A recent Delaware Court of Chancery decision provided a thorough examination of the titular topic in connection with allegations of fraudulent enticement to invest. In Sehoy Energy LP v. Adriani, C.A. No. 12387-VCG (Del. Ch. June 16, 2021), the court discussed a few things that should be of interest to corporate and commercial litigators.

● The facts of this case provided the rare exception to the general rule that breach of contract claims cannot be bootstrapped into a fraud claim.
● The court provided an excellent recitation of the five elements of a fraudulent inducement claim. See Slip op. at 27-30. The court also provides key reasoning about the application of those principles.
● Another useful nugget with wide applicability is the court’s discussion about the following principle: when rescissory damages are granted, the claimant cannot also receive contradictory money damages. See Slip op. at 31 and footnote 183.

 

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Chancery Court recently decided OptimisCorp may be able to prove three ex-directors disloyally withheld from the struggling physical therapy company a $6.7 million award they had won in a derivative action against its former outside counsel for legal malpractice during a bitter board feud in OptimisCorp v. Atkins et al., No. 2020-0183-MTZ opinion issued (Del. Ch. July 15, 2021).

Vice Chancellor Morgan Zurn’s July 15 opinion denied the ex-directors’ motion to dismiss breach-of-duty and unjust enrichment charges because of evidence that as derivative suit plaintiffs, they put their own interests first by seeking to divide the award among their shareholder allies even when it became a company asset that Optimis badly needed.

Notably, the court likened the three directors’ duty to that of a trustee, especially when the derivative charges they brought against ex-Optimis counsel regarding his advice about the legality of their ‘ambush” ouster of CEO Alan Morelli  resulted in an award to the company and all its investors. “The board may, and sometimes must, relinquish control over that asset to a stockholder representative in a derivative action,” the Vice Chancellor wrote. “Defendants’ position that they owed no duty to the company as derivative plaintiffs is inconsistent with Delaware law.”

She cautioned lawyers immersed in bitter contest-for-control litigation that “defendants’ disdain for Morelli and Sussman does not obviate their duties to them as stockholders, or to the other stockholders, or to Optimis” adding that per Delaware General Corporation Law, after the award, “the Optimis board should have regained its power under Section 141(a) to make decisions regarding the use of the benefits derived from corporate litigation.”

Background
The three defendant directors — William Atkins, Gregory Smith and John Waite — had been in conflict with CEO and Chairman Alan Morelli since October 2012 when they purported to remove him from both positions in a surprise board meeting. The ex-Optimis counsel was drawn into the battle when the three directors charged him with malpractice for some of the legal positions he took during the many lawsuits spawned by the contest for control.

After the parties agreed to arbitrate the claims against the ex-lawyer for the company, an arbitrator found him liable to Optimis for legal malpractice and breach of duty in Sept. 2019 but despite the severe financial problems the company was experiencing at that time, the defendants did not turn the award over, the vice chancellor said. She found that it cost Optimis a total of $4 million counting loss of market share, referral sources, patients, payors, goodwill, and revenue, combined with the levy the defendants filed on Optimis operating unit’s accounts receivable funds, interfering with its business operations and Optimis’ cash flow and forcing it to borrow at a $1.4 million cost.

The defendants, who now hold positions with an Optimis competitor, turned over the full award only after the vice chancellor, in a June 19 bench ruling, found the award to be derivative and ordered them to comply, the court said.

Turning to the breach of duty and unjust enrichment charges, Vice Chancellor Zurn rejected as being “wrong under Delaware law,” defendants’ arguments that:

1. Any fiduciary role and duties they assumed as derivative plaintiffs prosecuting the arbitration was with respect to their fellow stockholders only, not to the corporation itself,
2. “[E]ven if Defendants owed fiduciary duties to Plaintiff, Delaware law does not impose upon them any obligation other than to maintain the derivative action for the benefit of the stockholders,” and therefore Plaintiff has not pled breach as a matter of law,” and
3. Delaware law does not recognize a claim for money damages for a derivative plaintiff’s breach of fiduciary duty.

In answer, the court ruled that:

1. “Defendants’ position that they owed no duty to the Company as derivative plaintiffs is inconsistent with Delaware law. Defendants owed fiduciary duties to the Company and its stockholders with respect to the corporate asset entrusted to them.”
2. “As a fiduciary, the representative plaintiff owes to those whose cause he advocates a duty of the finest loyalty… Any stockholder seeking to bring a derivative suit on behalf of the corporation has to act in the best interest of the corporation.”
3. “Optimis is not required to plead and prove damages in order to state a claim for breach of fiduciary duty, but has nonetheless done so by alleging that withholding the Award caused Optimis to take out unfavorable loans costing the Company approximately $1,500,000.”

