The Court of Chancery recently allowed, after trial, a claimant to disregard the corporate entity, which the court found was involved in a fraudulent conveyance. The case styled: Fringer v. Kersey Homes, Inc., C.A. No. 9780-VCG (Del. Ch. June 25, 2018), begins with the following three sentences:  “The great advantage of the corporate form is that it permits investment and ownership without risk of personal liability for entity debt.  This advantage has its limits, obviously.  One such limitation is involved here.” (FYI: There is no typo in the Plaintiff’s name in the above case caption.)

For those interested in the topic of “piercing the corporate veil,” friend of the blog, Professor Stephen Bainbridge, has co-authored a book that includes an in-depth scholarly analysis of the topic. The good professor has published a lengthy list of books and articles on corporate law that are often cited by the Delaware courts.

Although the net result is the same, this decision does not undertake a “conventional analysis” that directly addresses piercing the corporate veil, and the facts of this case are not likely to be repeated, but a number of more traditional “piercing the corporate veil” cases have been highlighted on these pages over the last 13 years.

Brief Background:

The corporation involved, Kelsey Homes, Inc., was a defendant in a prior lawsuit based on allegations of fraud in connection with an agreement to sell a modular home. At the time of that agreement, Kelsey Homes, Inc. was “moribund.”  By the time trial approached in the prior fraud suit, its only asset was the modular home at issue in the litigation.  Kersey Homes, Inc. had transferred its only asset in a back-dated bill of sale to a relative of one of the stockholders, and then defaulted on the fraud action.

The court found that the stockholders of the corporate defendant were wrong when they thought that a judgment against the now-insolvent Kersey Homes, Inc. would be beyond the reach of the resulting judgment creditors.

The court held that the “sale” of the only corporate asset to a related party was a “sham” and the transfer was fraudulent under Delaware’s Uniform Fraudulent Transfer Act. The court granted the plaintiff in this case  a levy on the property, to receive the sales proceeds in an amount sufficient to satisfy the judgment.

Procedural History:

The prior fraud suit against Kersey Homes, Inc. regarding the sale of the modular home, resulted in a judgment being entered by the Superior Court.  Although Kersey Homes, Inc. had initially defended the Superior Court action, shortly before trial they informed the court that they would not defend it.  The modular home that was the subject of the Superior Court lawsuit, was transferred by Kersey Homes, Inc. to an affiliated party in exchange for discharging a prior debt of Kersey Homes, Inc.  This transfer of the only asset of Kersey Homes, Inc. was made about one year into the litigation over the home that was the subject of the transfer and about two months prior to judgment being entered shortly before the trial date.

The instant litigation in the Court of Chancery was commenced about two weeks after the judgment was obtained in the Superior Court. The Chancery complaint sought relief against Kersey Homes, Inc. (which filed a certificate of dissolution several months after the Chancery complaint was filed), as well as the principal stockholder of Kersey Homes, Inc. and the related party that had received the fraudulent transfer.  Kersey Homes, Inc. did not defend the Chancery litigation.

The court did not believe the testimony of the principal stockholder in part because the transfers were not documented and the only person available to testify about the transfer was the transferor.

The court determined that a more likely explanation for what happened was that the principals of Kersey Homes, Inc. realized they might be liable for a judgment and decided to take steps to evade any judgment that might be obtained. At the time of the fraudulent transfer, Kersey Homes, Inc. was already out of business and insolvent, without assets to satisfy a judgment.  But about a year earlier, the only asset of Kersey Homes, Inc. had been transferred for no consideration.  In an effort to defend a potential fraudulent conveyance claim, the principals of Kersey Homes, Inc. attempted to cover their tracks and create a story about a backdated transfer one year earlier.  The court found that those transfers were intended to avoid execution on a judgment.

Key Legal Principles:

The court reviewed the elements of a claim under the Delaware Uniform Fraudulent Transfer Act (“DUFTA”) whose purpose the court described as providing a remedy to creditors who were defrauded by debtors who transfer assets or incur obligations with the intent to hinder, delay or defraud any creditor or, without receiving reasonably equivalent value. The court described the elements of a claim as recited in Section 1304(a) of Title 6 of the Delaware Code.

There are eleven factors that the statute lists as non-exclusive factors to consider in determining whether there was actual intent to defraud. It is not necessary that all the factors support a finding of intent.  In this case, the court found that seven of the factors supported a finding of actual intent to defraud.

The court also found that Kersey Homes, Inc. violated Section 1305(a) which provides that a transfer is fraudulent as to a creditor whose claim arose before the transfer was made, if the debtor made the transfer without receiving a reasonably equivalent value or the debtor became insolvent as a result of the transfer. See footnote 117.

The opinion also discussed the broad latitude that a court has to craft a remedy subject to applicable principles of equity. Even though the original judgment was against a defunct corporation, the court traced the fraudulently transferred assets of the corporation to its current owner who was a stockholder in that corporation.

In sum, the court allowed the plaintiff to levy execution on the home involved in order to satisfy the judgment obtained in the Superior Court. The court also required the defendants to account for rental receipts on the house, and to the extent the sale of the property is insufficient to satisfy the judgment, the shortfall shall be made up from the rental receipts.

Because of a statute that applied in the Superior Court to grant treble damages for consumer fraud on senior citizens, the court found it inequitable to depart from the American Rule on fees.

A recent Court of Chancery opinion provides a useful reiteration of the reasons why the entire fairness standard will apply to a transaction between a controller and a controlled corporation. The case of In Re Hansen Medical, Inc. Stockholders Litigation, C.A. No. 12316-VCMR (Del. Ch. June 18, 2018), arose from a squeeze-out merger.  The court addressed claims by a purported class of minority stockholders who alleged that a group that controlled more than 50% of the acquired company, used their control to negotiate a beneficial deal for themselves at the expense of the minority stockholders.

