Chancery Finds Corporate Officers Usurped Corporate Opportunities and Converted Resources in Violation of their Fiduciary Duty of Loyalty

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. 

UPDATE: A subsequent Chancery decision in this case was highlighted here.

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).