Unjust enrichment claim may also proceed

The court said, “[b]y withholding the derivative proceeds from Optimis, Defendants unjustly enriched themselves with ill-gotten benefits to the detriment of Optimis, while also causing other direct and indirect harm to Optimis on a significant scale. Under Delaware law, “[u]njust enrichment is the unjust retention of a benefit to the loss of another, or the retention of money or property of another against the fundamental principles of justice or equity and good conscience.”

In a recent letter ruling, the Court of Chancery deferred any decision on whether or not there was a violation of Rule 3.7(a) of the Delaware Lawyers’ Rules of Professional Conduct. In Re Straight Path Communications Inc. S’holder Litig., C.A. No. 2017-0486-VCG (Del. Ch. July 12, 2021).

Rule 3.7 generally prohibits a lawyer from simultaneously appearing as a trial advocate and as a witness, but Rule 3.7(a), when used as a sword, is problematic and disfavored.

Although the court explains what must be demonstrated in order to successfully apply the rule to prevent a lawyer from being both an advocate and a witness in the same case, the court deferred decision because the issue had not been properly “teed-up.”

Moreover, the court acknowledged a principle previously made clear by the Delaware Supreme Court, that only the Delaware Supreme Court has the authority to enforce the Rules of Professional Conduct, with a limited exception.

The Court of Chancery did not decide whether that limited exception applied to the facts of this case, and declined to determine whether or not a violation of ethical precepts affected the ability of the trial court to do justice. Such a finding would allow the trial court to enforce the Rules of Professional Conduct as an exception to the Delaware Supreme Court’s exclusive jurisdiction to rule on that issue.

The Delaware Court of Chancery recently explained under what circumstances dual claims will be allowed to proceed for both breach of fiduciary duty and breach of contract in the context of the manager of an LLC allegedly using LLC assets for his personal benefit in a manner not shared by all the other LLC members. In Largo Legacy Group, LLC v.  Charles, C.A. No. 2021-MTZ (Del. Ch., June 30, 2021), the Court addressed many noteworthy bedrock principles of Delaware commercial litigation. [I recently co-authored an article for the Delaware Business Court Insider that discussed other Delaware decisions that allowed similar tandem claims to proceed.]

Practitioners would be well-served to keep this decision handy in their virtual toolbox because it includes many statements of Delaware law that have widespread applicability to commonly encountered business disputes, especially among LLC members.

Basic Background

The detailed facts provided in the court’s opinion are essential to fully understanding this case, but for the limited purpose of highlighting the most consequential statements of law, I’ll only provide a modest amount of color to give context to the rulings. Although arguably involving usurpation of corporate opportunity, the parties and the court referred to the claims as a more generic and simple breach of fiduciary duty. The LLC in this case owned a hotel as well as adjacent land that was undeveloped. According to the complaint, which was viewed in the context of a motion to dismiss under Rule 12(b)(6), see Slip op. at 18-19,  the LLC manager transferred the adjacent land to a separate entity that the manager personally owned and controlled. He assigned zero value to the land of the LLC that was transferred to his own entity. Among other things, the manager allegedly also paid himself for redevelopment costs from LLC funds, instead of retaining the value of the adjacent property for the LLC and its members. Slip op. at 36-37.

Key Takeaways

  • The most momentous part of this opinion is the explanation about why the fiduciary duty claims were not preempted by the breach of contract claims–notwithstanding the primacy of contract under Delaware law. Slip op. at 37-38. Compare footnotes 124 and 125. In sum, the fiduciary duty claims only survived to the extent that they did not duplicate the breach of contract claims.
  • Importantly, the court buttresses its reasoning with the venerable Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 439 (Del. 1971), which announced one of the most famous equitable principles: “inequitable action does not become permissible simply because it is legally possible.” Slip op. at 39 and fn. 106. Another variation on this bedrock principle of Delaware law is that corporate actions must be twice-tested: once by the law and again by equity. Fn. 106.
  • As applied to this case, the court explained that simply because the LLC agreement may have been technically complied with–default fiduciary duties do not disappear as a check on managerial conduct. Id. [The LLC agreement expressly allowed the members to compete against the LLC,  which might explain why the malfeasance was not described as an usurpation of corporate opportunity.]

