as well as other commentators.

Since that publication, which raised questions about the rule, the scholarship on the topic now includes several law review articles, including Andrew F. Halaby and Brianna L. Long, New Model Rule of Professional Conduct 8.4(g): Legislative History, Enforceability Questions, and a Call for Scholarship, 41 J. Leg. Prof. 201 (2016-2017)(Halaby Article); Note, Discriminatory Lawyers in a Discriminatory Bar, 40 Harvard J. Law & Pub. Pol. 773 (June 2017)(Harvard Note).

It is a violation of the new Model Rule 8.4(g) to engage in discrimination based on “race, sex, religion, national origin, ethnicity, disability, age, sexual orientation, gender identity, marital status, or socioeconomic status in conduct related to the practice of law.” Discrimination includes “verbal” conduct that “manifests bias.” The eleven protected categories are not entirely inclusive. Omitted from the classifications are such personal attributes as weight, height and veteran status, for example.

For the first time since I started writing the ethics column for The Bencher over 20 years ago, someone wrote a letter to the editor about my column. The author of that letter about my column on the new rule was the president of the ABA. The issues raised by the new model rule deserve a robust analysis and scholarly debate. A few recent law review articles contribute to that goal. More scholarship on the topic is needed. This short essay merely identifies some of the aspects of the recently promulgated model rule that require further study before being adopted by the various states.

Let’s start with the basic premise that everyone should abhor illegal discrimination and harassment in all its nefarious forms. One of the issues created by the new model rule, however, is that it expands the concepts of both discrimination and harassment in a way that reasonable people can, and do, sincerely differ about. Should we impose serious penalties on, and describe as a violation of legal ethics, conduct that reasonable and ethical people sincerely disagree about for intelligent reasons?

It deserves mention that the membership of the ABA counts for a relatively small fraction of all lawyers in the U.S. Yet, the leadership of the ABA is making normative judgments, and setting moral standards, for a majority of the lawyers in this country on a matter about which most of the country is deeply divided. As the Halaby Article explains, the process used to adopt Model Rule 8.4(g) did not benefit from the same level of participation and the same lengthy comment period as did many of the prior major changes in the rules that govern the legal profession. Remember that these rules subject those who violate them to possible loss of their license to practice law and their ability to make a living.

In their zeal to create a utopia, which some might view as a dystopia, the authors of the new model rule have not avoided the fallacy that the end always justifies the means, or to use another maxim: they threw the baby out with the bath water. We should “keep the baby” and find a more nuanced approach to eliminating the bath water–in this case, unwanted discrimination, harassment and lack of diversity in the profession.

The British statesman William Pitt the Younger was attributed with the observation that “necessity is the plea for every infringement of human freedom.” We can all agree that invidious discrimination and harassment should be condemned, but not everyone agrees that other fundamental rights should be trampled on in order to achieve the goal of banning such discrimination and harassment.

One of the problems with the rule is vagueness. It lacks a definition for what it prohibits: discrimination, harassment and applying that behavior to socioeconomic status, for example. Definitions in substantive law, and other sources, can certainly be used as a reference, but they are not uniform and may not apply in all contexts. The Halaby Article describes the new model rule as being “riddled with unanswered questions, including but not limited to uncertainties as to the meaning of key terms…as well as due process and First Amendment free expression infirmities.” Others are more supportive.

Although the Harvard Note argues that amendments to the new model rule should be made before states begin adopting it, overall it supports a codification of the moral judgment that discrimination and harassment are cardinal sins that must be banned from the legal profession. What constitutes a sin, however, needs to be defined. An inherent problem of the ABA’s attempt to use new Model Rule 8.4(g) to codify moral judgments, is that the ABA membership constitutes a small percentage of all lawyers in America and reasonable people can differ about whether the leadership of that group is the appropriate elite to adopt rules that impact personal behavior beyond the administration of justice–much like the magisterium of a church would articulate rules that apply to all areas of one’s personal life – – not only rules governing the practice of law.

Equitable Jurisdiction Found Lacking in Debt Action

The Delaware Court of Chancery is a court of equity with limited jurisdiction. Contrary to what some may assume, not all corporate and commercial litigation can be heard in this famous court. (Delaware’s trial court of general jurisdiction is the Superior Court.) A recent opinion has practical application for litigators to the extent that it applies the well-traveled, but not often well understood, nuances of the limited scope of the equitable jurisdiction of the Delaware Court of Chancery. Yu v. GSM Nation, LLC, C.A. No. 12293-VCMR (Del. Ch. July 7, 2017).  This letter decision explains the three ways to secure equitable jurisdiction, but the court reminds practitioners that the mere incantation of key words invoking equitable relief will not suffice.