Noteworthy nuggets of Delaware corporate litigation principles applied in this decision include the following:

• The court discusses the two ways in which a person or a group of persons will be considered “controllers” for purposes of determining the applicable standard of review. See Slip. Op. at pages 15 and 16.
• The court explained that the entire fairness standard applies to a transaction between a controller and a controlled corporation. See page 15.
• The court also distinguished several prior decisions, on a factual level, where no control group was found. See footnotes 79 and 80.
• The court provides the definition and an explanation of the entire fairness standard at page 25.
• The court explains that in line with the case of Cornerstone Therapeutics, Inc. Shareholder Litigation, a plaintiff must plead a non-exculpated claim for breach of fiduciary duty against an independent director protected by an exculpatory charter provision adopted pursuant to Section 102(b)(7), or that director will be entitled to be dismissed from the suit. See page 26 (citing 115 A.3d 1173, 1179 (Del. 2015)).
• Notably, the court explained, however, that an exculpatory charter provision does not apply to claims of breaches of the duty of loyalty, claims against officers or claims against controlling stockholders. See footnote 104.
• The fiduciary duty of disclosure was discussed, and in particular the truism that: “Directors of a Delaware corporation have a fiduciary duty to disclose fully and fairly all material information.” See footnote 109. The court added that when a board chooses to disclose a course of events or discuss a specific subject, it cannot do so in a materially misleading way by only disclosing part of the story and leaving the reader with a distorted impression. Rather, “disclosures must provide a balanced, truthful account of all matters they disclose.” See footnote 111.
• The court discusses what facts will be considered material and what omissions will be considered material.
• The court also discusses the prerequisites for satisfying a claim for “aiding and abetting a breach of fiduciary duty.” See pages 31 and 32.

The recent Delaware Court of Chancery opinion in Deutsch v. ZST Digital Networks, Inc., C.A. No. 8014-VCL (Del. Ch. June 14, 2018), addresses the court of equity’s authority to issue arrest warrants to enforce its orders. But because it involves facts that are so unusual, for purposes of a short blog post, the only aspect of the decision that is likely to be of widespread application is the court’s careful and scholarly analysis of why it has the authority to issue bench warrants for the arrest of corporate officers whose company has failed to comply with prior court orders finding the company in contempt.

Although the court has the authority to issue bench warrants for the arrest of the corporate officers for the failure of their company to comply with prior court orders, the court decided that before it would issue bench warrants, it would give the corporate officers one final attempt to comply with prior orders and, if requested, the court would hold an evidentiary hearing. In any event, the corporate officers would be able to purge the sanction of coercive imprisonment at any time by complying with the prior orders of the court.

The background facts and procedural history include a demand for books and records from a Delaware company whose principal place of business is, or was, in China. The company ignored multiple prior orders of the court, including prior contempt findings, based on the failure of the company to comply with prior orders.

SUPPLEMENT: A Bloomberg article links to this post and provides a more detailed commentary on this case.

In a recent Delaware Court of Chancery decision in Edinburgh Holdings, Inc. v. Education Affiliates, Inc., C.A. No. 2017-0500-JRS (Del. Ch. June 6, 2018), the court addressed certain procedural rules that should be of interest to corporate and commercial litigators to the extent that the court explains when certain causes of action may or may not be pursued at the same time in the same case.

Brief Background:

This case involved the sale of an education-related business that provided for future payments contingent upon the acquired business achieving certain revenue targets after closing.  The contingent purchase price was payable in four annual installments.  The litigation arose from the refusal of the buyer to make the final annual payment.

Key Legal Principles Addressed by the Court:

For purposes of this short blog post, it is useful to address three important principles applicable to corporate and commercial litigation that should be of widespread applicability and interest.

• The court explains those situations in which a breach of contract claim–and a breach of the implied covenant of good faith and fair dealing–may be pursued in the same case. There are situations where such claims would be duplicative, or an implied covenant claim would be preempted by a breach of contract claim for the same actions, but this opinion explains when one may “thread the needle” to pursue both claims at the same time. See Slip op. at 21 and footnotes 82 to 84.
• Likewise, dual claims of both breach of fiduciary duty and breach of contract in the same case may only be pursued when they do not run afoul of the following prohibition:“Delaware courts will dismiss a breach of fiduciary duty claim where it overlaps completely with a breach of contract claim and arises from the same underlying conduct or nucleus of operative facts as the breach of contract claim. To determine whether there is an independent basis for fiduciary claims arising from the same general events, the Court inquires whether the fiduciary duty claims depend on additional facts as well, are broader in scope, and involve different considerations in terms of potential remedy.” See Slip op. at 38 and footnotes 136 and 137.

Another articulation of well-established law in this decision that is of great practical usefulness for commercial litigators is the truism that the court explained: one cannot “bootstrap” a breach of contract claim into a fraud claim. See Slip op. at 26 and 27 as well as footnotes 100 and 101. In particular, the court explained that:

• “Delaware law holds that a plaintiff cannot “bootstrap” a claim of breach of contract into a claim of fraud merely by alleging that a contracting party never intended to perform its obligations. In other words, a plaintiff cannot state a claim for fraud simply by adding a term ‘fraudulently induced’ to a complaint or alleging that the defendant never intended to comply with the agreement at issue when the parties entered into it.”
• Moreover the court observed that “couching an alleged failure to comply with a contract as a failure to disclose an intention to take certain actions arguably inconsistent with that contract is exactly the type of bootstrapping this court will not entertain.”