A few other well-settled principles that are well-known to readers are still worth reiterating as a refresher:

  • Traditional common law fiduciary duties of loyalty and due care apply to LLC managers–unless unambiguously limited. Slip op. at 30 and fn. 84.
  • In order for traditional fiduciary duties to be eliminated or limited in an LLC agreement, the language must plainly and unambiguously disavow common law fiduciary duties. Slip op. at 30-31 and fn. 87-91.
  • Primacy of contract only preempts fiduciary duty claims when the LLC agreement expressly and unambiguously disavows fiduciary duties. Id.
  • Any ambiguity in the language of the LLC agreement about whether fiduciary duties were waived–is resolved in favor of the full panoply of duties. Fn. 117.
  • The court relied on the well-worn USA Cafes case to explain why the individual manager of the entity that served as the manager of the LLC was exposed to personal liability for breach of the fiduciary duty of loyalty. Fn. 96.
  • A classic description of the elements of fiduciary duty and what that obligation entails, is always useful. See Slip op. at 32-33 and fn. 92-95. E.g., a fiduciary “cannot play ‘hardball’ with those to whom a fiduciary duty is owed.”
  • Tolling of the statute of limitations is available in three situations.  Slip op. at 21-23. One of them is equitable tolling during a plaintiff’s reasonable reliance upon the competence and good faith of a fiduciary. No evidence of actual concealment is necessary for tolling under this category. Slip op. at 26.
  • Inquiry notice is explained in terms of when someone should have been aware of activity that would trigger the beginning of the statute of limitations period–which Chancery usually follows but is not required to do so. Id.
  • Chancery follows a 3-part test to determine if a claim is time-barred. Although the defense of laches is not well-suited for a Rule 12(b)(6) motion, see fn. 66, Chancery often follows the 3-year S/L for breach of contract, fraud and fiduciary duty claims. Slip op at 21-23.
  • A prior action for books and records based on the LLC agreement was withdrawn after this plenary action was filed, but the court allowed a claim to proceed for breach of the LLC agreement due to failure to provide the requested books and records required under the LLC agreement.

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

Delaware’s Supreme Court recently reversed the Chancery Court’s refusal to stop a stock sale intended to shift the power balance between rival deadlocked UIP Companies Inc. stockholder factions, finding the sale likely inequitable — although fairly negotiated — if designed to impede investors’ franchise right in Coster v. UIP Companies, Inc., et al., No. 49, 2020 opinion issued (Del. June 28, 2021.)

The en banc high court’s unanimous opinion required the trial court to reconsider its ruling that after the UIP board found the stock sale to the defendant shareholders passed the rigorous entire fairness test they were not required to decide whether it would wrongly tip a 50/50 standoff with plaintiff stockholder Marion Coster. After remand, if the Chancellor decides the board acted for inequitable purposes or in good faith but for the primary purpose of disenfranchisement without a “compelling justification” it should cancel the stock sale, and consider appointing the custodian plaintiff requests, the justices said.

A higher law

While a transaction that is proven to be entirely fair as to price and process may be legal, it could still be inequitable because two seminal state Supreme Court opinions say that under Delaware corporate law, the sanctity of the shareholder franchise tops entire fairness review, Chief Justice Collins Seitz wrote.

The decision will likely be closely studied by corporate law specialists who advise owners and investors in real estate, securities and commodity investment firms which are often recently created, closely held and wracked by contests for control. Notably, the Supreme Court took the occasion to reiterate that “careful judicial scrutiny will be given [to] a situation in which the right to vote for the election of successor directors has been effectively frustrated and denied.”

“As early as Schnell v. Chris-Craft Industries, Inc., 285 A.2d at 439, we recognized that a board of directors could not escape judicial review of its actions by pointing to the legal authorization to undertake a given act” he said, noting that “Delaware law recognizes that the stockholder franchise is the “‘ideological underpinning’ upon which the legitimacy of the directors managerial power rests.:

The Supreme Court, in MM Cos., Inc. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003), later endorsed the standard the Chancery Court used in its ruling in Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988). Blasius held that, even though Schnell did not apply when the board acts in good faith, if the board nonetheless acts for the primary purpose of impeding stockholders’ franchise rights, the board must prove a “compelling justification” for its actions.

Background

The litigation arose during a deadlock between two 50 percent shareholders of UIP Companies Inc., a Delaware-chartered real estate investment services parent corporation that operated through three subsidiaries and made special purpose entities – high risk, high return investments – a major part of its business. Two of its three founders, Wout Coster and Steve Schwat, each ended up with half of UIP’S stock
After Wout died before the company decided on a value for his stock, his wife, Marion ended up a rival to Schwat and the three-member board.