The background of this case includes a request to pierce the corporate veil, about which the Court of Chancery has exclusive jurisdiction. In addition to serving as an example of how difficult it is to successfully pierce the corporate veil, this decision explains why the Superior Court could provide adequate relief to the plaintiff by providing a money judgment.  There was insufficient detail in the pleadings to explain why a money judgment could not be paid, and therefore the court dismissed the complaint with leave to refile or transfer the case to the Superior Court within 60 days pursuant to 10 Del. C. § 1902. See generally footnotes 7, 9 and 10 regarding equitable jurisdiction, and also 10 Del. C. § 342, re: Chancery’s limited jurisdiction.

Also of practical application is the discussion by the court in this letter ruling of the exclusive jurisdiction that Chancery has over equitable fraud claims, but in this case there was no basis for an equitable fraud claim. The use of the words alone to allege equitable fraud claims is not enough.

In addition, the court explained that in some instances the Superior Court and the Court of Chancery may both entertain claims for unjust enrichment, but if the unjust enrichment claim, as in this case, is merely a contract-related theory of recovery that accompanies a breach of contract allegation, then the claim is only legal, and not equitable. See footnote 25.

Fiduciary Duties in Limited Partnerships

For my latest column in Directorship, the publication of the National Association of Corporate Directors, I discuss a recent Delaware Supreme Court decision that addresses fiduciary duties as modified in the context of a limited partnership agreement. The case of Brinckerhoff v. Enbridge Energy Company was previously highlighted on these pages, but the opinion remains required reading for any lawyer who needs to know the latest Delaware law regarding how fiduciary duties can be modified by agreement in non-corporate entities, and the interfacing of those modified duties with the implied covenant of good faith and fair dealing. Professor Stephen Bainbridge, friend of this blog, kindly linked to the referenced column.

Corwin Cleansing Not Always a Sure Defense For Director Misconduct in the Merger Realm

This post was prepared by Brian E. O’Neill, Esq. of Eckert Seamans

A recent article in Law 360 surveys three recent opinions in which the Court of Chancery rejected the Corwin cleansing doctrine in the merger context, in which the directors’ misconduct created various forms of coercion upon the stockholders.  The article entitled When Delaware Courts May Reject Corwin Cleansing: Some Clarity (July 13, 2017) (sub. req.), reviews the Court of Chancery’s refusal to apply the Corwin cleansing doctrine through the lenses of situational coercion, structural coercion, and extraneous bad acts.

The article discusses cases that explicate when director misconduct cannot be cleansed by the affirmative majority vote of the fully informed, non-coerced stockholders in favor of a merger. In Saba Software Stockholder Litigation, C.A. No. 10697-VCS (April 11, 2017), Vice Chancellor Slights found inapplicable Corwin’s cleansing effect due to the board’s ongoing pattern of failing to restate financial statements to account for past fraudulent activity.  As a result, the Court found that the stockholders had no choice but to approve a merger at a fire sale price.  In Sciabacucchi v. Liberty Broadband Corp., C.A. No. 11418-VCG (May 31, 2017), Vice Chancellor Glasscock refused to apply Corwin to cleanse the directors’ linkage of the approved merger with an equity award to the corporation’s largest stockholder.  Notably, the Court found that plaintiffs had adequately pled that alternative financing was available.  Last, in In re Massey Energy Company Derivative and Class Action Litigation, C.A. No. 11418-CB (May 4, 2017), Chancellor Bouchard refused to apply Corwin because the directors’ misconduct  was “unrelated” and “extraneous” to the merger at issue and therefore could not be cleansed by a majority vote of the stockholders.

Chancery Dismisses Claim Due to Lack of Fiduciary Relationship

A recent letter opinion provides a practical description of the elements required to satisfactorily plead a breach of fiduciary duty claim, as well as a definition of situations where a fiduciary relationship may be found. In Beach to Bay Real Estate Center, LLC v. Beach to Bay Realtors, Inc., C.A. No. 10007-VCG (Del. Ch. July 10, 2017), the Court of Chancery also observed the non-controversial truism that minority members of LLCs generally do not owe fiduciary duties to the LLC or other members.

The court explained that in Delaware a fiduciary relationship may be found in:

“. . . a situation where one person reposed special trust in and reliance on a judgment of another or where a special duty exists on the part of one person to protect the interest of another.” See footnote 68.

Moreover, the court explained that there “must be an allegation of an agreement supplying such a duty or a special relationship creating such a duty.” The court observed that in its experience, “thieves and their victims rarely consider their relationship an equitable one on account of that status alone.  Rather, there must be some repose of special trust . . . or reliance . . ..”

The court allowed, however, for the possibility that “in certain circumstances a minority member of an LLC, with access to confidential information, could stand in a fiduciary relationship to the entity or other members.” But, non-conclusory allegations in support of a relationship creating such a duty were found lacking in the complaint in this case.

As an aside, this decision also features quotes from William Faulkner and colorful language about procedural irregularities concerning this matter.

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