When the two factions were unable to elect directors, Marion filed suit in Chancery Court seeking the appointment of a custodian to break the deadlock and the Schwat faction countered by selling stock to a board ally. Coster added a suit challenging that motive.

Beside the point?

In her opinion, the Chancellor found that although the directors were conflicted, the price and negotiation of the sale passed the required entire fairness test, so any other considerations – such as the board’s motivation – were “beside the point,” since there was no more demanding test.

On appeal, the high court said, “In our view, the court bypassed a different and necessary judicial review where, as here, an interested board issues stock to interfere with corporate democracy and that stock issuance entrenches the existing board.” It said the Chancellor should have considered whether “the board approved the Stock Sale for inequitable reasons, or in good faith but for the primary purpose of interfering with Coster’s voting rights and leverage as an equal stockholder without a compelling reason to do so.”

May, not must

If the Court of Chancery on remand considers the appointment of a custodian, under 8 Del. C. § 226(a)(1) the court “may”— not “must”— appoint a custodian when deadlock occurs, the justices decided. “The court will have to consider several factors, including whether on a more complete record the appointment of a custodian will breach agreements or otherwise harm the corporation.”

 

A recent Delaware Court of Chancery decision is useful for its description of the various options that a non-breaching party to contract has if she believes that a breach of contract has occurred. In Macrophage Therapeutics, Inc. v. Goldberg, C.A. No. 2019-0137-JRS (Del. Ch. June 23, 2021), the court explained that among the options available for one claiming a breach of contract: is not self-help.

Regular readers of these pages may recall multiple prior blog posts on both veil-piercing and reverse veil-piercing over the last 16 years. Serious students should review the book on the topic by the renowned corporate law scholar, and a friend of this blog, Professor Stephen Bainbridge. The Delaware Court of Chancery recently recognized reverse-veil-piercing in the matter styled: Manichaean Capital, LLC v. Exela Technologies, Inc., C.A. No. 2020-0601-JRS (Del. Ch. May 25, 2021).

Much commentary has already been published about the public policy and related implications of this decision. See, e.g., Professor Bainbridge’s emphasis that the opinion in this recent Chancery ruling only endorses “outside reverse veil piercing and not insider RVP.” See also Keith Paul Bishop’s commentary on the case.  See generally samples of Professor Bainbridge’s  multiple publications on the topic as referenced in many of this blog posts. I typically do not supplement existing extensive commentary on a decision that has already been the subject of many published insights, but because this is a topic of enduring importance, I want to call to the reader’s intention some of the existing commentary.

Of note, in connection with the facts of this case, is the long list of entities involved as parties, and the court’s observance that to disregard the legal entities, it was first required to engage in conventional corporate veil-piercing, as well as reverse corporate veil-piercing by traveling the following route: reaching upwards to the parent, and then downwards to reach wholly-owned subsidiaries. The court acknowledged that the legality of reverse veil-piercing appeared to be a matter of first impression in Delaware. The ruling was in the context of denying a motion to dismiss under Rule 12(b)(6), so we do not yet know the final outcome if the case goes to trial.

The court found that the pleadings sufficiently alleged fraud and injustice that might result, depending on the evidence presented at trial, from abusing the corporate form to avoid collection of a judgment.

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Court of Chancery recently ruled that SmileDirectClub Inc. investors did not have derivative standing to charge that their stock value was disloyally devalued by their directors’ excessively-priced insider transaction because it originated before the initial public offering in which plaintiffs became stockholders, in In Re SmileDirectClub Inc. Derivative Litigation, No. 2019-0940-MTZ, opinion issued (Del. Ch. May 28, 2021).

Vice Chancellor Morgan Zurn’s May 28 decision dismissing breach-of-duty charges interpreted a key Delaware Supreme Court opinion on the contemporaneous ownership requirement as saying the challenged insider stock sale must be dated when the SmileDirect board approved it—not when it took effect after the IPO.

The opinion should be a useful guide for determining derivative standing, particularly for thorny issues that often arise involving the timing of mergers and stock sales. It applies Section 327 of the Delaware General Corporation Law using the state supreme court’s ruling in 7547 Partners v. Beck, 682 A.2d 160 (Del. 1996), to determine when an alleged wrongful act occurred and the Chancery Court’s Leung v. Schuler, 2000 WL 264328 (Del. Ch. Feb. 29, 2000), ruling to decide whether a transaction qualifies as an exception to the Beck rule.

Using that guideline, Vice Chancellor Zurn found that the SmileDirect insider stock sale fit squarely into the Beck category and had little in common with the Leung exception.

Background
SDC, a pioneering direct-to-customer med-tech supplier of discounted orthodontic treatments founded in 2014, decided to reorganize its ownership structure as a Delaware-chartered company in 2019 and disclosed that it would use the proceeds of an IPO to repurchase the earlier investment of six insider directors and their entity allies.

The complaint filed by plaintiffs Kerry Harts and the Doris Shenwick Trust alleged that they were unaware when they bought stock in the SmileDirect’s 2019 IPO that it would be devalued by an insider stock sale that the board had agreed to earlier. The suit charged that the board breached its duty by agreeing to use most of the IPO’s proceeds to pay an “exorbitant price” to purchase the investments.

When the stock price cratered in the days after the IPO because of the prior purchase-price payout, new investors were cheated, plaintiffs said.

No stock, no standing, no suit
The defendants moved to dismiss, arguing that although the stock buy automatically went into effect at the time the IPO provided it with funds, the agreement was inked earlier, when plaintiffs had no stock. The Vice Chancellor agreed, noting that the IPO prospectus clearly disclosed the board’s intention to use up to $808 million of the proceeds to pay for the old SmileDirect stock.

“In Beck, the Delaware Supreme Court held “the timing of the allegedly wrongful transaction must be determined by identifying the wrongful acts which [the plaintiffs] want remedied and which are susceptible of being remedied in a legal tribunal,” the Vice Chancellor said.

But she noted that, “When the plaintiff challenges “the technicality of [a transaction’s] consummation,” rather than the terms of the transaction itself, the Court will measure standing from the time the transaction was completed.”

Nothing like Leung
Plaintiffs argued that, as in Leung, “the wrongful act forming the basis of the derivative claim took place when the [Insider Transactions] w[ere] completed, after Plaintiffs became stockholders,” as “no claim could have arisen until the Company’s intent was manifested despite changed circumstances,” namely the continuously declining stock price and the allegedly undisclosed regulatory challenges that were publicly aired only after the IPO closed”

But the Vice Chancellor ruled that this case bears no resemblance to Leung or any other opinion on Beck exceptions. She said plaintiffs’ primary issue is that the Board:
(1) fixed the Insider Transactions’ price together with the IPO, knowing both prices were inflated; and (2) consummated the Insider Transactions at those prices, even as the market.

Baked-in price
Regarding the alleged board agreement to an overpriced insider sale, she said the board, “must have approved or acquiesced in the pricing” before Plaintiffs purchased stock in the IPO because that price “was baked into the IPO, and Plaintiffs were aware of it.”

In granting the motion to dismiss, Vice Chancellor Zurn noted that “this does not mean Plaintiffs are without recourse; it simply means that Plaintiffs do not have the authority to pursue these derivative claims on SDC’s behalf.”

A recent Delaware Supreme Court ruling validated a decision of the Delaware Court of Chancery from almost two decades ago which held that federal bankruptcy law does not entirely preempt the Delaware LLC Act in all respects to the extent that the LLC Act provides for a member of an LLC to become an assignee only with economic rights upon the filing of bankruptcy by that member. Zachman v. Real Time Cloud Services LLC, 228 A.3d 1065 Order (Del. April 20, 2020).

For purposes of this short blog post, I am going to provide a few key bullet points and recommend that the reader review the entire decision issued in the form of an Order.

● Section 18-304 of Title 6 of the Delaware Code, which is part of the Delaware LLC Act, provides a description of those situations where a person ceases to be a member of a Limited Liability Company. Section 18-304(1)(b) states that a person ceases to be a member of a Limited Liability Company when he files an involuntary bankruptcy petition.
● The Delaware Court of Chancery in Milford Power Co., LLC v. PDC Milford Power, LLC, 866 A.2d 738, 762 (Del. Ch. 2004), reasoned that to the extent Section 18-304(1)(b) provides that a member who files for bankruptcy ceases to be a member, but becomes an assignee with economic rights only as codified in Section 18-702(b), the normal federal preemption of bankruptcy law does not apply to interfere with the implementation of that aspect of the Delaware LLC Act. The Zachman Court upheld the reasoning in Milford Power which reached the same conclusion.
● The Court’s reasoning included an observation that Section 18-304 is not preempted by federal bankruptcy law because a member filing a personal bankruptcy petition ceases to be a member of the limited liability company at that time.
● Section 18-702(b) of the Delaware LLC Act codifies the status of that former member as an assignee only with economic interests and no further managerial role in the limited liability company post-bankruptcy filing.
● This ruling is best understood in the context of the detailed facts of the case as recited in the Court’s decision.